Toll Brothers, Inc. Q3 FY2022 Earnings Call

Good morning, and welcome to the Toll Brothers Third Quarter Earnings Conference Call. The company is planning to end the call at 9:30 when the market opens. During the Q&A, please limit yourself to one question and one follow-up. Please note this event is being recorded. I'd now like to turn the conference over to Douglas Yearley, CEO. Please go ahead.

Thank you, Jason. Good morning. Welcome, and thank you for joining us. With me today are Marty 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. Before I begin, I ask you to read the statement on forward-looking information in our earnings release from 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, pandemic impacts, and many other factors beyond our control that could significantly affect future results. In our fiscal third quarter ended July 31, we reported earnings of $2.35 per share, up 26% compared to the third quarter of 2021, driven by continued gross margin expansion. Our third quarter adjusted gross margin was 27.9%, an improvement of 230 basis points compared to last year and 90 basis points better than guidance. SG&A expense was 10.3% of homebuilding revenues, which was 20 basis points better than both our guidance and last year's third quarter. We delivered 2,414 homes in the quarter, at an average price of approximately $935,000, generating $2.3 billion in homebuilding revenue. Although we achieved record third quarter revenues, net income, and EPS, our revenues were lower than anticipated due to fewer deliveries than projected. The shortfall resulted from unforeseen delays with municipal inspections, continued labor shortages, ongoing supply chain disruptions, and a softer demand environment. We missed our deliveries guidance by 336 homes. Most of these deliveries were concentrated in a handful of communities and markets. For example, in California, we had 200 homes completed at quarter end, but due to delays with city inspectors and utility companies, we could not get the final inspections or the electricity needed for certificate of occupancy. The change in the demand environment also impacted Q3 deliveries. The combination of fewer spec sales, outside lender delays, a modest uptick in cancellations, and customers taking more time to sell their existing homes all resulted in fewer deliveries. Due to these challenges, we are lowering our deliveries guidance. We now expect to deliver between 3,250 and 3,550 homes in our fourth quarter and between 10,000 and 10,300 homes for the full year. Our adjusted gross margin in the third quarter at 27.9% was 90 basis points better than projected, primarily due to favorable mix and effective management of costs. We ended the quarter with a solid backlog of 10,725 homes worth $11.2 billion. We had a total of 190 cancellations in the third quarter, equal to just 1.6% of the 11,768 homes in backlog at the beginning of the quarter, comparable to our cancellation rate of 1.2% in the first half of 2022. Since 2010, our average cancellation rate as a percentage of backlog has been 2.3%. We believe looking at cancellations as a percentage of backlog is much better than as a percentage of current orders. We have not seen any change in cancellation rates in the first few weeks of August. We have consistently had the lowest cancellation rate in the industry for many decades, which reflects the financial strength of our customers and our build-to-order model, where buyers personalize their homes and become emotionally invested. They make a non-refundable down payment averaging $80,000, which also signifies their financial commitment, as our low backlog cancellation rate in the third quarter shows. Our buyers have remained committed to their new homes even in this uncertain environment. Our backlog consists of homes sold in the very strong pricing environment of the past year, which positions us well to continue expanding our gross margin in the fourth quarter and into fiscal year 2023. We project an adjusted gross margin of 29.2% for the fourth quarter, and we are reaffirming our full-year guidance of 27.5%. As our third quarter progressed, we saw a significant decline in demand as many prospective buyers stepped to the sidelines due to steep increases in mortgage rates, significantly higher home prices, a volatile stock market, and rising inflation. Buyer confidence was impacted by constant headlines about a softening housing market and general uncertainty regarding the economy's future direction. All of these factors contributed to a psychological market change, and buyers remained cautious through the summer months. Consequently, our net signed contracts were down approximately 60% in units compared to last year's historically strong third quarter. In dollar terms, signed contracts were down 44% year-over-year as contracts in the third quarter benefited from price increases we have steadily applied throughout the year. Throughout most of the third quarter, we deliberately did not pursue buyers with incentives, believing demand was very inelastic. Buyers were on the sidelines and not seeking better deals. On average, incentives in our third quarter contracts were around $16,000 per home, up only $5,000 from the average in the first half of 2022. In recent weeks, we have seen signs of increased demand as sentiment appears to be improving and buyers are returning to the market. With higher quality traffic, we have also begun modestly increasing incentives, to which buyers are responding. August sales included an average incentive of about $30,000. In the first three weeks of August, our average weekly non-binding deposits were up 25% compared to July. We have also seen a rise in digital leads and foot traffic to our model homes. Our sales teams are reporting higher quality traffic, and in several recently opened new communities, we have witnessed strong deposit activity. While these observations span only a few weeks, they are encouraging signs, and we are cautiously optimistic that the housing market is settling into a more normal seasonal cadence. Despite short-term uncertainty, we believe that fundamental drivers supporting the housing market in recent years remain intact. These include favorable demographics, with more millennials reaching their prime home buying years and baby boomers relocating for new lifestyles, the undersupply of new homes over the past decade leading to a substantial deficit and tight supply for sale, migration trends driven by increased workplace flexibility, and a greater appreciation for homeownership that Americans have embraced in recent years. We are confident that these long-term trends will continue to support homeownership demand well into the future. In the current environment, we believe it is increasingly important to be disciplined and capital efficient in our operations and land acquisition strategy. We are focused on controlling SG&A costs and enhancing efficiency by managing headcount and reducing expenditures. We have also taken a more conservative approach to underwriting new land deals, continuing to renegotiate or terminate options if they no longer meet our stricter standards. At the end of the third quarter, we owned or controlled approximately 82,100 lots, down 3,700 lots from the end of the second quarter. About 51% of these lots were optioned, down from 53% at the end of the second quarter, partly because we terminated options on over 3,000 lots during the quarter. Long term, we aim for a mix of 60% optioned and 40% owned lots. Additionally, nearly 11,000 of our owned lots are committed to buyers in our backlog. Excluding these, 59% of our land is controlled through options. We also continue focusing on our return on equity. In the third quarter, we repurchased $92 million of our common stock. Since the fiscal year's start, we have repurchased about $385 million or 5.8% of our diluted share count at the close of fiscal year 2021. We have paid $67 million in dividends year-to-date and retired $410 million in long-term debt in our first quarter. We expect share repurchases to remain a key part of our capital allocation strategy going forward. Additionally, we are committed to employing capital-efficient strategies in our land acquisitions. Last week, we announced a new joint venture between our City Living division and Sculptor Real Estate to develop two luxury condominium communities in the New York City market, including the latest addition to our Provost Square development in Jersey City, where we have sold 60 units at an average price of $1.1 million over the past three months. We will act as a managing member and development lead, overseeing approvals, design, construction, and sales, and we hope to add future properties to this venture. The structure of these transactions and our strategic partnership with the experienced team at Sculptor demonstrates our commitment to maximizing capital efficiency in our City Living operations. With that, I'll turn it over to Marty.

Thanks, Doug. Before we get into the income statement, I want to discuss the average sales price for our newly signed contracts this quarter. The average selling price for contracts signed in the third quarter of fiscal year '22 was $1.3 million. It's worth noting that this average was higher this quarter due to the lower number of contracts we signed. Consistent with our usual approach, the total contract value for the quarter includes both the dollar value of new contracts signed and the dollar value of option sales for homes sold in prior quarters. It's not unusual for buyers to choose finishing options one or two quarters after they sign the initial contract. Typically, this practice does not affect the average sale price for new orders, but it did this quarter because of the small number of contracts in Q3 compared to Q2 and Q1. On a normalized basis, we estimate the average selling price for Q3 contracts was closer to $1.15 million, which still reflects an increase of about 7% compared to Q2. This increase was due to our pricing strategy over the past year, including our decision not to offer incentives during much of the third quarter, along with a favorable mix. In our third quarter, we generated homebuilding revenues of $2.3 billion, down 7% in units but up 1% in dollars from a year ago. We reported pretax income of $366 million compared to $303 million in the third quarter of fiscal '21. Net income reached $273.5 million or $2.35 per diluted share, compared to $235 million and $1.87 per diluted share last year. The increase in pretax and net income primarily resulted from a significant year-over-year gain in gross margin. Our adjusted gross margin for the third quarter was 27.9%, up from 25.6% in the third quarter of '21 and 90 basis points better than we anticipated. As Doug pointed out, the outperformance was mainly due to a favorable mix and efficient cost management. We expect the adjusted gross margin to be 29.2% in the fourth quarter and maintain our projection of a 27.5% gross margin for the full year. The estimated gross margin for homes in our backlog remains strong, indicating a positive pricing environment experienced throughout much of the third quarter. With 10,725 homes in backlog and about 3,400 deliveries anticipated in our fourth quarter at the midpoint, we have over 7,000 homes in backlog that will support our deliveries in fiscal year 2023. The estimated gross margin for these deliveries is better than our projected full year 2022 margin. SG&A as a percentage of revenue in our third quarter was 10.3%, compared to 10.5% in the same period last year, and 20 basis points better than projected, despite lower-than-expected revenue. This was mainly due to reduced selling and marketing expenses. Our third-quarter joint venture land sales and other income reached $13.2 million, surpassing our breakeven target, primarily due to unexpected gains from land sold into joint ventures that we initially projected would happen later in the year. We had originally planned to sell several stabilized apartment living and student housing properties in our fourth quarter, expecting to generate around $50 million in income from unconsolidated entities. However, we are postponing these sales to fiscal year 2023, anticipating better pricing from buyers. Consequently, we are reducing our 2022 full year joint venture, land sale, and other income target to $60 million. Overall, our total investment in Apartment Living at the end of our fiscal third quarter was $565 million, consisting of $133 million in 18 properties that are stabilized or in lease-up, where we believe unrealized gains are approximately $400 million. Additionally, we have $289 million invested in 23 properties currently in joint ventures and under construction, along with $143 million in land and projects, totaling 28 properties that are fully on our balance sheet but intended for future joint venture development. This pipeline will enable us to produce consistent gains from apartment sales in the coming years, which we expect will nicely complement our core homebuilding business. Returning to our results, impairments and write-offs amounted to $6.2 million in the quarter, primarily reflecting some due diligence costs or lost deposits on land we no longer intend to pursue because they don't meet our stricter underwriting criteria. Our tax rate for the third quarter was 25.3%, which is 70 basis points better than projected. We now estimate a tax rate of about 24.8% for the fourth quarter and 25% for the full year, a slight improvement over our previous guidance, as we anticipate approximately $10 million in Section 45L energy tax credits reinstated in the recently signed Inflation Reduction Act. We closed the quarter with a net debt-to-capital ratio of 34.3%. We had $316.5 million in cash and equivalents and $1.8 billion available under our $1.9 billion revolving bank credit facility, which is not maturing for over four years. This gives us significant flexibility to grow and return capital to our shareholders. At the end of the quarter, our book value per share was $48.74, and we expect it to be around $52.50 at fiscal year-end. Now, let me cover additional items in our guidance that we have not yet discussed. Based on the strong pricing in our backlog, we expect our fourth-quarter average delivered price to fall between $935,000 and $955,000. We have adjusted the full year average to $920,000 at the midpoint. We expect interest and cost of sales to be about 1.8% of home sales revenues in the fourth quarter and for the full year, reflecting a 40 basis point decline compared to full year 2021. This decrease is largely attributed to retiring higher interest rate debt over the past few years, which has reduced our leverage as well. We anticipate further reductions in interest and cost of sales in fiscal year 2023. We project SG&A as a percentage of home sale revenues to be roughly 8.7% in our fourth quarter and 10.5% for the full year. Our weighted average share count is projected at 118.5 million for the full year. We expect our community count to be about 350 by fiscal year-end. We have lowered this community count forecast due to entitlement delays and supply chain disruptions affecting land development, as well as our strategy to intentionally postpone the opening of some communities until 2023. Over the last two years, we opened communities earlier than usual without models and from sales trailers or even off-site due to high buyer demand. We do not expect that trend to continue in the near future and will return to our usual practice of opening communities with completed model homes and fully finished sales centers. Importantly, we possess or control enough land to significantly increase our community count in fiscal year 2023. Now, I will turn it back to Doug.

Thank you, Marty. I want to take this opportunity to thank our incredible Toll Brothers team members who continue to work tirelessly on behalf of our clients in these unprecedented times. It is their dedication and passion for our business that makes us all so excited for the future. Jason, now let's open it up for questions.

Thank you. We will now begin the question-and-answer session. As a reminder, the company will conclude the call at 9:30 when the market opens. Our first question comes from Alan Ratner from Zelman & Associates.

I appreciate it. My first question is regarding the delivery guidance; I noticed it was reduced by about 1,000 homes for the year. Can you provide a rough breakdown of how much of that is due to the supply chain challenges you've mentioned, meaning these homes won't be delivered by year-end as previously expected? Additionally, how much of this reduction might stem from a more conservative outlook on demand? I understand you have been building more speculative homes, and I assume there was an expectation that some of them would sell and be delivered before year-end. How much of the reduction is simply due to caution regarding the timing of those sales and deliveries?

Good question. Our model consists of about 80% build-to-order homes and 20% speculative homes. The reduced guidance is likely around 10% to 15% due to fewer speculative sales that can be sold and delivered within the same quarter or a short timeframe, as that is not the main focus of our business model. Therefore, the remaining 85% to 90% is largely influenced by supply chain issues. Recently, both we and the industry have faced significant challenges in obtaining transformers from utility companies, which are necessary to provide electricity to completed homes, as well as getting electric meters installed. This is a new challenge for us but can have considerable impact, particularly in California. Additionally, about one-third of the issues arise from local government challenges, including delays in inspections and obtaining certificates of occupancy, as well as some buyer-related delays. With higher mortgage rates, buyers are experiencing more difficulty in selling their existing homes, which can elongate the qualification process. We have also seen a slight increase in cancellations, which we have accounted for. While August cancellations are not significantly up, they have increased slightly. Combining all these factors, very little of the reduction can be attributed to the speculative sales strategy, as that is not our primary business; rather, most of the reduction stems from the production-related issues I described, which include both municipal and utility company challenges.

Got it. That's really helpful. Thanks for walking through all that, Doug. Second, on the incentive environment, I appreciate your comments there just in terms of the inelasticity of demand through the quarter. So it's the easiest way to think about the incentives that you're offering in August 30,000, so that's roughly double from where you were before, pretty modest overall. It's about 1.5%, I guess, in terms of, I guess, a potential margin impact. When you're talking about your margin in backlog and kind of the expectation for improvement in '23, recognizing that these incentives are on new orders today, what are the conversations like in terms of your buyers in backlog? Are they coming to you expecting a similar incentive? Are you prepared to offer that type of incentive to a buyer to keep them in backlog? And ultimately, how aggressive are you willing to get on the incentive front before kind of just taking a backseat and letting other builders compete in that area? Because traditionally, you have not been very aggressive there.

Sure, I'm going to provide a longer answer because I know this is important to everyone. In Q2, our incentive was $11,000 for a house priced at $1.1 million, which is about 1%. In May, it was $12,000; in June, $15,000; in July, $22,000; and in August, it reached $30,000. Even at $30,000 for a $1.1 million house, we're still under a 3% incentive, which is historically low. When selling a $1.1 million house, it's typical to offer the buyer $10,000 to $30,000 to assist with things like design choices or closing costs. We noticed early in May and June that buyers were stepping back due to rising home prices, mortgage rates doubling, and concerns about inflation and a soft market. We anticipated a slower summer and decided not to pursue those buyers with incentives. Instead, we focused on our $11 billion backlog, which made more sense for our business model. We didn't need to push out finished inventory, so we chose not to chase buyers who weren't engaging in negotiations. Post-July 4th, we began to see an increase in traffic. We survey our 350 sales teams weekly, and I've been involved in calls each Monday. Traffic improved, and buyers seemed more interested and willing to negotiate as they realized it was more of a buyer's market. As a result, we modestly increased our incentives and experienced positive outcomes. However, whether we continue incentivizing will depend on individual communities, as we remain responsive to feedback from our sales teams. As summer concludes, we expect better traffic and higher quality leads, acknowledging it is a buyer's market, and we'll adjust our strategies accordingly. I’m not claiming that the $30,000 incentive in August marks a bottom; the future is uncertain, but our outlook is more positive, and we will adjust as needed. We won’t pursue aggressive incentives because our business model doesn't require it. Regarding our backlog, we don’t negotiate on that front. Buyers have around $80,000 in down payments and a strong emotional connection to their future homes. Around 80% of them are custom designing their homes from the start. This is a significant lifestyle change for them as they enter new schools and create their dream homes. Historically, we haven’t seen rates like these, and currently, our backlog is stable. We do help clients who may need extra time or assistance with mortgage options, but we are not renegotiating with our backlog as most buyers are committed and moving ahead. Apologies for the lengthy response, but I know this is a key concern.

The next question comes from Michael Rehaut from JPMorgan.

First, I wanted to get more clarity on the average weekly deposits for the first three weeks of August, which are up 25% from July. This is a helpful number that highlights the improvement you're beginning to see. I was curious if we could also have that number on a year-over-year basis, specifically comparing the first three weeks of August this year to the same period in August 2021, as well as the year-over-year figure for July.

Sure. It's important to note that we're only looking at three weeks, so while I feel cautiously optimistic, this timeframe is quite short. However, we are encouraged that deposits have increased by about 25% compared to July. When we examine the year-over-year data, the deposits for the first three weeks of this August are down around 45% compared to the same period last year.

August.

My apologies. Thank you, Marty. The three weeks of this August are down about 45% to the same three weeks of last August. In terms of cadence, we talk about the same contracts in each month of May, June, July this year, which was about 420 agreements or orders per month. Now when you look at last year, July was elevated significantly over the last 2021, May end of June. But this year, it was more level. And so if you consider the deposits being up 25%, you just do the normal math on conversion ratios. It would be fair to say that for the next week or so until this month is over, that 420 sales that we saw in July would be about 500, if you do that math. And I'm not going to guess at all as to what September and October may hold, except that I think we are encouraged by what we see, and we've certainly loosened the strings, as I just mentioned to Alan, in terms of the incentives, and we're getting out of the summer doldrums. So we're, again, have that cautious optimism as to where we're headed. Does that answer your questions?

Yes. The second part of that was what was July down year-over-year, but you may even not have that in front of you. I guess the second question I had was just kind of drilling into the comments around gross margins. Last couple of calls, you talked about an expectation for fiscal '23 gross margins to be up over fiscal '22. I'm not sure if I heard it slightly different, but this call so far, what you've said is the gross margins in backlog are above what you expect for the overall fiscal '22, and you expect expansion into fiscal '23. I was wondering if you still feel what your level of confidence is that as you look at overall fiscal '23, that might still be up over fiscal '22?

Sure. Regarding July 2022, deposits were down 56% compared to July 2021, and agreements decreased by 66% against the same period. For 2023's gross margin, we have over 7,000 homes in backlog that we expect to deliver this year, primarily in the fourth quarter, with the remainder anticipated for next year. This doesn't account for our total annual deliveries, as we still expect to sell more homes in the fourth quarter and early 2023, which will be delivered by the end of October 2023. This includes build-to-order homes and many of the spec homes that are part of our strategy. I can't provide specific guidance on those today, but we usually offer that in December. A significant portion of 2023's deliveries, which have high margins, is already accounted for, but we'll need to observe how the market changes for the remaining sales and will provide updates in December.

The next question comes from Dan Oppenheim from Credit Suisse.

I was wondering in terms of the timing of community openings, you talked about delaying some openings to have them fully set given that some of the new communities when they come online, kind of strong orders, does that impact what you would think about in overall order trends for the fourth quarter of the year?

Dan, we're pretty well split with new community openings quarter-by-quarter. If we see the market improving or if we have a specific location where we have a lot of pent-up demand, we may go back to the COVID style open out of the back of a station wagon on a farm field. But that is not our intention right now. This company is always white glove every opening. We are the Ritz-Carlton. We don't open until everything is perfect. And that's how we like the launch. But when you get into a hot market, when you have a lot of pent-up demand, if we can get roads in and houses built, right, which is the other part of it. We don't want to be opening if we can't pull permits and start construction. But if all of that falls together in certain locations, there will certainly be exceptions to our older and now current strategy of get the entrance in, get the flowers planted and get the model home perfect and off we go. But in terms of the cadence, go ahead, Marty.

And we opened 20 to 25 communities in each of the first 3 quarters of this year, and we project to open 35 to 40 in the fourth quarter of this year. Now while that number is down compared to what we had previously thought, it is still up significantly over the first three quarters. So we do expect a boost in the fourth quarter from new community openings compared to the most recent quarters, right.

Next year, as we mentioned earlier, we are well-positioned to grow our community count significantly since we have the land secured. We plan to open these communities when the timing is right and for the reasons I outlined, although it will depend somewhat on the market conditions. I am very encouraged by the successful openings we have experienced recently, with substantial demand resulting in sales of 5, 10, 15, or even 20 homes within the first couple of weeks of a new launch. The interest from buyers is evident, and with the right offerings in desirable locations, we are achieving success. For example, we recorded 60 sales in three months in New York City at an average price of $1.1 million. The New York market has not softened as much as others, and unlike other areas that experienced drastic changes, it has remained stable, allowing us to maintain a long list of qualified buyers whom we are actively working to serve. There are definitely positive developments across the country with new openings, which we find encouraging.

Great. And then just a quick follow-up. You mentioned the expectation of book value at year-end. Wondering how you're thinking about allocating capital given the discount to book relative to this environment where you're sort of reassessing putting more into land and such?

Well. Dan, we've demonstrated a commitment to returning capital to shareholders through the dividends that we paid this year as well as the buyback, and we've done that as we've grown the company. I think we would continue to look at balancing buybacks. We'll pay the dividends. And we will continue to pursue new land deals. Many of those new land purchases are from old land contracts, and they still work. It is increasingly difficult for new land deals to meet our underwriting standards. So the balance will continue to exist. We will see what the opportunity set is and what the cash flow is.

The next question comes from John Lovallo from UBS.

This is actually Spencer Kaufman on for John. Maybe just picking back up on some of the comments from the last question. Can you just talk about what you're seeing across your various markets? Which markets are more challenged today? Which markets are hanging in better than most? And are you seeing any difference in buyer activity between your affordable luxury product and your more traditional homes?

The active adult segment has shown stronger performance compared to affordable luxury homes. This is likely because the buyers in this segment are wealthier, and mortgage rates have less impact on them. For these buyers, the issue isn't about monthly payment affordability as prices rise. Historically, we have observed this trend, and it seems to be consistent again in the current market. Our strongest markets are located in Philadelphia, New Jersey, Southern California, New York City, Atlanta, Denver, Dallas, and the Southeast Coast of Florida. Conversely, the weakest markets tend to be those that were previously the most sought after. These markets, including Phoenix, Austin, Boise, and Reno, are taking longer to adjust because of significant price increases. This adjustment relates to affordability as these areas often fall into the affordable luxury category, which has experienced more pressure as rates have increased.

Okay. That's helpful. Appreciate the color. And maybe can you just talk a little bit as to what would need to happen in order for you guys to see widespread impairments?

I'm sorry, I didn't....

Yes. I think things would have to go a lot worse than they're going right now for widespread impairments. And just to kind of reiterate the breakdown of our inventory that I gave last quarter, it hasn't moved too much. We have about $9.4 billion of inventory, $6.25 billion of that is construction and progress associated with our backlog. So there shouldn't be much concern at all about that backlog. The backlog has upper 20s gross margin to it. We're seeing very low cancellation rates. So there's not too much to that about $2.5 billion of our inventory is owned land that also has strong margins associated with it. And around $450 million of our inventory is land deposits and about $80 million of that is refundable, and those are four pieces of land that we have not acquired that we have under option. So with a close to 30% gross margin, and a 20% operating margin from home sales, we'd have to see dramatic reductions in price for impairments to be of concern. And as you have that dramatic reduction in volume or price, you're also going to have reductions in costs. So it would have to be much more significant than a 25% or 30% decline in price to trigger any impairments. And those impairments would be associated with those smaller buckets of inventory, land and deposits, not so much associated with our homes under construction and backlog.

The next question comes from Matthew Bouley from Barclays.

I had a question on ASP and pricing power in light of all these communities you've got coming online. I appreciate that detail you gave around the order ASP in Q3. So that's helpful. But as we think about these future community openings, I mean, how should we think about sort of the opening price points and margins on that? Is that an area where you might flex a little bit given current market conditions?

It really depends on the location and the interest levels. We prefer to maintain a 30% gross margin, but if necessary, we will make adjustments. These decisions are made at a local level, and we are quite confident in our current underwriting for the new openings, which continue to demonstrate significant gross margins. Before each community opens, we conduct a pricing analysis based on detailed market comparisons and the number of interested VIP buyers. We carry out a thorough evaluation to determine the best locations for openings, while closely monitoring potential returns. At this moment, I am very confident that the communities we plan to open in the next year will all perform well.

Got it. Regarding the sales pace and underwritings, it seems that the current sales pace is perhaps lower than what was projected previously. The question is how to balance the desired inventory turnover against the potential pressure on returns, or whether this situation simply leads to a reduction in land acquisitions. How do you manage these considerations?

We have been discussing for a few years that it's not only about profit margin, but also about capital efficiency and return on equity. We are carefully balancing price with the pace of sales. The slow quarter we experienced does not mean we're ignoring the situation or halting sales in an effort to maintain margins. We understand there is a balance, and the lack of sales was due to buyers being hesitant in May, June, and early summer. We didn't believe it was solely a price issue, unless we were willing to significantly lower prices to attract a few buyers. As the market dynamics change, we aim to effectively balance the incentives needed to drive sales while keeping an eye on return on equity and capital efficiency. Our strategy emphasizes strong margins, capital efficiency, and healthy returns. Regarding land acquisition, our underwriting criteria have tightened further. Previously, we required a 30% gross margin matched with a 30% internal rate of return, but we've now raised that to 65%. This means we are factoring in current sales rates and pricing, which poses a challenge since both sales pace and prices, with additional incentives, have decreased. With the increased thresholds, we will maintain discipline in our approach. After completing due diligence, we conduct new analyses to determine whether to proceed, and we are willing to renegotiate with land sellers. If they are unyielding, we will walk away from deals. The slight decline in our option lots this quarter occurred because we removed 3,000 lots that no longer met our stricter standards, and we dropped another couple of thousand lots the prior quarter for the same reason. I am pleased with our disciplined approach to land acquisitions. Our solid land portfolio enables significant community growth next year, and we plan to continue operating in this manner moving forward.

The next question comes from Susan Maklari from Goldman Sachs.

My first question is, can you just talk a little bit about the supply chain and build times. And as we are seeing the market shift, how you're thinking about the forward trajectory for the construction cycles as we go into the back half of this year and then into next year?

Sure. Currently, our average cycle time from agreement is approximately 13 months, or 380 days. This duration includes the time clients take to finalize their choices and for us to obtain a building permit, so the actual construction time is less than the full 380 days. For affordable luxury homes, the cycle is about 60 days shorter due to smaller and simpler designs. The cycle is increasing. Right now, we are facing challenges with items that we previously considered reliable, like transformer boxes, which are essential for supplying electricity to several homes on a street. Utility companies seem to be facing shortages in these transformers. This is one of the ongoing issues in the industry concerning finished trades. Our homes are more complex; beyond drywall in a Toll Brothers home, there is considerable detail involved in finishes like tile, millwork, and cabinetry. Currently, we are experiencing some pressure from trades on the finishing side, which has lengthened certain schedules. For example, we've seen drywall delivery times extend by a couple of weeks compared to our previous timelines. However, I do have some positive indications for next year regarding the supply chain. We are in regular contact with our primary suppliers, and I've received some optimistic feedback, although we are not incorporating this into our internal projections or those shared with you.

Okay. That's helpful. And then following up, understanding that spec is only about 20% of the business, but can you talk about where you are in terms of the spec inventory? And how you're thinking about adding to that as we go forward?

Yes. We're in really good shape right now with spec. We have about 1,800 what we define as spec, which means the homes have a footing, which is a foundation in the ground. So spec doesn't mean it's finished. Internally, it means we have started a home. We have forward concrete. We have a footing in place for a home that has not yet sold. And sometimes we'll sell that house at frame because now you can get it in five months instead of getting it in 13 months, and sometimes we'll hold that house until finishes. So we are in very good shape. Now not every one of those specs that sits at footing is moving forward right now. We are making some decisions to move houses forward on a full cadence, and we're making decisions in other locations to sit and wait to see where the market goes. Behind those 1,800, we have many houses that have permits in place and in some municipalities, that can be a couple of months to get a permit. So we will decide when that permit gets to go, which means we're going to move forward with footings and build the house. But last year, our spec inventory was depleted because the market was so hot. We were selling very rapidly, and I'm very happy now to have the 1,800 at footing or beyond with more a permit behind that because now we can pull levers in certain locations based on market conditions as to when and how quickly we move forward with this. But overall, the strategy, we think, is the right one at our price point to be 80% build-to-order, which is what most people want with Toll Brothers, but then 20% are houses that are available in a quicker turn time. Now many of these specs, you are allowed to have finishes because we'll put the house on the market, let's say, a drywall, so you can still pick your kitchen cabinets, your countertops, your flooring, which our clients want.

We have time for one last question. That's from Mike Dahl from RBC Capital Markets.

Thanks for accommodating me on short notice. Doug, I wanted to revisit the deposits and orders from August. Regarding your comment about tracking toward approximately 500 orders in August, can you share how the conversion rates from deposit to contract have been performing in recent months? Additionally, what does this imply for achieving a target of 500 orders in August?

Sure. We're currently seeing that about 70% of our deposits convert to agreements, which is consistent with our performance over the past few quarters. In fact, our five-year average conversion ratio is 71%, and we are right on that mark from last month, last quarter, or last year.

Okay. That's very helpful. And then my follow-up, just given what you articulated around the build cycle or the order to close cycle, what are you finding is the right balance of incentives for your buyer right now? And I don't mean magnitude, but I mean kind of pipe because it's easy to see where if there's something that's quicker close a financing incentive where you could have visibility on kind of cost of locking and buying down the rate that could be affected. But with your cycle, what's making the most sense for you for your buyers?

Mortgage buydown is our top priority. We have programs that allow our clients to secure mortgage rates under 5%. However, these rates may not be available for the long term, as we can't lock in a sub-5 rate for 13 months. There are opportunities closer to the delivery time. We always assist clients with closing costs. Recently, we held a kitchen and bath weekend event featuring upgrades for kitchens and master bathrooms, as those are popular areas for investment. Options included higher-level cabinets, countertops, and appliances, which are typically effective. Our incentives are frequently adjusted; for instance, this weekend we are offering a finished basement, and next weekend there will be a $25,000 credit at our design studio for finishing. In today's market, where interest rates are a concern, that's where we usually begin with incentives. We also have about 20% cash buyers, so there are strategies to attract them to our design studio or our kitchen and bath event. Our approach is dynamic and intentional. We don’t alter the price sheet, and the local teams have the flexibility to adjust their incentives according to what will be most beneficial for their clients. Okay, Jason, I think the time is up. And thanks, everyone. Jason, thank you, and thanks, everyone, for your interest and your support. We are always here to answer any questions you may have offline. And have a wonderful end of summer. Take care.

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