Toll Brothers (TOL) Q3 Preview

by Dan August 22, 2016 1:28 pm • Trade Ideas

Event: Toll Brothers (TOL) reports their fiscal Q3 results tomorrow before the open. The options market is implying about a 4% one day post earnings move, which is shy of the average move following the last 4 quarters of 6.85%, but basically in line with the 10 year average one day move of about 3.8%.  

Price Action / Technicals:  TOL is down about 12% on the year and down about 26% from its 52 week and 10 year highs made a year ago.

The stock has spent the better part of 2016 trading between $26 and $30:

[caption id="attachment_65807" align="aligncenter" width="600"]TOL 1yr chart from Bloomberg TOL 1yr chart from Bloomberg[/caption]

Taking a long term view, the stock’s consolidation in 2016 is below very key technical resistance, former support for 2013, 2014 & 2015:

[caption id="attachment_65808" align="aligncenter" width="600"]TOL 5yr chart from Bloomberg TOL 5yr chart from Bloomberg[/caption]

The stock is (and has been for a while) at a technical inflection point with near term support near $25, with little overhead resistance above $30 for another 10%.

It’s also important to note, that TOL, the fifth largest holding in the iShares U.S. Home Construction etf (ITB) massively under-performs the etf, up nearly 6% on the year, and the S&P Homebuilder etf (XHB) up 5% on the year.

Expectations into the Print:  One reason for the relative under-performance ytd for TOL is their focus on luxury homebuilding in locales like New York and California.  UBS, who rates the stock a buy had the following to say about the quarter in a note to clients excerpted by Bloomberg:

UBS: Focus on traffic/sales patterns in California luxury mkt and growth trends in southern part of state vs slowdown in north; also pay attention to NY Metro area, outlook for City Living segment  Look for changes in gross margin forecast; sees 2Q gross margin strength lasting through rest of year

TOL remains well positioned given limited inventory in mkts like California, share gains in higher end business; sees mgmt being “opportunistic” with share buybacks given strong balance sheet, cash generation

Options Volatility Snapshot:  30 day at the money implied volatility (the price of options – blue) is elevated as expected into the print at 30%, while 30 day realized volatility (how much the stock has been moving – white) is at 52 week lows and has absolutely collapsed over the last few weeks:

[caption id="attachment_65809" align="aligncenter" width="600"]From Bloomberg From Bloomberg[/caption]

The low implied move relative to the last year’s historical suggests options traders don’t see too many surprises. If in fact the stock does not move as much as expected, realized vol will stay depressed and implied should get hit hard.  This could present trading opportunities around the event.

Estimates & Forecasts from Bloomberg:
-3Q adj. EPS est. 62c (range 59c-64c)
-3Q rev. est. $1.24b (range $1.22b-$1.26b)
-3Q gross margin est. 25.8% (2 ests.)
-FY16 rev. est. $4.97b (range $4.25b-$5.16b), co. forecast $4.76b-$5.36b (May 24)
-FY16 gross margin est. 25.8% (range 25.3%-26%), co. forecast 25.8%-26.2%

My View: I have no idea how healthy the high end housing market is, demand for new homes and what a late 2016 rate increase will do for orders and margins on homes. But the consolidation is fairly constructive, and on a beat and raise the stock is up easily in line with the implied move. The relative under-performance of the stock suggests that investors are worried about something and prefer to put their cash in other areas of U.S. construction. If the stock were to miss and guide down I suspect you see a move easily in line with the implied move with follow through back towards support in the mid $20s.

So What’s the Trade?

Defining risk isn’t easy here with very few set-ups for cheap calendars or risk reversals without considerable downside risk. For those looking to play for a breakout on a technical basis premium needs to be spent. For instance, with the stock around $29.25, the Sept 29/31 call spread is about .75. That defines risk to less than the implied move, and starts in the money so total extrinsic premium at risk is only about .50. But it is still pretty binary with only 1.25 profit potential while risking .75 that could easily be cut in half or worse if the stock were to fail here. There are some call butterflies that reduce that extrinsic premium at risk but they have lots of commissions and may not be worth it even if correct on direction.

For longer term views, a 5 dollar wide upside call spread in Dec could make sense looking slightly out of the money. The Dec 30/35 call spread is about 1.25 and offers up to 3.75 in potential profits if the stock is at or above 35 at year end. But again. That’s not ideal if the stock goes down or sideways on this report because it starts out of the money but for those very convinced into year end its a way to define risk.

The same would be true for those looking for a breakdown back towards the 2016 low just below $24.