If homebuilder Toll Brothers (NYSE: TOL) had the opportunity, it probably would like to turn the calendar back to 2021. At that time, many real estate experts suggested that, if possible, prospective homebuyers should pull the trigger since inflation will continue rising. Recently, though, the Federal Reserve poured cold water on that thesis, suggesting the opposite framework will be true. Now, an inventory metric is revealing that things may not be great, going forward. Therefore, I am bearish on TOL stock.
Despite some emerging signs that companies such as Toll Brothers may be due for a valuation unwinding, the mainstream media still presents a bullish framework from the perspective of home sellers. For instance, just a few days ago, TIME issued a warning that those waiting for the housing market to crash shouldn’t hold their breath, according to experts in the field.
Even more perplexing for those monitoring TOL stock, the underlying company continues to post encouraging financial results. The luxury homebuilder released its Q3 results (ending July 31, 2022).
Adjusted for non-recurring items, TOL posted earnings per share of $2.35, beating Wall Street’s consensus estimate of $2.30 a share. In the year-ago period, Toll delivered earnings of $1.87 a share. Over the last four quarters, the homebuilder surpassed estimates all four times.
On the revenue front, Toll rang up $2.49 billion, beating the consensus target by 0.37%. The firm also beat its own tally from one year ago (sales of $2.26 billion). Similar to the bottom-line trajectory, Toll topped consensus estimates for revenue four out of the last four times.
Based on the stats above, market observers might be tempted to bid up TOL stock. However, the glaring detail is that the security lost 37% of market value on a year-to-date basis. Also, over the trailing month, TOL declined by 7%. Therefore, the narrative isn’t quite as compelling as the Q3 results would have people believe.
Nonetheless, on TipRanks, TOL has an 8 out of 10 Smart Score rating. This indicates moderate potential for the stock to outperform the broader market.
TOL Stock and the Days Inventory Outstanding Problem
Although TOL stock looks encouraging from the current snapshot of events, the market is a forward-looking arena. Therefore, it’s not about what is right now but rather what will likely be in the future. Under this framework, Toll Brothers may not be appealing for arguably most investors, and it largely has to do with the company’s days inventory outstanding (DIO). This metric is used to estimate the average number of days a company keeps inventory before finding a buyer for it.
For Toll’s fiscal year ended October 31, 2019, it featured a DIO metric of 498.5. One year later, days inventory outstanding only increased slightly to 500.8. However, with inflation rapidly eroding the purchasing power of the dollar, this line item fell conspicuously to 415.1.
Naturally, with people competing against each other in unprecedented bidding wars, Toll Brothers and its ilk began selling their products at an aggressive rate. For context, in Fiscal Year 2007, the company had a days inventory outstanding of 517.25.
Circumstances got so bad (in terms of inventory levels) that this metric dipped to 315.7 in Fiscal Q4 2021. However, the paradigm is shifting. In the following fiscal Q1 2022 report, Toll disclosed a DIO of 541.94, representing nearly a 72% increase quarter-to-quarter.
To be sure, the metric has come down to 441.48 in the most recent Q3 report. Nevertheless, the trend is clear: DIO as a whole is rising, reflecting a major pivot in the underlying economy.
The Fed Changes the Rulebook
Toward the end of August, Fed chair Jerome Powell gave his policy speech at the annual economic symposium at Jackson Hole, Wyoming. Acknowledging the multi-decade highs in inflation, Powell reiterated the central bank’s commitment to tackling sharply rising consumer prices.
According to the official transcript, the Fed chair stated the following. “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth.”
“Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
Investors should key in on two central admissions. The Fed understands that controlling runaway inflation will take time. Second, Powell recognized that raising the benchmark interest rate will incur pain for households and businesses.
Put another way, the paradigm of generally dovish monetary policies – exceptions, of course, exist – which has been in place for decades will shift and shift dramatically. Moving forward, hawkishness will rule the day, which doesn’t support risk-on investments or risk-on behaviors.
Therefore, TOL stock finds itself now on the wrong end of the economic and monetary spectrum.
Is TOL a Good Stock to Buy?
Turning to Wall Street, TOL stock has a Moderate Buy consensus rating based on four Buys, seven Holds, and zero Sell ratings. The average TOL price target is $53.33, implying 17.6% upside potential.
Conclusion: Recognizing the Signs
Just as much as the Fed chair recognizes the signs of what he must do to control inflation before it becomes an insurmountable crisis, investors should also realize that the framework for TOL stock has changed. With the incentivization structure no longer favorable for buying real estate (at elevated prices), it’s probably time to head for the sidelines.
