Toll Brothers, Inc. (NYSE:TOL) Q3 2023 Earnings Call Transcript

Toll Brothers, Inc. (NYSE:TOL) Q3 2023 Earnings Call Transcript August 23, 2023

Operator: Good morning, and welcome to the Toll Brothers Third Quarter Fiscal Year 2023 Conference Call. [Operator Instructions] The company is planning to end the call at 9:30 when the market opens. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Douglas Yearley, CEO. Please go ahead.

Douglas Yearley: Thank you, Betsy. Good morning. Welcome, and thank you all for joining us. Before I begin, I ask you to read our statement on forward-looking information in our earnings release of last night and on our website. I caution you that many statements on this call are forward-looking based on assumptions about the economy, world events, housing and financial markets, interest rates, the availability of labor and materials inflation and many other factors beyond our control that could significantly affect future results. With me today are Martin Connor, Chief Financial Officer; Rob Parahus, President and Chief Operating Officer; Fred Cooper, Senior VP of Finance and Investor Relations; Wendy Marlett, Chief Marketing Officer; and Gregg Ziegler, Senior VP and Treasurer.

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We had another terrific quarter and are very pleased with our fiscal third quarter results. We beat our guidance for home sales revenues, adjusted gross margin, SG&A margin and earnings. Our quarter end backlog of 7,295 homes and $7.9 billion is strong, and our cancellations remain very low. The market for new homes is solid, and we are well positioned with the right strategy in place to take advantage of it. As a result, we are raising our full year guidance for all of our core homebuilding metrics, including deliveries, adjusted gross margin and SG&A margin. We now project earnings of between $11.50 and $12 per diluted share in fiscal 2023 and a return on beginning equity of approximately 22%. In the quarter, we delivered 2,524 homes at an average price of $1.06 billion, leading to record third quarter home sales revenues of $2.7 billion.

Adjusted gross margin was 29.3% or 140 basis points above last year’s third quarter, and our SG&A expense was 8.6% of home sales revenues 170 basis points better than last year. Our margins continue to benefit from cost controls and greater leverage from higher revenues. With a significant beat on our top line and improved margin performance, we delivered earnings per share of $3.73, a third quarter record. We signed 2,245 net contracts for $2.2 billion in our third quarter, up 77% in units and 30% in dollars compared to last year’s third quarter when mortgage rates were much lower in the 5% to 6% range. On a per community basis, we sold at a pace of 2.2 homes per month compared to 1.3 last year and 2.3 last quarter. Demand was stronger than normal in our third quarter compared to the second, with contracts down only 4% sequentially versus the long-term average of down 15%.

Remember, the second quarter is historically stronger than the third since it is in the heart of the spring selling season. So running almost flat Q3 to Q2 is very encouraging, particularly with rates higher in Q3 than Q2. Demand was also solid across both geography and product lines in our third quarter and we raised price by an average of $20,000. We saw particular strength in the Mountain and South regions where we tend to have lower average prices. Due to the shift in mix and notwithstanding the price increase, our average sales price was flat compared to the second quarter. In terms of cadence, we saw a relatively steady number of deposits and contracts each month of the third quarter. Actually, June was our strongest month when normally, July is strongest.

Often, that is influenced by a sales event. And this year, we ran a national sales event in June rather than July. As we start our fourth quarter, demand remains solid. August deposits are usually down 25% to 30% versus July based on long-term historical trends as summer winds down and kids returned to school. So far in August, deposits are only down 11% and both physical and web traffic is up slightly compared to July. While it is only three weeks, this is encouraging considering the increase in mortgage rates that has occurred during this period We attribute the solid demand for new homes, at least in part to the well-publicized shortage of existing homes for sale. Existing homeowners are clearly reluctant to give up their low-rate mortgages.

And while rising rates remain a challenge for the overall industry, they further cement the lock-in effect that is kept to resell inventory at historically low levels. This has become a tailwind for homebuilders and especially the larger well-capitalized builders who build at lower costs and are better positioned to take advantage of spec building and buying down mortgage rates. The supply/demand imbalance created by low resale inventory, compounds the impact of the persistent underbuilding of homes over the past 15 years. Even before resale inventory dropped, there was a structural shortage of anywhere between 3 million and 6 million homes in this country. In addition, demographic and migration trends continue to provide long-term support for the industry with millennials forming families and buying their first home later in life when they have higher incomes and accumulated wealth.

AB boomers who are either retiring or planning for it are also moving as they adjust to their new lifestyles. There also appears to be an increase in generational well transfer with parents helping their kids buy homes. All of these factors combined have kept demand for new homes solid in the face of higher rates, and we are benefiting. Our strategy of increasing our supply of spec homes, which we implemented several quarters ago, has helped us meet demand while also helping to improve our cycle times. Our spec homes represented approximately 40% of our orders in the third quarter and we expect that to continue in the near term. Specs were 28% of deliveries in the third quarter. We define a spec as any home without a buyer that has a foundation poured.

We sell our specs at various stages of construction with a preference to sell before we finish the homes as many of our buyers want to personalize their homes. In this way, our buyers are able to select their fixtures, appliances, flooring and other finishing options while we benefit from a faster and more efficient construction schedule. At third quarter end, our backlog stood at $7.9 billion and 7,295 homes. Our cancellation rate as a percentage of backlog was 3.2% in the third quarter, down from 3.9% in the second quarter. Our industry low cancellation rate is due to significant upfront down payments our buyers make as well as the emotional attachment they form as they personalize their homes with us. Our buyers also tend to be more affluent.

In the third quarter, 25% of our buyers paid all cash, up from 23% in the second quarter and our long-term average of 20%. Buyers who do take a mortgage make higher down payments with an average LTV of 68% in this past quarter. We are also seeing modest improvements in our cycle times of supply chains and labor constraints continue to ease and as we increase production of spec homes. We expect cycle times to continue to improve as we move forward, which should further benefit our already strong cash flows. Turning to land. At the end of our fiscal third quarter, we owned or controlled 70,200 lots, half of which were controlled and the other half owned. Excluding the 7,295 lots committed to home buyers in our backlog, our controlled land represents 56% of total loss.

Our lot count is down nearly 15% year-over-year, which reflects our selective approach to buying land and our focus on ROE and capital efficiency. Still, this land position provides us with sufficient land needed for growth in fiscal year 2024 and beyond and allows us to continue being selective and disciplined in our approach to buying land. Since the start of the third quarter, we repurchased $163 million of our common stock bringing our year-to-date repurchase to $265 million at an average price of $68. We have also paid $69 million in dividends year-to-date. We expect buybacks and dividends to remain an important part of our capital allocation priorities well into the future. As a reminder, we have planned for $400 million of share repurchases in fiscal 2023.

Assuming we buy back an additional $144 million at the current price in the fourth quarter, which would get us to the $400 million for the year, we will have bought back about 5% of our diluted share count at the beginning of the year. With that, I’ll turn it over to Marty.

Martin Connor: Thanks, Doug. It was a great quarter. We grew earnings per share by 59% and net income by 52% over last year. Homebuilding revenue of $2.7 billion was a third quarter record and increased 19% compared to one year ago. We delivered 2,524 homes in the quarter, up 5% year-over-year. With the outperformance in the third quarter, we are raising our full year deliveries guidance. We now expect to deliver between 9,500 and 9,600 homes, an increase of approximately 200 homes at the midpoint of our previous guidance. We are also increasing our guidance for full year average delivered price to between $1.05 million and $1.15 million. This translates to a homebuilding revenue projection of approximately $9.65 billion at the midpoint for the full year.

We signed 2,245 net contracts in the third quarter for $2.2 billion, up 77% in dollars and 30% in units over last year. The average price of contracts signed in the quarter was approximately $964,000, which was down 1.1% compared to our second quarter average price of $975,000. As Doug noted, we actually raised price by an average of $20,000 in the third quarter through base price increases and reduced incentives; which was offset by changes in mix. Turning back to the P&L. Pretax income was $553 million compared to $366 million in the third quarter of fiscal 2022. Net income was $414.8 million or $3.73 per share diluted compared to $273.5 million and $2.35 per share diluted one year ago. Our third quarter adjusted gross margin was 29.3%, compared to 27.9% in the third quarter of 2022 and 160 basis points better than projected.

The improvement was due primarily to better cost control and fixed cost leverage on higher-than-expected home sales revenues. We are raising our full year adjusted gross margin guidance from 27.8% to 28.5%. This 28.5% is also what we expect in our fourth quarter. Note that our fourth quarter gross margin guidance includes the impact of homes that we sold a year ago in a softer sales environment. SG&A as a percentage of revenue was 8.6% in the third quarter compared to 10.3% in the third quarter of last year. And this is 170 basis points better than projected. In dollar terms, our SG&A expense was $4 million lower this quarter compared to the third quarter of fiscal year ’22 despite over $400 million of additional home sales revenue and the impact of inflation.

As we’ve pointed out before, we’ve been very focused on becoming more efficient, and we are now seeing the benefits flow through our results. We are projecting full year SG&A costs to be approximately 9.4% of home sales revenues, which represents a 60 basis point improvement from our prior guidance. For the fourth quarter of fiscal year 2023, we expect SG&A to be approximately 8.8% of home sales revenue. Third quarter JV, land sales and other income was $39.4 million in the quarter or $14.4 million above our guidance. We now expect our full year joint venture land sales and other income to be approximately $105 million, down from the $125 million previously projected. This is due primarily to a challenged market for apartment building asset sales.

Our new guidance assumes we closed the sale of three stabilized apartment communities that we expect to sell in this fourth quarter. Our tax rate in the third quarter was 25%, 100 basis points better than our guidance. We expect our fourth quarter tax rate to be 26%, which would bring the full year rate to approximately 25.4%. We expect interest in cost of sales to be approximately 1.5% in the fourth quarter and for the full year as we continue to benefit from our reduced leverage. We expect community count to be approximately 375 by fiscal year-end with continued growth in fiscal year 2024. Our weighted average share count is expected to be approximately $111 million for the full year and $109.5 million for the fourth quarter. We reiterate our guidance for approximately $400 million of share repurchase year, implying approximately $150 million of buybacks in the fourth quarter.

Putting this all together, we expect to earn between $11.50 and $12 per share in fiscal year 2023. We expect to achieve a full year return on beginning equity of approximately 22%, and we expect to bring our book value to approximately $65 per share at year-end. This would be the second year in a row, we earned well over $1 billion, and this is in a period when mortgage rates doubled from slightly over 3% in November of 2021 and to their current level, around 7.5%. In addition, since 2020, we have generated an average of $1.1 billion of operating cash flow per year and we expect 2023 to also exceed $1 billion. Turning to the balance sheet. We finished the quarter with a net debt-to-capital ratio of 20.5%, $1 billion in cash and cash equivalents and $1.8 billion available under our $1.9 billion revolving bank credit facility providing us with ample flexibility to both grow our business and return capital to stockholders.

We also have no significant bank or senior debt maturities due until November 2025, which is fiscal year ’26 for us. In recognition of our financial position, the solid demand for new homes and strong fundamentals underpinning the market as well as our favorable long-term prospects, Standard & Poor’s upgraded our credit ratings to investment grade this quarter. We are now rated investment grade by all three major credit rating agencies. Now let me turn it back to Doug.

Douglas Yearley: Thanks, Marty. Before I open it up for questions, I’d like to recognize the hard work and dedication of all of our great Toll Brothers employees. It is your passion for our business and commitment to our customers that will ensure our continued success. Betsy, let’s open it up for questions.

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Q&A Session

Operator: [Operator Instructions] As a reminder, the company is planning to end the call at 9:30 when the market open. [Operator Instructions] The first question today comes from Rafe Jadrosich of Bank of America. Please go ahead.

Rafe Jadrosich: Hi. Good morning. Thanks for taking my question.

Douglas Yearley: Good morning, Rafe.

Martin Connor: Good morning, Rafe.

Rafe Jadrosich: Doug, I wanted to follow-up on a comment you made earlier on the gross margin. You’re seeing the fourth quarter outlook for 28.5% includes the impact of homes that were sold last year in a softer sales environment. How do we – you have more visibility than other builders on the gross margin outlook. How do we think about how that goes going forward, just given that we saw at the beginning of the year, the sales environment that definitely improved?

Douglas Yearley: Sure. So, we’ll give full guidance in December as we always do for 2024. And so, we’re not going to get ahead of ourselves right now. Marty’s comment and our guidance, which is about 80 basis points lower than the 29.3% gross margin we achieved in Q3, for a 28.5% in Q4 was just a reminder that if you go back 12 to 15 months, the market had slowed dramatically. That’s why we mentioned remember, back in April of ’22 is when rates went up dramatically, and late spring of ’22 through the summer and fall, the market softened dramatically, we reminded everyone back then that we were not going to chase the bottom and we didn’t. And so on 80 basis point drop is pretty well range-bound when you think about Q4 is going to represent a bit more of the sales that occurred back in that period of time.

But it’s – again, it’s only 80 basis points. Some of the sales from that slower time will continue into the beginning of ’24. But we’re not going to get into the specific guidance until December on where – the first quarter of ’24, and the balance of the year comes out. But there is some shorter-term pressure, but the pressure is modest, because we did not chase the bottom. Some of the other builders, as you know, had a pretty dramatic drop in margin for the sales that came through that period of time. And as you can see, based on our guide for the next quarter, our impact is very minimal.

Rafe Jadrosich: Thank you. That’s very helpful. And then just we’ve seen an improvement on the backlog conversion over the last few quarters here. How do we think about additional opportunity going forward? Where are you versus your kind of historical average? And how do we think that could play out over the next few quarters?

Martin Connor: Well, Rafe, I think we expect to see better backlog conversion, because of reduced cycle times on the to be built as we are in a more stable supply chain environment, we’ve addressed some reductions in SKUs, and we’re getting better at building the to be built. But the big piece is going to come from more specs. Specs this quarter were 28% of deliveries. We’re targeting 40% of sales. We achieved that this quarter. And so, they’ll be 40% of deliveries and they’ll have a little bit less time in backlog, a lot less time in backlog than a to be built.

Operator: The next question comes from Michael Rio with JPMorgan. Please go ahead.

Unidentified Analyst: Hi guys. Thanks for taking my questions. This is Andrew [indiscernible] on for Mike. I just wanted to get a sense of kind of regionally, market-by-market where you’re seeing that ability to push price a little bit better, and where it’s a little bit more summer? Thanks.

Douglas Yearley: Sure. So really pleased nationwide. And by the way, the $20,000 price increase we saw in Q3, I know the question will come up, it’s about a $10,000 drop in incentive plus a $10,000 increase in the base price or the sales sheet price. The incentive was about $55,000 in Q2 when it went to $45,000 in Q3, and then the price went up by 10%. That’s on average. And it’s not everywhere, some areas or more. We still have some locations where we’ve gone to – we’re still doing final and best seal bid on select communities or select inventory. The best markets, and we mentioned the Mountain and the South had done the best, this past quarter. Denver, very strong. Boise, Idaho is back in a big way after taking a pause. Southern California, very strong.

Atlanta, New Jersey and Pennsylvania, very strong, and then all of Florida, a bit softer where we’re still feeling a little bit of pain. Phoenix hasn’t come back yet. It’s better, but it hasn’t come back as we look forward to it coming back at some point, but not yet. And then on that list, I’d also throw in Portland, Oregon, which is a very small market for us. But that has been a bit softer.

Unidentified Analyst: Thank you for that granularity. I appreciate it. I guess I wanted to ask about the sustainability. Obviously, this was a very nice SG&A. Maybe if you can bucket out what was driving that and kind of the sustainability going forward?

Douglas Yearley: Sure. So, we talked now for over a year about a commitment and a drive to make Toll Brothers more efficient. And we’re not done. But our headcount is down 11%, and our business is growing. And there’s also lower inside and outside commissions being paid on the sales side, but it is primarily overhead. And we will continue to look for opportunities to do more with less. I’m super proud of the steps we’ve taken. It will continue. And those are the main drivers of it.

Operator: The next question comes from Stephen Kim with Evercore ISI. Please go ahead.

Stephen Kim: Yes. Thanks very much guys. Obviously, great results. Thanks for all your comments so far. I do think it might be worth sort of thinking about what might happen if you were to see a slowdown in demand, I appreciate that in August, you – what you shared with us certainly suggests you haven’t seen that much of a negative impact from higher rates. But I think it also fair to say, we don’t really know what’s going to happen with rates in the next few months. And so, hypothetically if you did see buyer demand slow. Do you look back upon strategy that you pursued last year where you let – orders slow significantly rather than get aggressive with incentives? Do you look back on that and say, this is – that we were vindicated that that was the right thing to do. And if demand slows in the months ahead. You are going to do – we should expect you to do a very similar thing that you did last year with respect to letting your order slow, but holding the line on price?

Douglas Yearley: Yes. I am very proud of this management teams, it’s very thoughtful decisions around our strategy to not chase the bottom. I think we ramped up our specs strategy at the right time. And building costs were beginning to coming down, supply chain was easing. And so yes, we are not – we are a margin focused builder with an understanding of course that capital efficiency, ROE finally at the right way. It’s critically important long-term success, but our houses are big. They’re complicated. They have a lot of upgrades, and features and they take a while to build, and we’re not giving them away. We’re not going to chase the bottom. It doesn’t mean we’re going to have our head in the sand and not have more incentives in a soft market than we had in a good market.

I mean that’s part of the conversation we’ve had around this modest drop in margin next quarter. But yes, I think the strategy has worked, and we will continue with that strategy if your hypothetical was to prove true.