When It Comes To Market Share, Toll Owns Move-Up's Biggest Slice
As 2023 veers from a better-than-expected run to the seasonal limbo of a mixed-signals budgeting season, market share is the name of the game for homebuilding firms. Their goal is to future-proof their business models. That, and to ignite earnings growth in 2024, 2025 and beyond. A deeper, heftier slice of every highly-active new residential real estate and construction market is key to unlocking the kind of time-released earnings required as a rule of engagement for those expected earnings opportunities.
At the same time, volatility, sustainedly-higher borrowing costs, and higher prices will impact both profoundly-constrained supply and structurally-strong-but-vulnerable demand forces as the broader economy makes up its own mind about whether a soft, hard, or no-landing future will pronounce itself in 2024, 2025, or beyond.
For Toll Brothers – which Tuesday announced Q3 2023 results and Wednesday discussed them with investment research analysts – winning market share today to boost and sustain earnings tomorrow counts as much as it does for anybody else. It's just that the market Toll Brothers competes – successfully – for primacy in is different than the rest of its national public homebuilding peers, and that difference carries with its own bevy of rewards, risks, challenges, and opportunities.
For instance, strategic public national homebuilders like D.R. Horton, Lennar, Pulte and others whose strategies target – with 25% to 30% to 40% business-mix emphasis – entry-level, first-time buyers vie with one another, head-to-head, for an outsized share of customers, talent and construction capability, land parcels, distribution channel deals, etc. It's a straight-on peer-to-peer feeding frenzy, and now, with dry-power cash troves amassed over the past 12 months and ready to deploy, the winning game for those players will be to outsmart, outspend, or out-maneuver each other.
Mostly, this is a tough prospect for the less nimble or less agile or less financially-primed to pounce among public company peers. It's also a reckoning moment for land-sellers, masterplanned community developers, etc. who may find themselves having to choose a lane on selling terms that may sort out as an either/or deal: A higher-lot-price vs. a more visible, reliable, and sustainable absorption take-down schedule when it comes to the so-called entry-level, more affordable, first-time-buyer positioned market.
Importantly, when it comes to the big market share grab ahead we anticipate, it's either welcome news or a deeply sobering prospect for privately-capitalized homebuilding operators, many of whose financing is personally-guaranteed and whose appetite for going out into today's land market for 2024 and 2025 lot pipelines is muted at best.
Right now, many of the hundreds of more interest-rate sensitive private operators may be staring down a "Dirty Harry moment." They, too, have to ask themselves, "Am I feeling lucky?" they consider a near-term outlook flanked by higher-for-longer borrowing costs and more-voracious-than-ever big public builders that suddenly regard peppy, pesky privates as their feeding ground.
For Toll Brothers, however, it's not your standard-issue private operator in the cross-hairs, but rather custom and semi-custom homebuilders that tend to project-finance their activity, as well as established operators in higher-ticket, resort-y zones that cater to the discretionary, nice-to-have buyers.
Some analysts describe these buyer prospects as "immunized" from interest rates, both where they are, where they could go, and for however long they may remain there.
Toll Brothers' Q3 results blew through both the firm's own guidance and consensus expectations, at least partially because of how the dynamics of its discrete customer pool behave at almost a parallel universe separate, distinct, and above other homebuilding enterprise peers.
Earlier this year, New York Times economics writers Jason Karaian and Jeanna Smialek wrote a piece, "Is The Entire Economy Gentrifying?" that helps us understand how to look at Toll Brother's present results and future business as an outlier among America's top 10 public homebuilding enterprises.
The notion of premiumization was raised in nearly 60 earnings calls and investor meetings over the past three weeks.
It is an indication of a changing economic backdrop. Inflation and consumer spending are expected to moderate this year, which could make it more difficult for firms to sustain large price increases without some justification.
The premiumization trend also reflects a divide in the American economy. The top 40 percent of earners are sitting on more than a trillion dollars in extra savings amassed during the early part of the pandemic.
So, while homebuilding public peers – the ones that count on 25% to 40% of their sales going into an ever-more-challenging entry-level segment – compete in a crowded arena right now, Toll Brothers can forage for present and future opportunity "far from the madding crowd."
Doug Yearley, in Q3 earnings performance comments with investment analysts spoke to this explicitly in responding to a question suggesting that Toll Brothers customers are, in fact, more immune to the vagaries of today's interest rate and inflation scourges, and show that by paying all-cash or at least more cash down to buy a Toll Brothers home. Yearley says:
20% of our clients were all cash. This quarter was 25%. And there's a good reason for it. [Our buyers say:] 'I have the money. I'm wealthy, and I don't love a 7.5% rate. So, I'll put more of my own money to work and less of the bank's money to work.' Our LTV has gone from 70%, it is for those that do get a mortgage to 68%, same reason.
Our buyers are clearly wealthier. They have equity in their homes. Remember, the resale market is very interesting, but good, solid used homes... They sell, and they're selling quickly, and they're selling, in many cases, above asking price. What is sitting on the market is the old tired inventory which actually makes it even better for us, because not only is the resale market really tight.
... We hope our buyers have some of the better homes that are moving faster. And therefore, they may be getting a bit more equity out of their home than they had thought. So they're wealthier. They're getting a bit more equity out of the existing home, and they want to move... It's not a strict financial decision, it's a family decision. It's emotional. It's moving all of your life. It's getting the kids in the better school. It's moving down as an empty nester. It's buying the second home. And all of that wins, it trumps the straight financial calculation on the back of a napkin, and where do they go? They may start on a resale market. They can't find anything. We're really proud of what we do. We're really good at what we do. We have groupies. People want and aspire to get into the Toll Brothers house."
This customer, Yearley explains, translates into a competitive and market share challenge and opportunity – as regards land acquisition, and potentially mergers and acquisition activity – that sets Toll Brothers apart:
We're moving in the direction of having less owned land, but I'm not going to agree that two years is possible only because our business model, where we buy land is a bit different. Our land is very special. It's very unique and not every deal lines up with somebody there to feed you finished lots at the corner of Main Street and Main Street in Greenwich, CT, Princeton, NJ, Irvine, CA ... "
That higher-tier of customers, and their "inoculated" financial behaviors in today's high-interest-rate marketplace comes through, Yearley notes, in their counter-intuitive preferences when it comes to Toll Brothers options and upgrades orders.
Long-term averages for our upgrades – and that includes the lot premium -- run at 21%. In Q3 2023, it's been 27%, $236,000. That's counterintuitive, right? With rates going up, do you think maybe people are moving towards smaller homes, more affordable homes? Not the case. That goes right to the wealth of our clients and how we do it. This is their dream move. And if they can afford it, they're going to reach."
What Yearley and the Toll Brothers team are not overconfident about is any notion that their capacity to constantly create new streams of customer demand can be taken for granted as a sure bet. Still, if things slow down so much that even the market for the top-most tier of the "K economy" begins to soften, Yearley says, there's a plan:
We are a margin-focused builder with an understanding of course that capital efficiency, and return on equity, finally, is critically important to our 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.
That's part of the conversation we've had around this modest drop in margin next quarter. I think the strategy has worked, and we will continue with that strategy.
We've been generating more than $1 billion of free cash flow for the last several years, three or four years. We have dropped our lot count by 15%, still being able with a lot - land we control to grow community count last year, this year, next year and beyond. Our land teams are very good at structuring land deals, to be more capital efficient. We're doing joint ventures. We're relying upon land bankers. We're getting purchase money mortgages from land sellers. We're buying improved lots just in time."
In a time period where competing for a bigger slice of the market share pie is critical to both business-model sustainability and an opportunity to ignite earnings growth, the Toll Brothers position – as pretty much the master of move-up – stands as a future-proof runway it has all to itself.