LGIH - My Mid-quarter Review

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LGIH - My Mid-quarter Review

Who is LGI Homes?
This company was founded in 2003 and is headquartered in The Woodlands, a suburb of Houston. The company designs, constructs, and sells homes in Texas, Arizona, Florida, Georgia, New Mexico, Colorado, North Carolina, and South Carolina, and is expanding into other states like Oregon. Their biggest market by far is Texas where they started out, but others are starting to catch up.

There are a lot of home builders. What is its secret sauce?
It’s not really a secret, but what they do is market to renters, first time home buyers, and say “You can have a home of your own for the same monthly payment that you are paying for rent.” That’s a very powerful appeal, as you can imagine.

Another thing that impresses me is that they have managed to be successful in Texas, in the middle of the oil-patch, in an oil blood-bath, so they probably know what they are doing and will know how to manoeuvre a bit better in the next housing downturn than their peers.

How do they do that?
They build a very simple home and build it cost effectively. This allows them to charge a low price for it. They have standard floor plans they build over and over. LGIH sends direct mail to renters in apartment complexes near its new-home communities, explaining how the renters can afford to own an LGI Home for the same amount or less than their monthly rents. Instead of advertising the price of a home, LGI touts the homes’ monthly payments of $700 to $1,000 a month.

A potential buyer is sent to the sales offices of a nearby LGI community, where they investigate whether they qualify for a low down-payment loan, perhaps a 3.5% FHA loan. Or for those with really good credit, LGI even offers “no money down” financing. If they qualify LGI will literally walk a couple out to a finished home they can buy. Many of them never even imagined that they could become homeowners.

That sounds dangerous. What if there is a recession and a lot of these people lose their jobs?
It sounded dangerous to me too, but as I understand it (correct me if I’m wrong), they don’t actually carry any of the mortgages. They just build and sell the houses.

What is your history with them?
I’ve been a stockholder for about five months now. They’ve moved up to be my fifth largest position. That’s probably because some of the other stocks dropped precipitously in value and they didn’t.

How successful have they been?
You wouldn’t believe it! Here are their quarterly sales revenues in millions of dollars for the last eleven quarters. And remember, this is in Texas, in the oil crisis!
36
60
68
77
76
106
93
108
121
159
174
Revenue was up 68.5% from 2012 to 2013, and up 58.9% from 2013 to 2014. It was up 65.1% in the first nine months of this year, so the law of big numbers hasn’t caught up with them yet. they haven’t announced their December quarter and year end yet, although they did pre-announce December quarter closings which were up 45% from the year before.

And here are their earnings over the same time. The March quarter (winter) is always slowest. I put those in italics so you could pick them out. (even though they are lower than the other quarters, just notice the sequence: 12 cents in 2013, 22 cents in 2014, 33 cents in 2015. Wow!)
12
24
27
44
22
43
34
39
33
66
76
Earnings were up 149% from 2012 to 2013, but up only 29% from 2013 to 2014. They are up 77% in the first nine months of this year, so they are re-accelerating from the 2014 pace.

Gross margin has been stable at about 28%, or I guess up from 27% two years ago.

The average home price was $149,000 two years ago and was up to $186,000 in the last quarter they reported. And they are selling twice as many houses a quarter.

How has LGIH stock been doing?
When I bought the price was about $31 but it has sold off like everything else, and is now down to $21.50 with a PE of 10.0 !!! (It’s actually been as low as under $20, with a PE of 9). I’ve kept adding a little here and there. With that current PE of 10 their rate of growth of 12-month trailing earnings is 50%. After the December quarter results are announced their PE will be about 8.5 at today’s price, even if quarterly earnings don’t rise at all sequentially.

What’s keeping the price so low?
I believe it’s two things. Fear that Texas, where they have a large proportion of their sales, will stop selling houses because of the oil price crash. However the price of oil has been crashed for what feels like a couple of years now, and they are still growing like a weed. The other concern is that interest rates may rise, causing mortgage payments to rise on new mortgages. I don’t see that happening any time soon, to be honest. And if it did, LGIH says they would just build smaller houses. Besides which, if that happened and homes became more expensive, apartment rentals would undoubtedly rise as well.

To summarize
This again is more risky than SWKS, but not nearly as risky as SEDG, for instance. It’s younger than SWKS, it’s much smaller, and it’s in an industry (home building), which tends towards booms and busts. In addition, a rising interest environment will theoretically make it harder for mortgage payments to compete with apartment rentals. On the other hand, this company has found a niche, and developed a know-how, which has enabled it to grow both sales and earnings, in an oil-depressed State, at an enormous rate. I like it.

Saul

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I bought SKX, LGIH and SWKS a month ago.

Your quarterly reviews are a nice surprise Saul.

Surprise to me because I am new to these boards.

Timely for me too. Thanks again for these excellent reviews,

Frank.

PS I am up except for SWKS, but I expect it grow into plus teritory also.

Bought LGIH @ 19.30. SKX @ 26.96 SWKS @ 59. 60. and 66

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…with a PE of 10.0 !!!

I hope that LGIH does well for you and its investors. But if that happens, it will be because of continued growth in EPS, and not expansion of the P/E multiple.

Homebuilders are highly cyclical operations, and so their P/E ratios will generally be in the 8-12 range. Indeed, the time to buy cyclicals is when their PEs are high, on a trailing basis, (due to a low “E” at the bottom of the cycle), not low.

I assume that you, Saul, know this. But some other folks here may not.

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I think Saul’s thesis is quite clearly based on continued growth. The low PE just adds an element of safety.

For instance, I may whole heartedly believe that NFLX will continue growing rapidly. But at a PE of 300+, it could very well grow like a weed and the stock could drop precipitously. Heck it could triple sales and earnings, and the stock could get cut in half, and it would still have a PE of about 50. Purchasing NFLX is a bet that the market will continue to overvalue it.

But as you know, if you buy a stock with a PE of 10 and earnings triple, you’re pretty much guaranteed a sharp increase in share price. Otherwise valuations start to look a little silly. But then again, there’s GBX proving me wrong.

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Saul,

This again is more risky than SWKS, but not nearly as risky as SEDG, for instance. It’s younger than SWKS, it’s much smaller, and it’s in an industry (home building), which tends towards booms and busts.

LGIH is definitely more risky than SWKS. I would argue that it is also more risky than SEDG and probably more risky than any your other large- and mid-sized positions. Why?

Look at their latest balance sheet (as of 9/30/15). Cash was as $36.5M. Debt was at $247.8M. Why the big difference? The reason is that LGIH has a lot of inventory in the form of land, sub-divided lots, partially developed homes, and a little in completed homes. In total they had 23,419 owned and controlled lots. That’s a lot and since they are growing fast and it takes time to acquire land, get approvals/permitting to subdivide land into lots, build, etc. they need to hold all this inventory. In 2015 they sold 3404 homes so they have roughly 7x as much inventory (in the form of lots, not completed homes) as last years sales.

So why is this risky? There is interest rate risk. If rate rise then it becomes more difficult for buyers to afford as much house. Interest rates also increase LGIH’s borrowing cost on debt. I haven’t looked at the duration of their debt but their borrowing of future land acquisition will be affected. There is also market risk; if demand for home buying slows then they must continue to pay interest on all their debt financed inventory but their revenue which is needed to support their debt service will affect their earnings and cashflow.

If you compare their financials to a SWKS which has $1.2B in cash and no debt, you can see that the two companies have a very different capability to sustain a decline in sales.

Chris

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Chris,

EXCELLENT post on the high-ish debt that LGIH carries and the potential harm it could bring from various uncontrollable outside forces.

I’m still long LGIH, but I will temper my position size accordingly.

I knew this in the back of my head, it all makes perfect common sense, but you explained it beautifully for those of us that haven’t thought fully through that.

Appreciate the poat!

Mike

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So why is this risky? There is interest rate risk. If rate rise then it becomes more difficult for buyers to afford as much house. Interest rates also increase LGIH’s borrowing cost on debt. I haven’t looked at the duration of their debt but their borrowing of future land acquisition will be affected. There is also market risk; if demand for home buying slows then they must continue to pay interest on all their debt financed inventory but their revenue which is needed to support their debt service will affect their earnings and cashflow.

Chris, what you say is true. But housing inventory is low right now, and new home sales are still low historically, while the economy continues to slowly improve over time. That is likely to fuel demand for a while, and ultimately favorable demographic trends will begin to kick in as well. And remember, interest rate rises are driven in response to economic data or inflation, so – barring sudden high inflation – higher interest rates should go hand in hand with a stronger economy, leading to higher demand. One might think that higher interest rates would result in lower selling prices (to keep monthly payments roughly neutral), but according to Fannie Mae’s chief economist, the historical data doesn’t show that to be true.

Also, as a public company, LGIH has multiple sources of capital. With interest rates so low, debt might make the most sense today. But tomorrow it may not, and perhaps the company will tap capital markets instead if it thinks that makes the most sense. Or perhaps it will manage its inventory differently, loading up now while debt is cheap, but running a tighter ship if debt becomes more expensive. I don’t know, but those are both possibilities.

All I’m saying is that things are more nuanced behind the headline numbers.

Neil
Long LGIH

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Look at their latest balance sheet (as of 9/30/15). Cash was as $36.5M. Debt was at $247.8M.

I hate to see that much debt when I look at a company, but with LGIH I wonder: does it represents the same level of risk as for most companies? Usually, money is borrowed in order to purchase the tools necessary to do business (which will typically depreciate in value). However a home builder borrows money to purchase the exact same item it is selling (after improvements).

Here is my thinking below. Any thoughts on if this is a valid view or if I am justifying my investment?

The real estate inventory is not a liquid asset so it cannot fully offset the debt consideration, but it seems to me it cannot be completely ignored either. Here is the complete picture from the most recent quarter, direct from the press release:


 (in thousands)
 ASSETS
     Cash and cash equivalents   36,465	
     Real estate inventory      460,475

 LIABILITIES AND EQUITY
     Notes payable              247,809

For most companies, a portion of every sale goes towards periodic payments of their debt while keeping the assets. However, a homebuilder is selling off assets while simultaneously paying off equivalent portions of the debt.

I am guessing that for a company like LGIH, the debt is not tied directly to each lot they sell. But if the company is managing their finances well we should see over time that the ratio of debt to real estate inventory should remain relatively constant. Or better yet that it is decreasing over time for a profitable company.

Looking now at the most recent quarter press release, I am calculating the ratio of debt to real estate inventory compared to the numbers from a year ago reported in the same press release:


  Q3 2014: 216099 / 367908 * 100 =  58.7%
  Q3 2015: 247809 / 460475 * 100 =  53.8%

Looks good to me.

Looking at the most recent 10-K, I also see that interest is capitalized, meaning the interest is rolled back into the loan. Their customers pay the interest when they purchase a house.

Fast rising interest rates are a big risk to LGIH, however most likely rates will rise slowly (I recently had a talk about this with someone who works as a senior loan officer at a credit union). If interest rates do rise slowly (a big assumption I realize) as investors we should have plenty of time to see the effects on LGIH, in particular in the above calculated ratio of debt to real estate equity.

I can’t say I’m comfortable with the high levels of debt, but considering was enough to convince me it isn’t a sufficient concern to stay away from LGIH as an investment.

Any thoughts on this? Flaws in my reasoning?

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 ASSETS
     Cash and cash equivalents   36,465	
     Real estate inventory      460,475

Chris, If you look at it like this that 248 million in debt really looks much different, doesn’t it? Especially since LGIH is undoubtedly valuing that $460,000 in real estate inventory at what it paid for it, and its market value is probably in the range of 600,000 or more by now.

Certainly a major recession would cause real estate prices to fall, but a major recession would hurt every stock you could imagine (except maybe funeral homes?.. I don’t know.

I’ll stick with LGIH for now, and it’s one stock I really don’t worry about.

Best,

Saul

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Any thoughts on this? Flaws in my reasoning?

As long as they can keep selling houses, they will be able to handle that debt. If the market freezes for whatever reason, the debt burden will begin to deplete cash and eventually make the company insolvent (wort case scenario). Is that scenario likely? Probably not, but a company like SWKS could weather a 2008 like storm while an LGIH would likely suffer devastating losses. This was my point: the balance sheet is set up in a way that the company would have serious trouble getting through a major disruption.

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Take a listen to the USG last quarterly conference call from Febrary 5th - they are the largest wallboard supplier in the United States - sheetrock. Management is extremely bullish going into 2016 projecting 1.2M new homes to be built this year.

At 47:00 of the call they talk about the Texas housing market and indicate that declining prices in oil/gas is not having as negative effect as the narrative would make you believe.

Here is a link to the call:

http://phx.corporate-ir.net/phoenix.zhtml?c=115117&p=iro…

James Metcalf, USG CEO, snswrs a question:

“Yes, Mike, the inventories are very low at this point. There’s parts of the country right now – as I said, we started out January extremely busy. We knew January would come back from a order count. And as I said, we were thinking 5%, 6%, and then January was stronger than that. Texas is very busy. There has been, obviously, a lot of discussion about oil and fracking and what impact that’s going to have. And Texas is busy. Houston has slowed up a little bit but from very high levels. California is extremely busy, particularly on the residential side. I think it just came out that of the 20 top residential markets in the United States, more than half of them are in California. So California showed – in the fourth quarter it was the only region in the country that had positive shipments. So I believe the industry shipments in California in the fourth quarter were up 4% or 5% even with what we talked about, the absence of any surge buying.”

Link to transcript of the call:

http://seekingalpha.com/article/3870176-usg-usg-james-s-metc…

Frank - long USG, see profile for all holdings

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