TO: McIntire Investment Institute. FROM: James Reilly. SUBJECT: Toll Brothers Inc. Short Position Analysis DATE:

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1 TO: McIntire Investment Institute FROM: James Reilly SUBJECT: Toll Brothers Inc. Short Position Analysis DATE: BUSI ESS: Toll Brothers, Inc. designs and builds as well as markets and arranges financing for single family homes in wealthy residential areas in the United States. Toll Brothers is also involved in converting existing rental apartment buildings into high income residential high rises. Toll Brothers owns or has a stake in over 30,000 home sites in 21 states. I VESTME T SUMMARY: Toll Brothers (TOL) should be considered for a short position due to the dramatic instability of the United States housing market, decreasing investor confidence, and questionable United States economic future. The stock appears overvalued and despite the fact that the housing market is already low, the entry point has not been missed. Housing market instability: The recent collapse of the sub-prime mortgage market seems to have burst the housing bubble. The normally optimistic National Realtors Association said on April 11, 2007 that it expects a 0.7% drop in existing home prices, and a 14.2% decrease in new-home sales. Decreasing Investor Confidence: Credit Default Swaps (investment instrument used by investors to hedge against credit risk) for Toll Brothers increased to an

2 alarming 1.32 percentage point, from 0.71 of a percentage point at the beginning of the year. Further, money being invested in real estate mutual funds is rapidly declining. Questionable U.S. economic future: A recent report (3/28/07) by Federal Reserve Chairman Ben Bernanke signals unease about the United States economy, saying that core inflation rates remain uncomfortably high. The housing market would be very vulnerable to a declining U.S. economy. Financial Indicators: Toll Brothers Price to Earnings ratio shows that the stock price may be overvalued and prime for a short position. THESIS POI TS: Housing Market Instability: The construction of new homes is down 23% from March of 2006, signaling a slowing and stagnation in the housing market. The National Realtors Association forecasts a bleak outlook that reports declining housing prices and volume in the coming year. Potential homeowners seem more likely now to stay in rental apartments as the mortgage market remains unsteady. Toll Brothers has yet to position itself in the rental apartment market, though it has a history of purchasing rental apartments and converting them to luxury homes. Decreasing Investor Confidence: The rising CDS level for Toll Brothers signifies investor unease over the company s credit risk. Toll Brothers, whose bonds are just narrowly investment grade, would be greatly hurt if it was downgraded to junk grade, as the cost of financing new debt with junk bonds increases significantly. Also, money being invested into mutual funds that own real estate is down to $2 million per week on average, down from $400 million per week in February. Questionable Economic Future: The United States economy may be approaching stagflation a combination of slow economic growth and rising inflation which would be detrimental to the economy. This is evidenced by a recent consumer price index which measured an inflation increase of 0.6% in March, though the core index measured only a 0.1% increase. Core inflation remains a problem, though, as core prices have risen 4.7% in the first three months of this year, while they rose 2.5% in all of While a stagnant economy would have more of an effect on commercial real estate, which Toll Brothers does not have a stake in, residential real estate would still feel the effects, but to a lesser extent. Financial Indicators: Toll Brothers trailing Price to Earnings ratio recently has been around For the past five years, its P/E Ratio high was and its low was Thus, it seems that the share price is overvalued as poor earnings have not been completely reflected in its price. As existing inventories remain unsold, which will happen should the housing recession continue, earnings will decrease and the P/E Ratio will increase. Since the P/E ratio is still relatively low, poor earnings have not been completely reflected in the share price, so it seems entry point has not been missed. The

3 forward P/E ratio, however, is around 19.00, but I feel that Toll Brothers will miss earnings estimates and the forward P/E ratio is an underestimate. RISKS: Toll Brothers is not exposed to recently completed land purchases, thus its cost of land will be lower than most home builders. This means that most of the land owned by Toll Brothers was purchased before the housing market peaked, so they have not overpaid for most of the land that they own. They could potentially be in a position to purchase land for a low price now that the housing market has taken such a hit. Toll Brothers relies on volume rather than housing prices. If home prices decline but volume stays the same or increases, Toll Brothers would be able to increase profit margin due to price decrease in land and construction. Though most indicators signal decreasing housing prices and a decrease in the number of new houses purchased, Toll Brothers needs only to worry about the quantity of new houses purchased. If this number stays relatively steady while the price of houses decrease, Toll Brothers may be able to maintain or increase its current profit margin as construction costs will fall along with the house prices. Building permits in March rose 0.8%, signaling an increase in future construction. Despite inflation worries, it is possible that the U.S. economy stays strong and continued to prosper, evidenced by the record setting Dow Jones Industrial Average on April 20, Only 1% of buyers of homes from Toll Brothers use sub-prime mortgages as a source of financing, thus Toll Brothers is not as vulnerable as most companies to the collapse of the sub-prime mortgage market. RECE T EWS: In addition to the thesis points, it is worth noting here the criticism of the pay package that CEO Robert Toll receives. Laborers International, a construction union, withheld votes for Carl Marbach, Chairman of the Toll Brothers Board Compensation Committee, in protest of Robert Toll s compensation. Though Marbach was re-elected, this action was more of a statement by Laborers International that changes must be made in the compensation of Toll Brothers officials. Further, a class action lawsuit was filed by shareholders on April 20, 2007, accusing the company of violating federal securities laws.

4 I DUSTRY A ALYSIS: TOL VS. INDUSTRY LEADERS Statistic Industry Leader TOL TOL Rank Market Capitalization DHI 7.06B 4.49B 5 / 27 P/E Ratio (ttm) GFA / 27 PEG Ratio (ttm, 5 yr expected) MDC / 27 Revenue Growth (Qtrly YoY) GFA 82.40% % 14 / 27 EPS Growth (Qtrly YoY) GFA 35.10% % 6 / 27 Long-Term Growth Rate (5 yr) WCI 15.0% 11.0% 7 / 27 Return on Equity (ttm) NVR 64.22% 17.94% 6 / 27 Long-Term Debt/Equity (mrq) TARR / 27 ( CO CLUSIO : Always an issue with investing is the question of whether news that may positively or negatively affect the price of stock has already been priced into the stock. It is the opinion of this author that based on the thesis points, the housing market will fall to levels that have not been predicted or priced into Toll Brothers share price. VALUE ADDED RESEARCH: Ken Ryan, CFO, Van Metre Homes The residential housing market peaked in 2005 and is about 20 months into a slowdown. Hurricane Katrina put shockwaves thru the economy and disrupted the housing market, resulting in the slowdown and price adjustment. We are seeing a trend in people investing in houses but not actually live in them, with the purpose of waiting for the house s value to increase. This hurts the market. The housing market is cyclical, there are peaks and valleys. Housing companies are counting on job creation in the D.C. area which has been thought of as recession proof in the past. Whereas Van Metre Homes only works in the D.C. area, Toll Brothers is located all over the United States. Ryan doesn t see any changes through the rest of the year, maybe some improvement in the spring of 2008, but he thinks based on past experiences that the presidential election could slow the market.

5 Smaller companies don t have to deal with Wall Street, while Toll Brothers does. This has its upsides and downsides, but Ryan feels that right now not being involved with Wall Street is giving Van Metre an advantage. Bob Guanuaniv, Builder, Airston homes The housing market is poor right now and it s a difficult market for selling new homes. Margaret Holler, Weichert Realtors After Labor Day 2006, inventory drops began to hurt the market, and even now the inventory continues to drop. If the Federal Reserve lowers the interest rate and inventory drops, then the market will continue to stagnate. Certain parts of the country don t have as many jobs as the D.C. area, so the recovery won t be as good outside of the D.C. area. New home industry needs some help; they ve had a wonderful ride but it seems to be at an end. Lisa Lees, Mortgage Banker, Bank of America The mortgage market is softening, so the mortgage rates are coming more in line with the market because the values were out of range in the past 2-3 years. The upper bracket is hurting as a result. FI A CIALS: Profitability Profit Margin (ttm): 9.84% Operating Margin (ttm): 16.42% Management Effectiveness Return on Assets (ttm): 9.21% Return on Equity (ttm): 17.94% Income Statement Revenue (ttm): 5.87B Qtrly Revenue Growth (yoy): % Gross Profit (ttm): 1.60B Balance Sheet Total Cash (mrq): M Total Debt (mrq): 2.27B Total Debt/Equity (mrq): Current Ratio (mrq): 5.182

6 Book Value Per Share (mrq): Share Statistics Average Volume (3 month) 3 : 3,814,850 Shares Outstanding: M % Held by Insiders 4 : 21.40% % Held by Institutions 4 : 75.00% Shares Short (as of 12-Mar-07) 3 : 18.40M Short Ratio (as of 12-Mar-07) 3 : 4.6 Short % of Float (as of 12-Mar-07) 3 : 15.10% Shares Short (prior month) 3 : 16.41M VALUATION MEASURES Market Cap (intraday): 4.36B Trailing P/E (ttm, intraday): 8.01 Forward P/E (fye 31-Oct-08) 1 : PEG Ratio (5 yr expected): 1.98 Beta: 3.03 ( ew Ideas for MII: I feel that in order to encourage more participation in presentations by members, the McIntire Investment Institute should create an organized mentor program. In this program, a senior analyst or manager would be matched up with a newcomer to the MII during the first semester. Working as a pair, these two would put together a presentation for the MII and present to the group. By doing this, the newer members of the MII community would learn extensively about what should go into a presentation and then be able to present on their own. Further, this would encourage some individuals to present who might otherwise be deterred because they are nervous about their insufficient knowledge of finance. Another way to improve the MII would be to have a guest speaker visit once per semester. Preferable from an investment bank or a hedge fund, the speaker could talk about what it is like to present investment ideas to other professionals. A special thanks to Ken Ryan, Bob Guanuaniv, Margaret Holler, and Lisa Lees for allowing me to interview them. Yahoo.com was used for all charts and tables in this memo.

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