Toll Brothers, Inc. quarterly report, Q3 FY2018

Toll Brothers, Inc. — Fiscal 2018 Third-Quarter Form 10-Q

Reporting period: Quarter and nine months ended July 31, 2018. Toll Brothers is a luxury residential homebuilder operating through Traditional Home Building and City Living segments across U.S. markets. Fiscal year-end is October 31.

Financial performance and key metrics

Metric	Three months ended July 31, 2018	Three months ended July 31, 2017	Nine months ended July 31, 2018	Nine months ended July 31, 2017
Revenue	$1.913 billion	$1.503 billion	$4.688 billion	$3.787 billion
Income from operations	$229.7 million	$172.2 million	$447.8 million	$362.2 million
Net income	$193.3 million	$148.6 million	$437.2 million	$343.6 million
Diluted EPS	$1.26	$0.87	$2.81	$2.01
Operating margin	12.0%	11.5%	9.6%	9.6%
Net margin	10.1%	9.9%	9.3%	9.1%
Effective tax rate	23.6%	27.0%	18.7%	33.0%

Revenue increased 27% in the quarter and 24% year to date. Deliveries increased 18% in both periods, while average delivered prices increased 8% in the quarter and 5% year to date.
Cost of revenues increased faster than revenue year to date, rising 25%; cost of revenues was 79.8% of revenue versus 78.9% in the prior-year period. Quarterly cost of revenues was 78.9% versus 78.3%.
SG&A increased 13% in the quarter and 14% year to date, but declined as a percentage of revenue to 9.1% from 10.3% in the quarter and to 10.6% from 11.6% year to date.
Inventory was $7.958 billion at July 31, 2018, up from $7.281 billion at October 31, 2017. Inventory impairment charges increased to $28.7 million year to date from $11.3 million.

Cash flow, debt and liquidity

Cash and cash equivalents were $522.2 million at July 31, 2018, down from $712.8 million at October 31, 2017.
Operating activities used $72.2 million in the first nine months, compared with $408.0 million provided in the prior-year period, primarily reflecting a $541.9 million increase in inventory and higher receivables and other assets.
Investing activities provided $60.2 million, principally from $97.6 million of returns from unconsolidated entities and distressed investments, offset by capital expenditures and new joint-venture investments.
Financing activities used $178.6 million, including $426.9 million of share repurchases, $45.5 million of dividends and net loan repayments, partly offset by $396.5 million of net proceeds from issuing $400 million of 4.350% senior notes due 2028.
Total debt was $3.648 billion at July 31, 2018, consisting of $694.4 million of loans payable, $2.861 billion of senior notes and $82.3 million of mortgage-company borrowings. Debt to total capitalization was 0.45 to 1.00.
The company had no borrowings under its $1.295 billion revolving credit facility, approximately $1.12 billion of availability after outstanding letters of credit, and $174.0 million of letters of credit outstanding. Its leverage ratio was approximately 0.71 to 1.00 versus a 1.75 limit.

Material changes versus the prior comparable periods

Net contracts signed increased 20% year to date to $6.106 billion, representing 6,804 homes, and increased 12% in the quarter to $2.032 billion, representing 2,316 homes.
Backlog increased 22% year over year to $6.479 billion, representing 7,100 homes. Average backlog price increased 8% to approximately $912,600.
California was the largest growth contributor: year-to-date revenue increased 44% and income before taxes increased 44%. City Living revenue increased 34% year to date, but income before taxes declined 54% because of lower joint-venture earnings and lower-margin deliveries.
Income from unconsolidated entities declined 52% year to date and 37% in the quarter. The prior-year period included significant gains from joint-venture interest sales and stronger City Living joint-venture deliveries; fiscal 2018 included a $4.0 million impairment of a land-development joint venture.
The effective tax rate declined substantially because of the Tax Cuts and Jobs Act, including a $36.2 million deferred-tax remeasurement benefit, and a $4.0 million benefit from adoption of share-based compensation accounting guidance.
The company repurchased 9.874 million shares for $426.9 million during the first nine months and had authorization remaining for approximately 13.223 million shares at July 31, 2018. It paid dividends of $0.30 per share year to date versus $0.16 in the prior-year period.

Guidance, outlook, risks and unusual items

Management expressed confidence in demand, citing limited housing supply, favorable employment and consumer conditions, affluent buyers and the company’s land position. It expects gradually rising interest rates not to materially disrupt demand, but provided no formal numerical earnings or delivery guidance in the filing.
Land purchase commitments totaled $2.539 billion, requiring approximately $2.280 billion of additional cash if all parcels are acquired. Apartment-development land commitments were approximately $190.0 million.
The company owned or controlled approximately 53,600 home sites and was selling from 301 communities at July 31, 2018.
Joint-venture investments totaled $420.0 million, with $40.2 million of additional funding commitments. Guarantees could expose the company to an estimated maximum of $242.5 million for repayment and carry costs on debt already borrowed, or $293.0 million if related commitments are fully drawn.
Water-intrusion and stucco claims remain a significant contingency. Recorded estimated repair costs were $324.4 million, with $152.6 million of expected insurance and supplier recoveries. Management states that actual costs and recoveries could differ materially from estimates.
The SEC is investigating estimated repair costs for stucco and other water-intrusion claims, and the Pennsylvania Attorney General is reviewing stucco-home construction. The filing states that the scope and outcome cannot currently be predicted.
Inventory impairment charges increased, including charges related to weaker demand, higher site costs, bulk-sale decisions and revised pricing assumptions in certain communities.
Revenue recognition guidance effective November 1, 2018 is expected to reclassify retained customer deposits, move approximately $105 million of marketing-related assets to property and equipment, and produce an estimated $25 million reduction to retained earnings for costs no longer eligible for capitalization. The company is still quantifying other effects.
In August 2018, the company received $27.7 million from a Realty Trust asset sale and expected to recognize an approximately $27.7 million gain in the fourth quarter. It also formed a joint venture for a 1,244-unit Washington, D.C. apartment project.

Important facts for investors to verify

Whether elevated inventory growth, material and labor costs, and higher impairment charges pressure future gross margins and cash flow.
The conversion and cancellation rates of the $6.479 billion backlog, particularly in California and other higher-priced markets.
The ultimate scope, timing and recoverability of stucco and water-intrusion claims, including SEC and Pennsylvania Attorney General matters.
Actual cash requirements for the $2.539 billion of land commitments, apartment-development commitments and joint-venture funding obligations.
Joint-venture guarantee exposure and the adequacy of underlying collateral and partner reimbursement arrangements.
The final accounting impact of the new revenue-recognition standard and the Tax Cuts and Jobs Act provisional tax accounting.
Debt maturities, refinancing requirements and the effect of higher interest rates; a 1% increase in variable rates was estimated to increase annual interest expense by approximately $6.0 million.