Take-Aways: Six Insights Into Toll Brothers' Path To '24 And Beyond
While most of its public homebuilding company peers are trying to secure predictable volume of sales into and past mid-year 2023, the Toll Brothers playbook focuses equally if not more on ensuring its 2024 book of business is firmly in hand by this time next year.
That's how Toll rolls - a bit ahead of the rest. Here's how.
The Toll team just closed out the best single quarter in the best single year of performance in the company's 56-year history, a fitting way to honor the memory of founder Bob Toll, who died this past Oct. 7, at age 81.
Toll Brothers ceo Doug Yearley recapped the record-breaking achievement in opening remarks on Q4 and fiscal year 2022 earnings with investment analysts this morning:
In a year filled with supply chain disruptions, labor shortages, permitting delays, inflation, increasing mortgage rates and many other operational challenges, we delivered over 10,500 homes, the most in our history, and grew homebuilding revenues by over 15% to $9.7 billion."
Blockbuster financial performance was of course a common theme in quarterly and annual earnings calls through Bob Toll's five-plus decades as a lead strategist. Success and Toll Brothers are synonymous.
For those with longer multi-cycle memories, that's precisely because of times like now – ones that may trace a "best-of-times-worst-of-times" plotline during the next 12 months or more. Times of uncertainty and doubt and Toll Brothers are also synonymous.
Who wouldn't be curious right now to know how Bob Toll would look at the moment we're in, what he'd say about it? Humor, humility, realism, opportunism, and the undying fire of determination to withstand and continue to grow, come what may. You could expect all of the above from Bob Toll, answering Wall Street analysts questions on a bleak, early December day, facing a housing market with its own Rosetta Stone mysteries and meanings locked tight.
What you could also expect was – and is, and probably will be -- a study in contrasts.
Toll Brothers – its founder determined and its current leadership and organization of team members carry on to this day – stands apart from other public homebuilding enterprises in ways that matter. It's part of the same broad housing market cycle as everybody else, complete now with deteriorating conditions, uncertainty, and doubt.
It's just that who it serves and how it brings value to its clientele means Toll behaves and navigates in sharply different ways from its peers. That distinction comes through clearly in Toll Brothers' fiscal fourth quarter and 2022 fiscal year results and 2023 guidance, all powered importantly by
- A 2021 order backlog capable of giving a clear, reliable, cancellation-resistant performance to date that extended a bumper crop earnings, deliveries, and revenues juggernaut beyond Toll Brothers' peers – which started to show wear and tear on their order backlogs beginning a couple of months ago.
- A 2022 order backlog that continues to offer baseline business visibility well into 2023, allowing Toll to open communities in Spring 2023 with a deliberate focus on value, and to lever up spec home production to ease its buyers' minds of timing and interest-rate volatility.
The secret of that backlog comes down to two factors – the clientele and their behavior. Yearley offers the data and an explanation:
Our backlog is supported by substantial non-refundable down-payments averaging about $83,000 per home. Through our build-to-order model, our buyers choose their specific home site, structural options and design studio finishes that match their lifestyles and their tastes. As they customize their homes, they become both financially and emotionally invested. Additionally, with approximately 20% of our buyers paying all cash and the average LTV for those who obtained a mortgage at 71%, affordability is less of an issue for our buyers who tend to be wealthier with more disposable income. As a result, our backlog cancellation rate has been the lowest in the industry for decades, both through good and bad markets.
During the fourth quarter, our cancellation rate as a percentage of backlog was 2.9%, just slightly above the average of 2.3% since 2010.
This explains why the Toll Brothers team blew through consensus estimates and surpassed a prior year calendar that many other homebuilders will find it tough to beat.
Here, from this morning's Toll Brothers earnings call transcript are verbatim Q&A exchanges that lend further insight into the Toll difference on matters of pricing, incentives, falling input costs, new order demand, spec home production, and the impact of these factors on a business enterprise built with pan-cyclical business resiliency into who it is, who it's for, and how it behaves in contrast to peers.
Interest rate sensitivity
Doug Yearley
I don't think our buyer is even relatively insensitive to rates. I think they're very smart. They're wealthy and they are definitely aware of and focused on rates. Back in August, when we were all together, I spoke of some green shoots because rates have broken below 6 and we were encouraged for a few weeks. And of course, that went away as rates went up into the low to mid-7s. And now they are in, call it, the mid- 6s. And there are some very, very modest green shoots of the last few weeks as rates have come down, but I am not ready to get sucked back into the conversation I had with all of you in August when we felt better because it's just -- we have Thanksgiving in the middle of this, and it's just not enough time to understand if that move from 7.25% to 6.5% is enough to start triggering more demand. It's December, it's not the timing of the year to really comment on that. And we got a bit burned by the comments that the industry made in August that didn't play out.
But longer term, if these rates can break through 6 and get into the 5s, I think we're really going to be on to something. And I think that applies to whether it be first time or whether it be the Toll Brothers buyer. Our buyers are definitely wealthier, they have more equity in their homes, if in fact, they have a home that they're going to be selling. There's more cash that they put up. There's lower leverage on the mortgage. And so we have a lot of good things going for us. But they are absolutely aware of and sensitive to where rates are moving."
Pricing –2023 gross margin guidance of 27%
Doug Yearley
If you look on paper at those 8,100 homes in backlog, the margin is higher than 27%. But we are putting a cushion on that because we do know that there will be what we think is some modest elevation of cancellations. We also have some additional homes that we need to sell to hit the 8,500-home midpoint of the '23 delivery. And so we buffered it a bit when we've come in with our guide of 27% because of the current market conditions.
In terms of where we are today, the average incentive nationwide on the next home sold is 8%. And remember, that's not coming off of zero. Even in the very good times through COVID, we always had an incentive in the range of 3% to 4%."
Incentives strategy
Doug Yearley
The 8% [average incentives] is all inclusive of whether it be price drops, incentive increases or closing cost assistance or mortgage buydowns or anything that we can think of and that you can think of is included within that 8%. And yes, Bob, you said talked about Super Bowl Sunday to Easter or the Super Bowl now in February. So a few weeks before Super Bowl Sunday, and now it generally extends through late April – the heart of the traditional new home selling season. And as I mentioned, even in tougher times, we always expect more homes sold during that period than other times of the year. And so I think we strategically have made a good decision to work hard on delivering our backlog and protect it to incentivize where there is elasticity where the market is responding to incentives. But to really wait for delivery times to come down for building costs to start coming down and to focus on when it makes the most sense to be a bit more aggressive to go chase deals if we need to do that. And that is by each community, by each market and face, of course, upon the overall bigger macro market conditions and economies. And so that is the strategy in place. I also talked about layering in some additional spec build where appropriate in those markets that have better dynamics and to do that at a time when we can build those specs for a bit less to set up good results for 2024."
Orders and pace expectations
Doug Yearley
We don't have a sales quota. We've never run this company top down -- top line down but we're very mindful of the need if we get to that point of driving more sales. And I'm sorry for the vague answer, but that means that we analyze every community locally. We start having meetings with the sales team, with the community team. We do a deep dive into the market comps and we start making pricing decisions accordingly. We also may have some modest shift in product offering. Maybe you come in with a smaller house. Maybe you come in with the same house, but you pull some features out of it. There's a lot of different moves that we make. It's studied weekly, but it's studied very, very locally. So I can't tell you that if we sit at 1, 2 sales per month and really want to be at 2, we're going to start making some dramatic company-wide moves. It's going to continue to be market and community specific, and we will act accordingly as we roll through the spring season."
Anticipated input cost relief
Doug Yearley
.... From the third quarter to the fourth quarter, lumber dropped $12,000 to $14,000 per house just in one quarter there. ... I talked about building costs beginning to come down and cycle times beginning to come down. The front-end trades, the excavator, the foundation and concrete, the framer, window installation, siding, roofing, rough mechanical, electric plumbing, HVAC, and everything you do before you insulate a home and button it up with drywall, those front-end trades are now feeling less action as there are less starts. And they're the ones coming forward now saying, 'Hey, we have some capacity.' And as soon as you hear the capacity word as a builder, you say, great, and here's the new price. And so there's negotiation occurring on the front end, and that will naturally move through to the back end as those finishing trades also feel less activity.
Higher spec production?
Doug Yearley
I mentioned that we're very focused strategically on '24, and we will pull the levers necessary to have homes ready to be delivered in '24, which means we will increase spec build starting in the new year. That will be ready in early mid, end of '24. And it's been interesting, the last couple of quarters, while we're about 75% build-to-order, 25% spec, and the spec business for us has been better, it's been higher margin. The client, one of the reasons is they can lock a rate for a quicker delivery, and they want a little more certainty around the finances associated with buying the home. So our spec business has done well, and we've had a bit better pricing power, which gives us confidence. We're not going 50-50 and maybe we get to 30-70. We'll have to see, but it's going to be based on certain markets and how those markets are doing and where the elasticity of demand has been.
So we will continue to keep a close eye on market conditions and adapt accordingly. And if that means not just building more spec to set up those deliveries, but being a bit more aggressive on incentives, we're going to do that. We're not going to lose market share. We have the land to grow this company. We already mentioned 10% community count growth coming this year on the land we control, we have strategically delayed those openings, as I mentioned, so that they hit in a better part of the year, which is the spring season, and they hit, we're actively building models everywhere and holding off openings where in COVID, we would have opened them. We would have had what we call 'muddy shoes' opening, where it's hard to get on the job site, and you had to work hard to buy a home. We're going to -- you're going to -- this is going to be Ritz-Carlton white glove, everything perfect, and we're going to do it at the right time of the year."