In this episode of Market Foolery, host Chris Hill and Motley Fool contributor Tim Hanson look at a few of the market's biggest stories. Luxury home builder Toll Brothers (NYSE: TOL) raised its guidance, even though other real estate-centric companies have reported a shrinking market. The guys explain the disparity, and a few trends investors should watch in the housing market at large.
A report from The Wall Street Journal details how the majority of Tesla's (NASDAQ: TSLA) suppliers consider the company a financial risk. Are the suppliers overreacting? How can Tesla right this troubled ship? And, Tim makes a case for investing in junk-food stocks for the long haul. Tune in and find out more.
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A full transcript follows the video.
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This video was recorded on Aug. 21, 2018.
Chris Hill: It's Tuesday, Aug. 21. Welcome Market Foolery! I'm Chris Hill. With me in studio, for the first time in a long time, it's investor at large Tim Hanson. How are you?
Tim Hanson: It's been too long!
Hill: I was thinking about this.
Hanson: It's my fault. I've been out of the office.
Hill: Well, no, we've had one of those summer schedules, we're like ships passing in the night, in terms of our vacation. I was out, all that sort of thing.
Hanson: I was working remotely for some of that time. Just, to be fair. [laughs]
Hill: [laughs] You know what? When I was on Cape Cod, and up in Maine, I was not working remotely.
Hanson: You earned the time off. You deserve it!
Hill: We have talked recently on this podcast about the broader housing industry, in terms of the real estate market, talking about Zillow and Redfin (NASDAQ: RDFN), and talking about home improvement with Home Depot and their results. Let's start with actual homebuilders today. And that's Toll Brothers. Toll Brothers' stock up 12% this morning. Third-quarter profits for the luxury homebuilder came in higher than expected. Toll Brothers also raised guidance. It seems like some people were surprised by this. I get the feeling that you were not.
Hanson: It's interesting. Toll Brothers, within the homebuilding industry, is generally regarded as the luxury homebuilder. Bigger ticket homes, higher price points, so on and so forth, with a lot of exposure to California, some of the markets that have been a little bit hotter. I think with recently rising interest rates, if you look, they had a really strong second quarter, as well, the quarter prior to this. If you look at the data and the recent rising interest rates, I think people were expecting them to have cooled off a little bit. But they said no, basically every market remains strong. They like their backlog, profitability looks stable, so they were feeling pretty good.
I think there are a number of demographic trends that point to continued strength in the housing market. It's been going for a couple of years now. I think last time I was on the show, we talked about Home Depot and people reinvesting in their homes. There are a couple of interesting trends. One, is older Americans, 55-65 and older, are owning their homes longer and buying retirement homes, and you can expect them to live longer, so that housing stock's not going to turn over maybe as frequently as it would have in the past. Second, you're finally seeing mid-30-year olds finally get together and start homes. Then, as a knock-on effect of that, the renter rate overall is coming down.
Now, where it settles out is an interesting question. If you look at prior to the housing bubble, it was at around 35%. During the housing bubble, when everybody was buying homes, it dropped all the way to about 30%. It had spiked following the housing crisis at about 37%. Now it's about 36%. Does it go back to 35%? In which case, maybe this housing boom is going to be not so sustainable in the future? Or does it start to drop again and get closer to, maybe settle out 33-32%? Then, I think you would see a couple of more years of strong growth in the industry.
Hill: One of the things that came up recently was Glenn Kelman, who's the CEO at Redfin, talking about, in terms of their latest report, how buyer demand is waning. I think of Redfin as tying in with Toll Brothers. I think of Redfin as being a little bit more toward the luxury end of the market. They're not trying to be all things to all homebuyers. I'm curious how what we just saw today from Toll Brothers squares with that, or if it's always going to be the case that people who are actually building the homes, they're going to be the leading indicator, as opposed to the Redfins of the world.
Hanson: It's an interesting question. I had also read the reports about buyer demand waning. Obviously, you would expect that in a rising interest rate environment. I find your characterization of Redfin as being on the luxury end of the market kind of interesting. I don't know a ton about Redfin, but I'd always thought their main competitive point was lower rates, like, "We compete on price." I'd figured it was more of a middle market exposure. Maybe I'm wrong, I'm not sure.
Hill: If we're talking about housing and it's a question of who's right, between you or me, I'm going with you.
Hanson: [laughs] I appreciate that, but God knows I can be wrong pretty frequently. The other thing that's interesting about homebuilders versus ultimately a broker, a realtor, is that the homebuilder controls their portfolio, and a realtor is only as good as a portfolio, the inventory that they get from people. It could be that you're seeing a little bit of what we saw a few years ago, which is that two-speed economy. Wealthier people are still feeling really positive, but in a rising interest rate environment, the more price-sensitive consumer is backing off a little bit. Maybe you see less of that in Toll Brothers' portfolio, a little bit more of it in Redfin, which would result in the incongruous guidance. Time will tell. It'll be interesting to see how the non-luxury homebuilders report through, and what they're seeing in this time period. Obviously, they'll have very different exposures.
Hill: Yeah, that was one thought I had as you were talking. It really has been the case for the last few years, when Home Depot reports their results, the safe way to bet is, Lowe's is going to report roughly the same thing, slightly less good, but still directionally in the same way. I am curious now to see D.R. Horton, what kind of numbers are they putting up?
Hanson: People are definitely investing in their homes. I was recently doing a lot of reading about the pool industry and Pool Corp., which is basically a vertically integrated distributor of pool products. They were saying that people who had put off investing in either building a new pool or doing maintenance on an expensive part of their pool, they've been seeing a multiyear trend toward people doing that work now. Again, if you have a pool, you're probably at the higher end of the market, so you're a little bit more insulated than some other people. But, all these are really interesting trends to watch.
Hill: Shares of Tesla are down 16% since earlier this month, when Elon Musk published his tweet about going private, #fundingsecured. The latest wrinkle in what is really the best drama on Wall Street is this survey The Wall Street Journal reported on of 22 auto parts suppliers. Of the 22, 18 of them believe that Tesla is now a financial risk to their business. They basically think, either they're not going to get paid, or their payments are going to be delayed. Tell me what I should think about this. Part of me looks at this and says, "Well, this is, in some ways, a very niche version of the Consumer Sentiment Survey that comes out every month."
Hanson: Yeah, I think there are only 23 respondents, statistical significance.
Hill: And it's like, how are you feeling? That to me is less concrete than actual results. But by the same token, it's just not a good look. This is one more thing that just goes to not great optics for Tesla.
Hanson: Yeah. I think the business owners surveyed are absolutely right to consider Tesla a financial risk. Most of them are relatively smaller companies, for example. What's interesting, there are two sides to this coin. Looking back historically at Tesla's accounts-payable numbers, their days payable outstanding and the percentage of their payables relative to the size of their balance sheet really hasn't actually gotten bigger. They're pretty much paying today on the same terms they were paying five or six or seven years ago. And presumably, the suppliers are the same people. What's different is that the scale of those payables has exploded from $400 million back in 2014 to now, it's well over $3 billion in payables. So, for these relatively smaller businesses, you would expect that the account payable from Tesla, even if they're being paid on substantially the same time frame, it's now a really big account. Working capital is the lifeblood of a business like that, and Tesla is ostensibly borrowing more and more money from them. Obviously, that would be a concern for them.
The other reason why they should be concerned is, previously, four years ago, Tesla had substantially positive networking capital. Today, their networking capital is negative $2.4 billion. That means there's a $2.4 billion deficit between what they have liquid and what they don't need to pay liquid. Where's that money going to come from? Some of it is current debt. Elon Musk is kind of a magic man with his balance sheet. Maybe he can extend it, he can do something. But even if you net that out, they're still negative $300 million their networking capital. So, if you're a supplier, yeah, you should be concerned.
Now, they probably want to have a long-term relationship with Tesla, so you might not expect them to get aggressive. But it's certainly a stealth liability -- well, not a stealth liability, we're talking about it.
Hill: [laughs] Right.
Hanson: It's a big liability on their balance sheet!
Hill: I was going to say, The Wall Street Journal reported about it, I don't think it's stealth anymore.
Hanson: And one of the reasons for that is this other line item, of accrued expenses, is building up on their balance sheet. Some of that is associated with the warranties and repurchase guarantees they have with cars that are out in the world right now. If you believe some of the reports that bumpers are falling off in the rain, and so on and so forth, those liabilities could ultimately eat up the company, as well.
It's an interesting story. There are two sides to the coin. Tesla's saying, "We're not substantially different from what we were a couple of years ago." That's true, but they're also bigger, and there's some other things sneaking up on the balance sheet.
Hill: Well, and that's the thing. We talk at various points about different businesses that have a great story attached to them. This is one of them. Tesla has always been, among other things, a really great story. That's why I think this survey is slightly damaging. It's one more thing that Elon Musk and his management team have to respond to, as opposed to focusing on the job at hand.
Hanson: Well, and the other thing to remember is, a great business needs to create a great ecosystem. You have to not only be great with your product and your employees, you have to be great with your customers, you have to be great with your suppliers.
Hill: All stakeholders.
Hanson: You talk to James Sinegal, what's the great story where, he went proactively to a supplier and said, "We're squeezing you too hard. I'm going to pay you more."
Hill: [laughs] "We've run the numbers."
Hanson: "There's no way you're making money on our account."
Hill: "And we've figured out that you're going to go out of business if we keep these terms, so let's get some more favorable terms for you."
Hanson: Exactly. And you have to build that ecosystem, because that's the only way you achieve sustainable success. Now, if he puts a bunch of his suppliers out of business inadvertently, but saves Tesla, I mean, that maybe is just a stay rather than a sustainable solution. We'll see. There's a relatively well-known, but maybe obscure in the general population, balance sheet metric called the Altman Z-score. It measures different balance sheet requirements, and if you're below 1.8 for a period of time, Professor Altman predicts you'll be bankrupt within two years. I think Tesla now is at 1.1, and they've been there for a while. We'll see what happens!
Hill: I love that story about Jim Sinegal because it's a wonderful counterbalance to another story about Sinegal, which is when he was on the phone with Howard Schultz from Starbucks. I think Schultz was looking for better terms for Starbucks to supply to Costco, and Sinegal said something along the lines of: "I'm sorry to lose your business. If you excuse me, I need to call the person who runs Dunkin' Donuts to talk to them about their coffee." [laughs] And you know what? Howard Schultz worked it out. Good for him!
I'm always curious about, when you're traveling, what investment lessons you come back with, business observations, anything financial. Obviously, I want you to relax and enjoy your vacation with your family, but I know you well enough to know that the investing part of your brain never shuts off.
Hanson: It's funny. Our family trip this summer was to Western Canada. Went to Calgary and then the Badlands to see some dinosaurs, and then up into the Rocky Mountains. Obviously, if you go to Canada --
Hill: -- Wait a second. Dinosaurs?
Hanson: Dinosaur bones. Fossils. It wasn't Jurassic Park. But it's neat, if you go, you can hike on these trails and you can see the fossils being exposed. It's neat, it's really cool. The kids liked it. If you go to Canada, one thing that's ubiquitous in Canada, Tim Hortons. We went there for breakfast and my kids just could not get enough of the biscuits and the Timbits, which are the equivalent of Munchkins. My son has his Robinhood account now, so he's always on the lookout for stocks to buy. He said, "Can I buy Tim Hortons stock?" And I said, "Yes you can." And actually, I told him a story. A long time ago, when I was in college, I actually bought Wendy's (NASDAQ: WEN) stock on the thesis that Baja Fresh, which they owned at the time, was the next hot concept, and way better than Chipotle. Now, you fast forward a couple of years, Baja Fresh basically was worthless to Wendy's. Chipotle had gone on to be the winner in the burrito space. Obviously since reverted to the mean. But, made a lot of money on Wendy's because of Tim Horton's. They also own Tim Hortons, and Tim Hortons is growing crazy for them, they're growing all across Canada and the U.S.
So, I told Ben the story about owning Tim Hortons. And he said, "I want to buy Tim Hortons stock." I had fallen out of loop with Tim Hortons. When I looked back into it, they're now part of Restaurant Brands International. QSR, clever ticker.
Hill: Great ticker!
Hanson: Which combines Tim Hortons, Burger King, and Popeyes. When my son and I dug into that, he was just blown away one company could have Tim Hortons, Burger King, and Popeyes. I think that's next on his investment list. He already own shares of McDonald's on the thesis that people eat unhealthy food, and that that's just a durable thesis forever. And he's done well in McDonald's, to his credit. It's had a bonkers year overall.
Hill: That's a great thesis, and he's absolutely right about that.
Hanson: You have to keep it simple.
Hill: It is pretty amazing, when you look at what the QSR management has done, in assembling this portfolio. I don't know about you, but I personally am thankful that there is not a Popeye's that i physically close to this office. I would be there so often. It's addictive food!
Hanson: I don't know what they put in it.
Hill: It's really good!
Hanson: When Ben buys shares, go out and support them.
Hill: [laughs] Well, there's certainly not a Tim Hortons around here, so I'm going to have to hit the Popeyes. That'll be how I rationalize it. It's all in the name of research, and it's all in the name of supporting Ben. Tim Hanson, thanks for being here!
Hanson: Thank you!
Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!
Chris Hill owns shares of Starbucks. Tim Hanson owns shares of McDonald's and Starbucks. The Motley Fool owns shares of and recommends Chipotle Mexican Grill, Starbucks, Tesla, and Zillow Group (A shares). The Motley Fool has the following options: short September 2018 $180 calls on Home Depot and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Costco Wholesale, Home Depot, and Redfin. The Motley Fool has a disclosure policy.