LGIH leverage

O.k., boys and girls, class is in session. The teacher probably needs some help. There will be a quiz.

Subject: covenants in LGI Homes’ credit agreement with Wells Fargo as modified in 2017.

Covenants include 1) tangible net worth, 2) leverage ratio, 3) minimum liquidity and 4) EBITDA to interest expense. The leverage and EBITDA covenants have a trigger level which converts the debt from unsecured to secured. Then all of the covenants have levels that essentially are default levels.

The relatively easy covenent is liquidity which is $50 million minimum. Cash and cash equivilents at year end was $49.5 million and June 30 was $27.3 million, having burned $22.2 million during the six months. Perhaps here is more to ‘liquidity” than cash and cash equivilants.

But, my main focus is on leverage ratio. Leverage ratio is total debt divided by total capitalizaton. Total capitalization is number of shares times share price. That seems to be a strange covenent in that LGI Homes does not control overall market sentiment and therefore cannot directly control the leverage—other than by being conservative in borrowing. Have I interpreted the terms total debt and total capitalziations correctly?

In any event, as of June 30’s total debt and today’s share price, total liabilities were $525.32 million and the total capitalization is $995.6 million (source: E*Trade). The ratio is 0.528. The trigger for securing the debt is 0.575. The default is 0.6.

A 9% drop in the share price (debt being constant) would trigger the secured debt clause and a 12% drop triggers default.

Now, I am not trying to raise alarm. I think the above analysis is correct, but….

No, the purpose here is to return to the question of whether additional share issuance is in the cards. Considering the above existing leverage, the basis for my analysis is that LGI Homes will not want to increase borrowing. I don’t think I would like them to. The credit agreement is for $600 million (option to increase to $650 million) and at June 30 the had used only $363 million so at least $237 million available.

If they do not borrow, then equity issuance is needed to fund the cash shortfall for funding real estate inventory. Actually, the could leverage the equity issuance by some amount between 50% and 60%. During the first two quarters, LGIH did borrow $60 million.

Now, Saul is correct. Net profit is not the source of funds to expand. Need to look at cash flow. However, there isn’t much to add back in: depreciation and stock based compensation, so the total is $46 million for six months. Inventory increased by $118.3 million. That is a $72 million difference. Somehow, the inventory turns plays into this. 60 to 90 days to build a house, 30 to 60 days to close. 90 to 150 days versus 180 day accounting period. I’d say that a 150 day turnover on average (start to close) would explain the $12 million difference between inventory increase and borrowing plus cash flow.

If they do not increase leverage through borrowing, they need on the order of $40 million share issuance levered 50% to obtain $60 million. $40 million at (gasp) $40 per share (ease of calculation only, for now) is one million shares. That is 4.3% of 23 million fully diluted shares outstanding to fund 6 month’s growth. That’s a 9% dilution on annual basis.

If you were management, would you issue shares? If you are an investor, would you accept 10% dilution for 42% revenue increase? A mix of share issuance plus borrowing to reduce leverage?

The full credit agreement is included in an 8-k filed May 26, 2017.

KC

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Hi KC.

I haven’t followed LGIH closely, so I can’t offer much of a response to your well-researched post.

What I can say is that “liquidity” is usually defined as cash + equivalents plus remaining borrowing power (and maybe short-term investments, if they’re fairly liquid).

Thanks and best wishes,
TMFDatabaseBob (no position in LGIH)
See my holdings here: http://my.fool.com/profile/TMFDatabasebob/info.aspx
Peace on Earth

Can we get similar information for other successful builders, in order to compare, and see what they did in a similar situation?

Can we get similar information for other successful builders

Ed,

I think most of the board is tired of my LGIH ramblings, but…, to answer your question:

Most home builders do not have LGIH’s debt burden. Century Communities is another fast grower with a lot of debt. I don’t think I can give you a good answer.

However, I have a few more points to make:

  1. There was comment on the conference call. Not directly to share issuance, but to needs for capital and more borrowing. I think the question was misguided in that the covenants in the credit agreement has some limits on additional borrowing. The response referred to the high yield market and that LGI Homes was constantly reviewing capital needs and reviewing the capital markets and that they saw no need for additional capital to meet their growth needs.

  2. “Upon further review”, I discover that there are multiple definitions of “leverage”, including debt/capitalization, total debt to total equity, and financial leverage = Avg Total Assets/Avg Total Liability. I have sent a question to investor relations asking them to clarify what “leverage” means in the context of the credit agreement with Wells Fargo (8k filed May 25 2017).

As to the liquidity issue, I agree that established access to credit should count in addition to cash. As long as LGIH would not exceed limits of other covenants, they have no issue with having enough liquid assets.

There are other covenants in the credit agreement which are a sort of a minefield map for homebuilders. Interesting. One involves a limit on the amount invested in land. That 8-k is good reading.

KC