A Niche Market Success Story

By Usman Ghani –
July 15, 2013

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Usman is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

The housing markets still have room to run as the economic recovery of the country continues. What investors need is a company that can promise sustained growth in the coming years and for that purpose, I have selected a company known as Toll Brothers (NYSE: TOL). Toll Brothers designs, build and markets attached and detached homes in luxury residential communities. Let’s analyze why the company is positioned for growth.

Future growth prospects for Toll

Toll Brothers has a focused approach of targeting rich states like California, Texas, Miami and New York. Along with that, the company has been showing robust growth in its financial performance. In its 1Q13 results, the company reported a Year-over-Year (YoY) increase of 32% in revenue. The backlogs of the company stood at a solid $1.86 billion against a figure of $1.12 billion last year.

Toll Brothers targets a niche market that caters to the affluent American consumer only. Approximately, 78% of the homes sold by Toll Brothers are under the $700,000 bracket. The average selling price of the company’s homes has increased by 3.6% in the second quarter to a figure of $577,000. Furthermore, Toll Brothers is the only publicly listed U.S. luxury home builder. Due to this, the company has significantly larger access to capital for expansion. Other private players in the industry have remained capital constrained, which has limited their operational capabilities.

Another upside to the company is that it develops the widest variety of homes in the United States. Along with that, it has slowly entered the high-rise market. Its City Living pipeline has numerous high-rise residential properties under development in cities like Philadelphia and New York. This is a great niche carved out by the company as these major cities have a resounding affluent class that will definitely be interested in purchasing properties developed by a luxury builder.

Toll Brothers also benefits from its integration in the home building business. ESE consultant is a wholly owned subsidiary of Toll Brothers. Having an in–house engineering company allows several benefits to Toll which include superior land acquisitions and the maximization of land value. Toll Brothers also owns a Panel Truss Plant through which the company is able to manufacture and distribute floor and roof trusses, windows, wall panels and doors. Another business of Toll Brothers goes by the name of TBI Mortgage. The company has served 70% of Toll’s buyers in the 1Q13. With such wide integration, Toll will continue to exploit the recovery in the U.S. residential markets.

Lastly, the P/E ratio for Toll is 10.96, which is well below the P/E ratio of SP500 at 17.7. It means that the stock is undervalued with possible upside potential.

Downsides for other residential construction companies

On a long-term basis, other residential companies, such as Meritage Homes (NYSE: MTH) and Standard Pacific (NYSE: SPF), are at a disadvantage.

Meritage builds and sells first family homes in the United States. In its recent quarterly results, the company reported an increase in its home orders and home closings which led to an increase in its EPS. In the current market conditions, the future performance of the company seems attractive as backlogs of the company have increased by a whopping 89% on the YoY basis. This means that its customers have renewed confidence and they are willing to commit.

The situation is similar for Standard Pacific as it has reported some great numbers in its recent quarterly results. Its revenue increased by a whopping 61% on a YoY basis whereas its home deliveries increased by 48%. In recent news, the company has completed its acquisition of select assets from Centerline Homes. The assets include 3,000 home sites that will come under the control of the company. This acquisition will increase the company’s community count and move-up position in several attractive markets. 

It all looks great for both of these companies as they target the middle-income market for homes.The reality is not the same though as recently there has been a spike in interest rates. Market participants are concerned that the Federal Reserve may start to end its monetary policy of quantitative easing. As mortgage is the lifeline of residential real estate, the higher interest rates might slow down the recovery in the housing market. If I assume that the interest rates will keep on rising, then home builders targeting middle income groups will face a dilemma. On one hand they will have to reduce building due to the declining demand and on the other hand they will have to lower their prices, which will hurt their profits.

Toll Brothers’ answer to the downsides

The lower interest rates compelled mostly the middle income consumers to jump into the market for residential properties. If interest rates increase again, the middle income groups will be affected the most. As for Toll, its demand comes from the higher income segments of the economy and they are not affected as much as the middle income groups due to the changing interest rates. Therefore, I perceive that the demand for Toll’s residential properties will continue to rise.

The takeaway

The residential construction companies are poised for growth because the real estate sector of the United States still has to make its full recovery. With public perceiving interest rates to rise again, I believe that companies targeting middle income consumers will be affected the most. However, Toll Brothers, with its focus on a niche luxury market, will continue to prosper in the coming future.