Tickers in this Article: TOL, PHM, DHI, HOV, BZH, KBH
Back in June, I was cautiously optimistic on the shares of Toll Brothers (NYSE:TOL), provided that "the economy does not slide back into recession". Nowadays, that concern is looking more ominous, and uncertainties seem to be weighing on consumer sentiment. Toll Brothers is still the best property on the homebuilding block, but these days that may be like asking investors to choose between a haunted house designed by Disney and one designed by Lovecraft. Sure, there's a difference but they're both still haunted houses.

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Not a Lot of Good News in the Third Quarter
Toll Brothers reported revenue of $394 million for the third quarter, down about 13% in dollar terms from the year-ago level. Undercut by a 14% drop in units, Toll Brothers actually missed the average analyst guess, but investors should note that there was a pretty wide spread for revenue estimates, which certainly befits the uncertain state of housing.

Profitability was not entirely encouraging either. Reported gross margin slipped about half a point. Unfortunately, there is a morass of charges, writedowns and tax benefits that muck by the income comparisons. Nevertheless, pretax income net of writedowns increased about 70% from last year's level.

Orders are arguably more important than income at this point, and the news here was not great. Net orders rose only 2% this quarter - positive, yes, but much below the low-teens growth looked for by most analysts. Toll Brothers saw good growth in orders in the South (up 74%), but a sizable drop in the West and Mid-Atlantic regions, and order cancellation rates jumped to 7.4% (almost double the rate of the second quarter), while the absorption rate dropped 6%. (Analyst reports can be an investor's best friend. For more, see Analyst Recommendations: Do Sell Ratings Exist?)

Trouble Afoot?
Given the way things are going in the mortgage market these days, and the Fed's signals of a persistent low-rate environment, it may not be too long before there's a "3" handle on 30-year mortgages. Unfortunately, that would likely be a near-disaster for homebuilders like Toll, Pulte (NYSE:PHM), DR Horton (NYSE:DHI) and Hovnanian (NYSE:HOV), as it would suggest recessionary conditions and minimal interest in housing.

Making matters worse, several homebuilders are going to need refinancing in the fairly near future to meet their obligations. That could be problematic for companies like Hovnanian, Pulte, Beazer (NYSE:BZH) and KB Homes (NYSE:KBH) with higher cash needs relative to their obligations and current capital positions.

Quality Will Matter, but When?
Toll Brothers has built a good niche for itself as a nationwide builder targeting upper-income buyers. This is a customer category that is usually less vulnerable to unemployment and has better access to credit. The key here, though, is "usually". There are plenty of upper-income customers who've seen significant reductions in their net worth in recent years and worries about paying for future expenses like college (and/or repairing decimated retirement savings) may sap their enthusiasm for new houses. So while Toll Brothers has an attractive business model, it may be some time before the company can really leverage that model.

The Bottom Line
Toll Brothers may be among the best American homebuilders to own, but I would refer back to the haunted house example in the opening - the best haunted house is still a haunted house. There's likely long-term value here, but the uncertainties of the economy today make it hard to argue that this is a stock anyone needs to own. The pullback has created bargains across a range of industries, so investors are better served looking for cheap stocks in sectors with less uncertainty. (For more on cheap stocks, see The Value Investor's Handbook.)

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