Toll Brothers Stock: Valuation Has Already Priced Up Near-Term (NYSE:TOL)

Overview of investments

I rate Toll Brothers a hold (NYSE: TOL) as the valuation multiples have already priced the price up in the short term. However, I want to emphasize the positive demand trend that should last for foreseeable future, given the favorable housing supply situation and the outlook for lower rates. Positive revenue growth should translate into higher EPS growth as the margin benefits from lower rates and better operating efficiencies.

Business description

TOL designs, builds and sells luxury homes in the United States. TOL’s product offerings range from spec (speculative home) to single and custom attached homes. Part of TOL’s strategy is also to offer incentives to attract buyers. The company last reported its 3Q24 earnings two weeks ago, and it was a stellar one, with operating EPS of $3.60 beating the consensus estimate by a big margin. It was total revenues of ~$2.73 billion, gross profit of ~$775 million and EBITDA of ~$517 million. All of these were better than Street expectations of $2.71B, ~$730M, and ~$513.8M, respectively. One of the key growth metrics to monitor — orders — also saw a very healthy 11% growth.

Given the strong performance in 3Q24, management has raised its guidance for FY24, now expecting closes of 10,650 to 10,750 (implied y/y growth of 11-12%), versus the previous target of 10,400 to 10,800 (implied y/y growth default y/y of 8-13). %); ASPs of $975,000 vs. previous target of $960,000 – $970,000; Adj gross margins of 28.3% (vs. 28% previously). Coupled with these are lower general and administrative costs (now expected to be 9.4% as a percentage of sales versus 9.6% previously); and a higher share buyback target of $600 million from $500 million previously. Overall, guidance implies much stronger EPS growth, and management raised operating EPS guidance to a range of $14.50 to $14.75 from a previous target of $14.

Businesses should continue to see strong demand

In my view, current US macro conditions continue to favor TOL. I think the US is still in an undersupply situation, which benefits new home builders like TOL. With housing starts continuing to decline, it looks like this undersupply situation will continue for the foreseeable future. The counter to this is that mortgage rates have been gradually falling due to the expectation of a rate cut (which the Fed appears to be doing) and that has caused existing housing stock to come back online (believing the undersupply situation). I agree with this counterpoint, but note that a considerable amount of US homeowners have mortgages below 4%. Which means there is still some time before mortgage rates become attractive enough to encourage most homeowners to put their homes up for sale. To be clear, I’m not saying this won’t happen, but I think it’s highly unlikely to happen in the short term (say in the next 12 months). On the other hand, a lower mortgage rate is an instant boost to housing demand, especially given the housing affordability situation.

Indeed, the demand trend seen in 3Q24 was consistent with my view as demand slowed through June but accelerated in July due to lower rates. The acceleration in demand was so strong that it continued into August (the first three weeks of August). Therefore, this gives confidence that management’s guidance for 4Q24 to see 2,490 unit orders is achievable. In particular, demand strength was driven in most key TOL markets. Specifically, strong demand was driven by New Jersey, Pennsylvania, Washington, DC, South Carolina, Georgia (Atlanta), Las Vegas and California. While parts of Texas saw lower demand, the trend in demand followed how the company as a whole did, improving demand in August.

One more point regarding the increase in the number of resale homes. While this represents competition for new home sales, I believe TOL will remain competitive in the short term given its inventory of spec homes (3,400 at end of quarter, including 750 completed) and ability to offer incentives including rate reductions mortgage at 4.375% for the first year and 5.375% for the next 29 years (much cheaper than today’s > 6% mortgage rates).

Positive profit margin outlook

Looking ahead, falling mortgage rates should also give TOLs the ability to price their homes better (ie, better pricing power) because homebuyers have purchasing power much bigger. In addition, lower rates should also reduce gross margin pressure from TOL incentives (management noted that the cost of buybacks will decrease in line with housing affordability). All this, coupled with TOL’s improving cycle times and the ability to unlock operational efficiencies (one of the key reasons driving margin growth in 3Q24), I would expect margins to remain healthy for the foreseeable future. For what it’s worth, EBITDA margin peaked at ~28% in 2005 and is ~23% over the last 12 months, so there’s definitely room for expansion.

The problem is that the valuation has set the price in the above

Unfortunately, it seems to me that the valuation has already been positively priced at this point. Historically, TOL has seen its forward PE return from the ~4x forward PE threshold in 2022 to ~10x today (this is the 10-year average). This positive revision can also be seen in other homebuilders, where the industry multiple has returned to ~10x. As such, I don’t think there is a strong advantage from a multiple rating perspective. The upside from here will be driven by EPS growth. However, using consensus estimates as a benchmark, which TOL has historically beaten over the past 5 years, means that TOL shares will be worth ~$146 (~2% above the current share price) based on EPS estimate for FY25 of $14.63. Therefore, my view is equity neutral (but fundamentally bullish).

Conclusion

I give TOLL a hold rating. I agree that TOL should continue to see robust demand in the near term, driven by favorable housing supply and lower interest rates. However, the valuation has already factored in much of the upside as forward PE has recovered to its historical average (peers have recovered with the same trend). Any upside here must come from strong earnings growth, which, based on consensus EPS estimates, implies the stock is trading where it should be.