Friday, August 05, 2005

Playing The Spot Market…For Houses


“With buyer appetite so healthy, approximately one-third of our communities now have backlogs stretching out twelve months. Therefore, in a number of communities, we've chosen to hold off taking new home sale contracts rather than lock in sales prices today for deliveries more than a year away. Instead of selling out communities too quickly, we've chosen to ration our supply to maximize profit.”

So said Robert Toll, CEO of the red-hot high-end homebuilder with his name on the door, in the company’s press release announcing yet another huge quarter yesterday.

Toll Brothers, in other words, is playing the spot market.

This move could have interesting consequences down the road, should the red-hot housing market ever blow a gasket.

Back in the prime days of the last energy boom (1979-1981) the oil service companies faced a similar situation: too much demand for their services from oil companies eager to drill as many wells as possible as quickly as possible, and too little capacity.

Solution? They raised prices—and the oil companies happily paid up.

As background, the term “oil service company” actually encompasses a wide range of offerings, from low value-added, anybody-not-too-hung-over-to-drive-a-truck-can-do-this services such as putting down portable mats over swamps so equipment can reach a drilling site in the bayou, to high value-added, don’t-try-this-at-home stuff like building floating offshore rigs the size of a large office building.

When the oil bubble burst—and burst it did, suddenly and with no helpful warning from Alan Greenspan or CNBC talking heads—the oil service industry hit the wall in pretty much a sequential order, from low value-added services with day-to-day contracts that dried up overnight, to the high value-added equipment with long-term contracts that took years to finish.

If you were an anybody-not-too-hung-over-to-drive-a-truck-can-do-this road-builder like Newpark Resources, it was “See ya!”

If you were a smart, well-run, big-rig operator like Sedco, you had a few years to work off your backlog before the order book vanished and you had to shut down the yards.

By holding off on new home contracts in certain areas—in the hopes of getting higher prices down the road—Toll Brothers is no longer just “a homebuilder.” It is now also a speculator, making bets that prices will be higher next month, next quarter, and next year.

And since the reality that building a house is of the anybody-not-too-hung-over-to-drive-a-truck-can-do-this type of business, Toll runs the risk of becoming the Newpark Resources of the next building cycle.

But I’m sure they know what they’re doing. Demand this huge never goes away. Just ask the folks at Newpark.


Jeff Matthews
I Am Not Making This Up


The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

24 comments:

dthorn said...

Given that capitalism is fueled by risk takers being rewarded for risk, is it fair to criticize TOL for behaving in a manner consistent with the incentives? Maybe the question should be what took so long? The timing on this is odd as demand for their goods has been strong for some time.

Additionally, if the housing market goes down like the oil service sector in your analogy, there is nothing they can do to avoid going down with it, short of trying to call the top and exiting the business. The implication in your analogy was that both the value-add and non value-add companies get hurt - just offset by the length of contract - in TOL's case 12 months. It seems to me that this only increases the incentive to take risk. i.e. can’t avoid the downside, can maybe win on the upside.

I feel, perhaps unfairly, that you are trying to have it both ways with your post. You get to cozy up to the implication that you are negative on housing without saying anything explicitly, and all you point out is the rather obvious fact that, like other things in life, housing is risky.

Is it really fair to knock Alan Greenspan or CNBC talking heads for failing to give ‘helpful warnings’ if you are unwilling to yourself? (Emphasis on helpful as I am not sure your current warning was helpful, but maybe I am missing your point? I know you don’t want to offer specific valuation/investing opinion in this forum.)

Prudent Investor said...

During the late 90s, homebuilders and banks learned their lessons really well from the early 90s bust. So inventories have been kept in check at 4 months level for the longest time I can remember. A decade and some later, the question now is whether the principals concerned still acting like 1990 was yesterday, evidence may suggest that they are loosening up such as interest only loan and TOL acting as speculator for instance. Having said that, the homebuilders still haven't been overbuilding and I suspect the fuel for this bubble may take another a year or 2 before burning out. Borrowing from the Japanese experience tells you that even if you expect DOW JONES to trend down from here, housing market may take another year or two to peak.

Jeff Matthews said...

"dthorn": my reference to Alan Greenspan and CNBC not providing warning about the oil bubble bursting was sarcastic--the point being that people who play in bubbles always think they will get out before it bursts...and they never do. Nobody rings the bell when the bull market begins, and nobody rings the bell when it's over. It happens when the maximum number of players are least prepared for it.

As for "having it both ways" by implying I am negative on housing without actually saying it--well, I make no recommendations here...no "OK TO BUY" or "HOLD" or "REDUCE" ratings. This blog is about information that is not part of the mainstream consensus, period, whether it concerns a company like Overstock or a business like housing.

If you want somebody to pick stocks for you, watch Cramer's "Mad Money"--he is as well-informed as anybody in this business and he is not afraid to tell you exactly what he thinks about any stock you choose.

Logicalthought said...

From a practical standpoint, the homebuilders may as well do this, because if the housing market truly tanks, the supposed "buyers" they might have had "locked in" today won't bother showing up for the closing 12 months down the road, anyway.

homebuilder said...

I agree with Logicalthought. TOL is not just going to be able to capitalize on higher prices down the road, they will also be able to better manage the risk involved. Selling homes that far out and making decisions based on those sales creates much more risk for TOL than actually seeing what the market is like 12 months down the road. If and when the market turns, they will be left holding the bag on those "presales". The supposed buyers will disappear and TOL will end up with much more inventory than they planned in a market with no demand. It seems to me that TOL is taking a more conservative approach to future business than they have been recently.

dthorn said...

My observation in my first post was not that you didn't pick stocks like Cramer but that you had failed to give us any information in your TOL post like you promise.

As far as i can gather the observation you make is that housing is a risky cyclical industry that is low value-add. Well that happens to be the consensus. That is the reason housing stocks trade at low multiples relative to both the market and to their growth.

I am not, however, trying to pick a fight, I figured I was just missing your point. I enjoy your blog and I am glad you take the time to write it. (perhaps small praise as I even find Cramer amusing - in small doses)

Alonso said...

TOL has almost $4.5 BILLION in inventory on their balance sheets. How can anyone say they are not speculating on house prices?

Also, interesting isnt it that they are not generating any cash whatsoever in the past couple years? They are managing for earnings, not cash generation. I give it a year until we see AOL-style asset impairment charges against these mammoth inventory levels all the homebuilders are carrying.

DaleW said...

I find Cramer enjoyable in all does -- I just think the camera work on his show is ridiculous.

I agree with the last poster -- all of this is in the consensus. The idea that home prices will fall and home builders will get killed is probably the more dominant investment hypothesis on these stocks. I think the Time cover is trotted out by everyone (look at the midyear Barron's round table -- one ONE person is bullish on the sector, the oldest guy on the panel, I might add; everyone else thinks it's a bust) is a total straw man. For every Time cover I have seen, there is a bearish Economist or Barron's article. For every fool at a cocktail party talking about how he struck it rich in real estate and for every fool candidate on the Apprentice making it in real estate, there is a bearish person I meet at cocktail parties.

The last poster nailed it -- these things are trading with implied competitive advantage periods of negative 1-3 years. Or, re-arranging the math, a 100% proabability of down earnings or a lower probability of a big decline in earnings sometime reasonably soon.

This is where the 10-baggers come from. Dell at 6x earnings was just another commodity PC company. Same argument people trot out here. And of course Fred Hickey was standing by with his commentary that everyone would get killed in Dell at each and every click along the way.

It's in the stocks. And if the bulls are wrong, then this is why we have portfolios. I know some shorts (not Jeff, I don't know him) that don't get this -- it's frequency vs. magnitude, i.e., this is why we have portfolios!

Its_strange said...

I wonder what Greenspan thinks of the trading in Baidu.com , gains in jobs and wages , and the TOL move....

Jeff Matthews said...

So...I guess the non-consensus thing to do is to buy every house and condo you can get your hands on, right now, because somebody will pay more for it tomorrow and next week and next year, without regard to absolute value?

Naively, I thought the non-consensus thing to do was to buy real estate in 1990-92, when the S&L industry was in crisis and the Resolution Trust was hitting bids on perfectly good properties for a fraction of cost.

I guess--like the old-time money managers in 1999-2000 who either closed up shop or got with the New Economy--I'd better either jump on the real estate bandwagon or stop barking at the tires.

Nope. I'll put a stake in the ground right here, and say what so many others have been saying for so long that they've shut up already: the housing cycle is over. The high-water mark has been reached, today, August 5, 2005, when the 2 year yield hit 4.10%.

Those of you who expect the trees to keep growing to the sky, speak up and we'll tally the results.

Let's make it fun, clean, with no name-calling and some good arguments--just like the real estate bulls have been doing thus far.

And we'll see where things stand six months from now!

Its_strange said...

If that backlog is caused by speculators perhaps the appetite is a illusion. How much money would someone have to come up with if they wanted to lock in a price ? Zero ? Kinda like getting a mortgage ? ....Did TOL comment on the other two-thirds of thier communities ? . Does Robert Toll like to promote the stock ? Is he a builder or a Wallstreet smoothy ? What happens to the stock or housing market if and when TOL puts these homes up for sale ? .....And what " high-end" home takes a year or less to build ? ......

Its_strange said...

And with each passing day will we see TOL put a few more homes on the market ? .......I mean what will it take for TOL to ignore its new policy ? How much money ? ..........This could be just wallstreet gamesmanship.

coolbreeze_23 said...

Keep in mind that the price of housing is not booming everywhere in the country. Price gains in Charlotte, NC, and in many other red state locations have been modest. I wish I understood what it would take to bring the party here, but...we've seen tons of building, without radical price gains. So I'm not looking for a bust, either.

Logicalthought said...

coolbreeze: If, if fact, there really is "tons of building" without "radical" price gains where you are, then I'd think your chances of a "bust" are probably pretty good, too. After all, a lot of your "ton" of new supply has got to be getting absorbed by people fleeing other, pricier markets. Well, once that "fleeing" ends, who's gonna soak up that supply???

DaleW said...

So...I guess the non-consensus thing to do is to buy every house and condo you can get your hands on, right now, because somebody will pay more for it tomorrow and next week and next year, without regard to absolute value?

I thought we were talking about home builders, not homes. The economics of the industry and the economics of these equities are not wholly or even largely driven by home prices continuing to rise. Home prices could go sideways or even down from here and home builders would still outperform from here, in my opinion.

Naively, I thought the non-consensus thing to do was to buy real estate in 1990-92, when the S&L industry was in crisis and the Resolution Trust was hitting bids on perfectly good properties for a fraction of cost.

Did this not work out? I would think it did unless you were over-leveraged.

I guess--like the old-time money managers in 1999-2000 who either closed up shop or got with the New Economy--I'd better either jump on the real estate bandwagon or stop barking at the tires.

Who says it's one or the other?

Nope. I'll put a stake in the ground right here, and say what so many others have been saying for so long that they've shut up already: the housing cycle is over. The high-water mark has been reached, today, August 5, 2005, when the 2 year yield hit 4.10%.

I like the conviction, but the high water market in terms of national price appreciation was already hit three quarters ago. Check out the Freddie Mac data: http://www.freddiemac.com/finance/cmhpi/

Jeff Matthews said...

"DaleW"

1. I'm talking about residential real estate--the housing bubble which I have been told is the "consensus view." Home builders are part of the bubble, and I do not see why you distinguish one from the other.

I put up Bob Toll's comments as an example of the mindset of today's housing market--"don't sell now, sell later, when prices are surely going to be higher."

This is a bubble-type mentality, and it exists among individuals taking down mortgages they will never repay as well as home builders who truly believe that their trees grow to the sky.

2. Yes, buying real estate during the 1990-1992 bear market was very smart and worked quite well.

That was my point.

Not too many of the people who are buying housing today--with the urging of Time Magazine--thought it was a good idea to buy back then. Real estate was a "non-consensus" investment" and it paid off in spades. Today real estate is quite the consensus investment, and therefore unlikely to pay off at all.

Let me rephrase to make myself really clear: anybody buying a house today that they don't need to live in because they agree with the consensus view that real estate only goes up is in my view a moron.

3. As for the high water mark already having been reached, then somebody should tell homebuilders. In every single call I listened to this past week, managements talked about continued appreciation this past quarter.

Nobody said prices were down from their peak.

whydibuy said...

The bubble can be clearly seen in the financing of these propertires now. All those 100% mortgages and no money down or 5 yr balloons or no doc loans are timebombs assured to go off eventually. All bubbles of anykind always cast a financial shadow of imprudence.

Its_strange said...

did you guys take note of the fact TOLL's condos and townhouses are the fastest growing segment...

DaleW said...

I'm talking about residential real estate--the housing bubble which I have been told is the "consensus view." Home builders are part of the bubble, and I do not see why you distinguish one from the other.

Part of the bull story is a secular view on the national production builders gaining share against regional guys, increasing purchasing power on everything from land to interior components, and gaining a cost of capital advantage. If this feeds higher unit sales growth than the market and prices don't collapse, the equities are undervalued. That's why I distinguish the asset from those building and selling the asset.

I put up Bob Toll's comments as an example of the mindset of today's housing market--"don't sell now, sell later, when prices are surely going to be higher."

I agree there is a speculative mindset in the strategy.

This is a bubble-type mentality, and it exists among individuals taking down mortgages they will never repay as well as home builders who truly believe that their trees grow to the sky.

I don't know if I would go that far. Sure there are speculators in the home buying market -- why would one expect a truly efficient market not to have them? I personally think it'a a component of a healthy market.

2. Yes, buying real estate during the 1990-1992 bear market was very smart and worked quite well.

That was my point.


Great. That was the right tactic.

Not too many of the people who are buying housing today--with the urging of Time Magazine--thought it was a good idea to buy back then. Real estate was a "non-consensus" investment" and it paid off in spades. Today real estate is quite the consensus investment, and therefore unlikely to pay off at all.

This is where I disagree. The consensus isn't completely tilted to the bullish side. There are tons of people who refuse to play, both in terms of the actual product market (buyers) and in terms of Wall Street. I submit the overwhelmingly negative comments in the Barron's midyear roundtable. There was only one bull, John Neff, and he's like 75 years-old. You would think he has seen it all and isn't an emptyheaded new era speculator. The consensus among that group was heavily bearish. For every Time article, I can show you a bearish Economist article.

Let me rephrase to make myself really clear: anybody buying a house today that they don't need to live in because they agree with the consensus view that real estate only goes up is in my view a moron.

I wouldn't want to speculate in housing either. I view homebuilders as a different investment than homes, however.

3. As for the high water mark already having been reached, then somebody should tell homebuilders. In every single call I listened to this past week, managements talked about continued appreciation this past quarter.

Yes, home prices were still going up last quarter and are still going up. I don't think they need anywhere near the 10% real asset returns the national real estate market has generated in the last few quarters to make money.

Nobody said prices were down from their peak.

Home price appreciation has slowed; prices are not down from the peak. Are you looking for a decline in prices, a slowing of price appreciation, or something very pronounced?

DaleW said...

Let me rephrase to make myself really clear: anybody buying a house today that they don't need to live in because they agree with the consensus view that real estate only goes up is in my view a moron.

This is a distinct minority of home buyers, by the way. I disagree with the Wall Street/hedge fund view that the market is rife with speculators and is surely bound to crash as a result.

the management said...

Lads, listen to yourselves. What this company is doing is intentionally increasing its inventory (financed at prime plus a spread) and intentionally reducing its asset turn. Where in the world of business does this make sense? Would Michael Dell have done this? Did the people who bought Dell at 6x earnings buy it because they were sitting on a big inventory of semiconductors waiting for the price to rise?

Jeff Matthews said...

Well and simply put.

For the record, Michael Dell got caught long DRAM in his early days as a public company.

Since DRAM prices had been strong for some time and looked like they were going up forever, he decided to hoard them.

He was wrong.

To Dell's credit, he cleaned up the mess and got religion about all the metrics that made Dell great and that "the management" highlighted here: lowest inventory + lowest cost = fastest turns and highest return on capital.

Dell's DRAM miscue caused precisely the "10 bagger" buying opportunity others are dreaming about in today's home builders.

DaleW said...

Lads, listen to yourselves. What this company is doing is intentionally increasing its inventory (financed at prime plus a spread) and intentionally reducing its asset turn. Where in the world of business does this make sense? Would Michael Dell have done this?

I would submit this is an entirely different business than PCs. That is a turns business by necessity because the inventory is so perishable. Wal-Mart is a turns business by design and by competitive necessity. The land development and construction business is simply not a turns business by design or by necessity, largely because real estate is a highly fixed commodity -- they're not pumping it out in factories in Pudong.

I know antique dealers who would disagree with you on your strategy, I think Sotheby's and Christies would largely disagree with you, I think almost every real estate developer would disagree, and I think many wine growers and distillers would disagree with you. By this approach, Balvenie should just dial in a three-year scotch and cut the price by 50% -- voila, you get the same returns on capital.

I hear what you're saying if you agree this is a cyclical peak. It would make sense to turn inventory and take a lot more cash out. But if one disagrees with that premise, then one would disagree with the second premise. I know where Jeff stands on it.

Do you guys know the mean real return on real estate over 35 years has been 2.2%? Did you know that residential real estate has beaten this bogey since Q3 1997? Did you know it had underperformed in 26 of the 29 quarters prior to that point? Since 1980, real estate has outperformed roughly half the timem and underperformed half the time. There are tons of markets that are flat on their backs and the builders have just as much exposure to places like Houston, Dallas, Indianapolis, Boulder, Salt Lake, and Charlotte as they do to the Inland Empire and Central Valley.

I am certainly not claiming the builders are ten-baggers -- I used shorthand we use to describe something and didn't mean it literally. I think I explained the shorthand the other day.

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