LGIH growth

Some months ago I commented that LGIH’s future sales growth opportunity could be gauged by its number of lots. As growth company investors we want to be aware of the prospects for slowing growth. Even if LGIH has a low p/e, we could get some p/e compression.

The backlog of lots in Texas is declining. Of course the quarter-to-quarter numbers show some volatility, but to cherry-pick a bit, they had 12,804 lots in Q1 2014 and 12,894 in Q4 2015. That is an increase in absolute number of lots but the sales have increased. So, using a metric of lots divided by quarterly sales, the backlog has decreased from 38 quarters to 26 quarters.

However, Texas is only half of the current story. But, looking at all of the reporting geographies, the quarters of backlog has declined from 38 quarters to 25 quarters from Q1 2014 to Q4 2015. I am using some smoothing functions to calculate that.

When would the caution light go on? I asked investor relations about the lead time from raw land to buildable lots. I received a prompt reply (apparently sent around lunch time on Saturday).

It takes 18-24 months to turn raw land into a buildable site. You are correct this varies in every market.

I note that the NW lots did not show up until the Q2 2015 report and the first community has had its grand opening either end of Q1 2016 or early this quarter, but we don’t know how raw the land was. I think that 20 quarters of backlog would be a concern. With sales increasing at 30% and number of lots increasing at 15%, we wouldn’t get to there for two to three years.

KC, long LGIH

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The backlog of lots in Texas is declining. Of course the quarter-to-quarter numbers show some volatility, but to cherry-pick a bit, they had 12,804 lots in Q1 2014 and 12,894 in Q4 2015. That is an increase in absolute number of lots but the sales have increased. So, using a metric of lots divided by quarterly sales, the backlog has decreased from 38 quarters to 26 quarters.

I would not be too concerned about this. LGIH buys and builds away from the metro centers so their land acquisition is much lower cost than in the city centers. They can buy land much cheaper there. They can also buy larger tracts of land and then go through the process of subdividing. I think this implies that they can respond (buy buying up more raw land) should their owned and controlled lots drop. I believe that their strategy in the Houston area is a build/sell and replace approach. We must also remember that undeveloped land is not expensive to hold…it gets expensive when they start building making it important to build and sell quickly so that they can effectively manage their working capital.

Another question might be the following: isn’t demand for housing away from he city centers lower? LGIH researches the following before the making a decision start a development. First, they make sure that their target customer already lives in the area where they might develop. This means that there is already a population of potential customers near where the development would be located. These customers are renters who are likely to purchase and give up their rental. For these customers it must be verified that purchasing from LGIH will make financial sense for the current renters. Also, since they already rent in the area, it is presumed that they work nearby so buying would not significantly change their commute…this can also be verified.

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Thanks KC and Chris for an interesting discussion. I must admit though that I never even think about how many lots LGIH has. I figure the management clearly knows what they are doing, as they are doing extremely well, and that they can judge how many lots they need much, much, much better than I can, and it’s probably a waste of my time to try to second guess them. Perhaps that’s a passive way of looking at it but it works for me.

Saul

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LGIH buys and builds away from the metro centers so their land acquisition is much lower cost than in the city centers. They can buy land much cheaper there. They can also buy larger tracts of land and then go through the process of subdividing. I think this implies that they can respond (buy buying up more raw land) should their owned and controlled lots drop.

Of course LGIH can buy land and build more houses. They have a business model and they are executing it well. The point is that the business model cannot continue forever (ok., so what can?). 30% growth in housing units cannot be sustained with population growth of 3% (or whatever it is). O.k., there is pent up demand. But the business model at its core targets apartment dwellers, a finite demographic. I’m not suggesting that LGIH is about to fall off a cliff. What I am looking for is an early warning signal—if it comes.

I am suggesting that there would be two warning signals. One is obvious, slowing growth or stagnant growth. That would not be an early warning signal. The dropping value of your LGIH holding would be a contemporary and far more recognizable signal—but more painful. A better warning would be the drop in owned and controlled lots as measured by quarters of sales.

Captainccs had a relevant post on this board regarding INFN.

There are two (not one) economic laws: Increasing Returns and Decreasing Returns. Classical economics are based on the latter. It applies to commodity type products. If you have a piece of land you start farming the best part. If your crop is successful and the market wants more of it, you have to start farming less desirable land until you get to the point where additional land is so bad it’s not worth farming. You have decreasing returns per acre. The mathematics of this situation of supply and demand is fairly simple and has a SINGLE equilibrium point which economists can calculate quite accurately (market-clearing price).

The same applies to LGIH business model. It is true that they study demographics, due market research and identify suitable land. They can do this as long as the results indicate a suitable location. But they haven’t done so in Texas. Plenty of land in Texas. Maybe there are not plenty of attractive markets. Maybe. But I am sure that LGIH is putting their communities in attractive markets, and if they are good they have placed them in the most attractive markets. In recent quarters (very recent quarters, a very short time period) LGIH has not added land in Texas to maintain sales growth. Growth has been pretty flat compared to the overall growth in LGIH sales. LGIH growth is coming from new regions.

So, there are lots of regions, right? Well, we will see. They have entered the Northwest. Seattle. They could add in the Portland area around Beaverton. We all probably know of a location that might be suitable for the LGIH business model. But there is a limit, a single equilibrium point, a point where additional communities are “not worth farming”. I don’t know where that point is, but I do think that a drop in the number of lots, expressed in terms of quarters of house sales, could signal that LGIH has run out of room for the current business model to run. We could wait for a couple of bad quarterly reports, or wake up to a Seeking Alpha article that roasts LGIH. Or perhaps we can peek ahead a bit and get off the ‘S’ curve at the best point. I plan to monitor their lot inventory quarterly, and I hope it stays around 6 years for a long time. For years, because I, too, am a modified buy and hold investor. :slight_smile:

KC

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And, let me acknowledge that LGIH has variations to its business model. In addition to communities tailored more towards first time buyers, they have more upscale communities with recreation facilities and trails, etc., and they have communities for us retired folks. So they have slightly re-invented themselves in this regard.

LGIH can adapt and grow in somewhat different directions.

KC

I plan to monitor their lot inventory quarterly, and I hope it stays around 6 years for a long time.

Pretty good idea KC. Please keep us up to date.
Saul

KC I believe most of the home builders purchase options to tie up land for future purchase. A lot of the builders had to let many of their options expire worthless back in 2008-9 when building fell off the cliff costing them many millions.

JT
Long LGIH, SKX, SWKS, BOFI, INBK, PRAA, BIDU, PCLN, GOOG, FB, ULTA, GILD, CELG, AIRM, MIDD
REITs - HCN, DOC, COR, MPW, NHI
And bits and pieces of a dozen others

What I am looking for is an early warning signal—if it comes.

KC,

You are looking for and early warning signal. My opinion is that tracking lots owned or controlled by LGIH is not that signal. It is easy for them to buy more land with plenty of time before they need to build. Here are some signals that you might considered…

The real estate markets can be cyclical. As you said, there is a pent up demand for housing because there currently isn’t enough of a supply. After the 2008 financial crisis, many people lost their homes, builders stopped building, and many could not even qualify for a mortgage. Even the Ben Bernanke, FED chairman, could not qualify! Builders are still not building enough homes so the supply shortage persists. More jobs are being created, more Millenials are moving out of their parents’ homes. Getting a mortgage continues to become easier. Interest rates remain low. All of these are positives for the home builders, and some are especially beneficial to the homebuilders that focus on starter homes. So track the following:

  1. interest rates (affects demand)
  2. the stock of housing (supply) in the markets where LGIH is located
  3. the rate at which new construction, new permits, etc is occurring (affects future supply)
  4. employment figures (affects demand)
  5. wage growth (affects demand)
  6. the tightness of the mortgage industry (affects demand)
  7. the cost of a rental unit versus the costs o buying (affects demand)

Real estate markets are always local to tracking these market by market where LGIH is the best way to get indicators of their future success. Or you can just do what Saul does: track the average marco factors, watch the company’s results, and trust that management knows what they are doing.

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I hope I am not over extending this thread. My posts frequently lack sufficient background, have unstated purpose or assumptions and are deficient in detail. I am an impatient writer and I would make a terrible teacher. TMF1000 is an example of providing the thoroughness that I lack.

So let me go back and build at least some foundation. First of all, “early warning” is incorrect both factually and grammatically. The proper naming would be “earlier warning” which raises the issue of “earlier than what?” Answer: earlier than the market’s realization and reaction. The market is forward looking. Earlier Warning means looking farther ahead. Earlier Warning means being able to react before the market does.

We might be able to do this with LGIH as the company lists only four analysts following LGIH (and only three showed up for the last earnings conference call.)

Gaucho Chris lists seven indicators to monitor. (Gaucho Chris, I always am pleased to see that you have posted on one of “my” boards. I make sure that I read them.) Six of the listed indicators are widely available on a national level, including housing supply. Housing supply in specific markets can also be found on Zillow or Trulia. Perhaps renting/buying data could be gleaned from Zillow. But this data is being reviewed by many analysts. This provides an early warning to revenue and profit for the industry. But it provides no time advantage to the market reaction and it requires effort. I think the price action of a home builder ETF would be just a timely and easier to track, but the damage to LGIH, the stock, will have already been done.

In order for LGIH to continue to grow as it has, they will have to continue geographic expansion—to be more national. That will make monitoring more numerous local real estate markets more and more difficult. On the other hand, Or you can just do what Saul does: track the average macro factors, watch the company’s results, and trust that management knows what they are doing.

Well, I’ll take two of the three: watch results and trust management. In fact, that is exactly what the lot inventory does. It tracks the results of sales and lot purchases. It trusts that management is correctly assessing opportunities for new communities and is allocating capital wisely. It assumes that quarterly filings and conference calls will report current results and provide the next quarter’s guidance. It assumes, however, that management will not be forthcoming with information that it is seeing a shortage of new community opportunities that meet its business model’s metrics (when and if this should occur).

I am not interested in delving into macroeconomic indicators. I am willing to monitor this microeconomic indicator of lot inventory, specific to LGIH, which requires little effort and which might, possibly, provide actionable information – earlier.

That leaves me with one more observation that I have been wanting to make for some time. It is kind of a bone to pick with accounting and financial results. There has been discussion of GAAP and non-GAAP results and the pros and cons of each. But at a more fundamental level, there is a basic problem with accounting of any kind. Accounting attempts to show the health of a business by converting all real world product development, marketing skill, production efficiency, management skill, etc., etc., into dollar terms. All this enormous complexity and capitalistic competition is rendered into a few pages of numbers with dollar signs attached. That is o.k., I suppose, for bankers or maybe for value investors. But what happens next is that analysts and investors then pour over the numbers, and like witch doctors delving through chicken entrails, try to reconstruct the reality of the business (product development, marketing skill, production efficiency management skill, capitalistic competition….) and predict future results more accurately than several hundred others who are fingering the same entrails.

Well, I suppose it is just me and my aversion to detail and tedium. So be it. ? Sorry for the length, just blame the hot, dry season that keeps me indoors much more than usual.

Happy investing,

KC

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That leaves me with one more observation that I have been wanting to make for some time. It is kind of a bone to pick with accounting and financial results. There has been discussion of GAAP and non-GAAP results and the pros and cons of each. But at a more fundamental level, there is a basic problem with accounting of any kind. Accounting attempts to show the health of a business by converting all real world product development, marketing skill, production efficiency, management skill, etc., etc., into dollar terms. All this enormous complexity and capitalistic competition is rendered into a few pages of numbers with dollar signs attached. That is o.k., I suppose, for bankers or maybe for value investors. But what happens next is that analysts and investors then pour over the numbers, and like witch doctors delving through chicken entrails, try to reconstruct the reality of the business (product development, marketing skill, production efficiency management skill, capitalistic competition….) and predict future results more accurately than several hundred others who are fingering the same entrails.

I love it KC!.. But the trouble is: What else do we have that is better?
Saul

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I love it KC!.. But the trouble is: What else do we have that is better?
Saul

The business model.

For example, who is making money on the obesity epidemic?

Denny Schlesinger

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I love it KC!.. But the trouble is: What else do we have that is better?
Saul

I suppose one can only mitigate the circumstance by investing in the easier to understand businesses. Say, a home builder, convenience store/gss station, maybe a shoe company, rail car manufacturer… With tech companies, growth through acquisition, just live with it and have a sense of humor and some pain tolerance.

KC, long laughter, tolerance and tech companies rife with unknown unknowns and tangled entrails

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Thank you, KC (and others) for this great discussion and thought exercise.

I have a question on lot inventory: would you be more alarmed by decreasing inventory (indicating, as you suggest, a possible end of the rapid growth runway) or increasing inventory (possibly indicating a slowing of building)?

To the extent that we view lot inventory as an “earlier warning,” we need be pretty sure that LGIH is currently at (or we can reasonably estimate) what an “optimal” lot inventory should be. If it’s trending either up or down, is it trending toward or away from what it “should” be?

I do like your idea of lot inventory as more forward-looking, and likely more stable, than the inventory of completed homes. Any movement on that latter metric, and the market will probably instantly recognize and (over)react. But further complicating our view into it (and combining with Saul’s comment), changes in lot inventory could very well represent conscious bets by management about on the future growth environment they anticipate. So we now have to add in the layer of if we shareholders believe management is correct in their thinking. Parsing conference calls, filings, presentations and IR discussions may be the best way to mine those nuggets of insight.

It’s all about building that big-picture mosaic out of sometimes tiny pieces of seemingly unremarkable info…in a way that others haven’t yet.

They call me,
Mr TBS

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A little snippet from Zacks Confidential:

There are a lot of indicators pointing the way higher for home builders:

Healthy consumer thanks to unemployment rate down from 10% in 2009 to 5% today.
Lower commodity prices = lower cost to build a home.
Ultra-low mortgage rates allow folks to afford bigger homes.

Those are some pretty gusty tailwinds that bode well for this industry and explain why it has such a high Zacks Industry Rank.

Saul

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Lots can be bought and sat on for years, based off many factors. A builder can buy a bunch of lots and have no intention of building on them anytime soon. Simply bought them because they want to build there sometime and were expecting lot prices to increase.

So, many people/companies in the industry base their assumptions on permits pulled. This is a pretty good indicator for many as they can look at how many permits are pulled in an area. Who is pulling the permits. How many did they pull last month/quarter/year. Compare them to other residential builders.

When the market was getting hot back in 2006/2007 (right before it fell off a cliff), the demand for concrete workers and framers was so large, that we tried not to lose them. If they went to another contractor, we might not get them back. At least not when we wanted them.

So, we would pull permits and put in the foundation only and let it sit. You can let a foundation sit for a while and not do anything. Once you start framing, you then have to take it at least to getting it dried in.

We would let a foundation sit, but when we went to frame, we went to completion. A framed house, only a shell, starts to wear and weather, so when we started framing it, we completed it. The bank would only allow us to have X amount of spec homes, so there was a limit to what we could do. Financing just the dirt work and concrete was a lot more palatable. Also, that kept us able to pull the trigger and go right away when we decided it was ok on a number of units.

As I said above, permits pulled can be a good indicator. However, if I pull a permit, pour the foundation and let it sit, is that really a good indicator of what is coming in the near future? There are many factors, and I am not sure any single one or even two items are comprehensive enough to say one way or the other.

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MrTBS,

I have a question on lot inventory: would you be more alarmed by decreasing inventory (indicating, as you suggest, a possible end of the rapid growth runway) or increasing inventory (possibly indicating a slowing of building)?

Sorry for the late reply. I wrote one yesterday. But, I was in “Preview Message” mode and had a brain cramp. Wanted to make a change, moved my cursor there but missed the spot, hit backspace backspace backspace. !!! That moved me back several pages and when moving forward I ended up with a blank reply page :frowning: Argh.

Anyway, today a shorter version. Increasing inventory, as measured by quarters or years of current sales, is either decreasing sales or accelerating land purchasing/leasing. If it is caused by decreasing sales then we don’t have an “earlier warning”. We missed it, the share price is already down. If it is caused by accelerated land acquisition, we need to see if it is an anomaly or an indication of aggressive growth decision by management.

In Q3 2014 the metric went from 7.5 to 9.7 years, but then returned to 7.6 the following quarter. This was caused by a large increase in leased lots in Arizona. Those lots were not turned into house sales but were disposed of somehow.

While researching this I came across info that in most markets, most of the time, 2/3rd’s of the lots are “controlled” and 1/3 are owned. Also, it takes 45 to 60 days to build a house on a prepared lot.

KC

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