LGIH

[Oforfive]

I still have a sizeable holding in LGIH (#2 at 13.3%, behind Arista and ahead of Square and Nvidia, 14.7%, 13.25, 12.6%). These are %’s of my IRA which is a little over 2/3rd’s of total portfolio.

Why do I have LGI Homes included with these other highly praised companies/stocks? I believe in the management of LGI Homes and I believe the current housing cycle still has legs and I hope that the market sentiment will favor LGIH again if they meet and exceed FY18 guidance.

I assume the market was spooked by fears of rising costs and interest rates, supported by the non-GAAP gross margin results in FY17. LGI Homes had forecast 26.5 to 28.5% GM in the FY16 conference call whereas the actual was 26.9%. So, they came in towards the bottom of the range. But, how did they do against the other metrics against which they forecasted? They forecast 75 to 80 active communities and achieved 78 at year end. They forecast average sales price of between $210,000 and $220,000 and achieved $215,000. Of course, the big number is that they closed 5,845 sales against the forecast of greater than 4,700. This resulted in $5.24 earnings per basic share versus forecast of $4.00 to $5.00.

The near miss of gross margin was covered in the conference call. Management commented that they were too slow in raising prices to reflect the rising costs. This can be interpreted as their not foreseeing the rising costs. I’m sure that all eyes will be on first quarter gross margins (or even 4th quarter…, I don’t see the FY filing yet). With this in mind, how does FY18 look.

The Company believes it will have between 85 and 90 active selling communities at the end of 2018, close between 6,000 and 7,000 homes in 2018, and generate basic EPS between $6.00 and $7.00 per share during 2018. In addition, the Company believes 2018 gross margin as a percentage of home sales revenues will be in the range of 24.0% and 26.0% and 2018 adjusted gross margin (non-GAAP) as a percentage of home sales revenues will be in the range of 25.5% and 27.5% with capitalized interest accounting for substantially all of the difference between gross margin and adjusted gross margin. The Company also believes that the average home sales price in 2018 will be between $220,000 and $230,000. This outlook assumes that general economic conditions, including interest rates and mortgage availability, in the remainder of 2018 are similar to those in the first quarter of 2018 and that average home sales price, construction costs, availability of land, land development costs and overall absorption rates for 2018 are consistent with the Company’s recent experience.

There are a lot of numbers missing in the guidance to get from ASP and closings to $6 to $7 per basic share, so let’s check. Let’s start with year end active communities. They didn’t hit the high end last year. Maybe this is not surprising since closings were so strong. Last year they forecast only the low end, 4700. Had they forecast a 1,000 range as they did this year, it would have been 4,700 to 5,700 versus the actual 5,845—only a small beat. So, let’s use 88 active communities at end of FY 18. In order to reach 7000 closings in 2018, they need an absorbtion rate of 7.0 per month. Using the FY17 community count of 78, they had 6.67 absorbtion rate. Of course they didn’t have 78 active communities the entire year and there actual rate was more like 6.25, but we don’t know the timing of the additional communities so let’s use the year end numbers. On the positive side, they are 249 closings ahead of last year. That’s 0.23 absorbtion points (249/88/12=0.23). On the negative side, they have only 76 active communities at end of February. We really don’t know the status of the new communities or how many homes are left in existing communities. Lack of visibility, for sure. So I’m going to take 6,800 closings at $225,000 or $1.53 billion, an increase of 17.7% from $1.3 billion.

I will assume that management will be able to hit the high end of the gross margin forecast, 26%, which is below FY17’s 26.8%, because I think they have pricing power. That results gross margin of $398 million. SG&A have been trending down at 13% of revenue or $198 million and net before taxes leaving $200 million. The new tax rate should reduce state and federal taxes to 22% giving a profit of $155 million, compared to this year’s $113 million, an increase of 37% or $7.19 per basic share (assuming same shares as FY17). So, to me, the $6 to $7 per basic share makes sense and I project they will be at the high end.

LGIH closed today at $62.13 or a forward p/e of 8.9 or a trailing of 12. I’ve increased my holding by 50% in February and March, mostly between $57 and $60. $7 earnings and a 13 p/e would be $91. I’m not yet so jaded by SQ and SHOP, et. al., that 50% is not worth pursuing

I think LGIH has a place in my portfolio. Compared to my other 4 or 5 top holdings, they are far less vulnerable to disruption ( in fact, LGIH is a classic disrupter, something I’ve meant to post about). Also, many fewer unknown unknowns. We have investments of dollars in shares, but also of time in gaining knowledge. The key is making sure we haven’t just fallen in love with the stock. I guess to check that I should do a sensitivity analysis, looking at the low end of projections.

Using the low projections of closings, gross margin, and increasing S&G to 14%, I get $5.47 per basic share versus $5.24 this year. The increase is due soley to the lower federal corporate tax rate. I’ve checked this number twice. It is well below LGIH’s guidance of $6.00 to $7.00. O.k., if I keep G&A at 13% then I get $5.97. However, if they hit the top end of closings, ASP and GM, they make $8.44.

Wow! $5.24 and a grumpy market, p/e of 9 (as it was not too long ago) = $47. $6.50 and p/e 12 = $78. $8 and a happy market p/e 15 = $120. Today closed at $60.48 (didn’t get this finished yesterday). I’ll make a bold projection that LGIH will be between $47 and $120 this time next year. No, most likely will be between $47 and $120.

KC

[Oforfive]

No, most likely will be between $47 and $120.

I’m a big fan of Epsilon Theory. Enjoy the writing though there is little actionable content there. Earlier this week they wrote about the recent issue of the Harvard endowment performance compared to the S&P500 index. The part that resonated with me was this:

So what is an investment in a stock, really? It is a fractional, juniormost claim on the cash flow of a company, usually denominated in the currency of the country where it has its headquarters, the price of which at any given moment is determined by the investor out there who is willing to pay you the most for it — and nothing else. It has no “intrinsic value”, no “fundamental” characteristic that can be evaluated without knowing how a hundred million others will value and perceive it. It is a risky and inherently speculative investment.

Well, ok, this is in the context of an endowment fund with the objective of doing o.k. in a bull market and outperforming (preserving capital) in a bear, so “inherently speculative” arguably doesn’t describe your garden variety self-directed IRA. But, I think it is true that the return on our investments here, over the investment horizon of our average holding period, is as much or more determined by the perception of hundred million others as it is on skill of management or our understanding of the business model and its execution. In other words, next year LGIH might have a p/e of 9 or 15, a price of $50 or $120. Much of the range due to macro issues and market mood, not to the quality of management or business model or execution.

Here is a portion of the Epsilon Theory piece. Rather long, but they encourage readers to spread the word:

The fact that people really mean, “why don’t you just buy the S&P 500” when they say, “why don’t you just invest passively” tells us something else about most investors. When it comes to what they buy and what they own, and especially when it comes to conventions that manifest in indexes and benchmarks, they frequently haven’t given much thought to what it really is.

Try this yourself, with your boards, your financial advisor, or with your clients. Ask them, “What is it, really, that you invest in when you buy a stock?”

I’ve done it, so I’ll give you a preview: you’ll get a huge range of answers, usually relating to “ownership” of companies or businesses. So what is an investment in a stock, really? It is a fractional, juniormost claim on the cash flow of a company, usually denominated in the currency of the country where it has its headquarters, the price of which at any given moment is determined by the investor out there who is willing to pay you the most for it — and nothing else. It has no “intrinsic value”, no “fundamental” characteristic that can be evaluated without knowing how a hundred million others will value and perceive it. It is a risky and inherently speculative investment.

In my experience, this is not what most investors mean when they say to their advisor, “just buy me a portfolio of stocks.” What they really mean is “I want to own things I understand.” They believe that investments in businesses are simple and straightforward. Unfortunately, while the businesses and how they make money may seem perfectly sensible on the surface, the forces influencing the returns from ownership of a common stock are anything but simple and straightforward. Sure, diversification helps a lot, and there are decades of relevant data to help us build some confidence about some range of likely outcomes. There are also theories of varying quality about rational behavior in that spontaneous order we call a market. But what you really own is something whose value may confound any attempt at analysis or linkage to economic fundamentals over your entire investment horizon.

KC

[branmin]

Hi KC,
Was waiting to see if anybody else replied to your excellent post? Perhaps they are all out of LGIH? $47-$120.00 is quite a spread and wonder if you are trying to convince yourself?

I hope you are right but could this be dead money for quite some time and are you prepared to wait? Don’t fall in love with a stock. Dump it and add to your winners. If you feel strongly that it’s going over $100.00 then get back in at a later stage.

This was also last year a high conviction stock for me so I wish you well but too many other fish in the sea at present to catch alive and fresh before they die.

[MONYMAN3]

I think LGIH could easily get back to the $70s. I was in it as low as 27.00s. This pullback is probably an overreaction to the possibility of higher interest rates cutting down on demand. My belief is that higher interest rates for 30 year mortgages at this level should not be a big headwind. We’ve become accustomed to abnormally low rates. However I have learned from prior hard learned lessons not to let winner drop below certain levels that I set. When it breached $60 that was enough for me and I got out.
I don’t see a “V” bottom happening and so I think for now my money is better off elsewhere while the market resets given the rate fears. I can always get back in when things look better. Good luck for anyone still in.

Rob

[invain]

I am still holding from $29 but watching closely. I think this was oversold on interest rate hype; rates are still extremely low historically and I have a hard time believing the small amount mortgage rates have increased over the last year or two is going to deter people from buying homes THAT much. Then again my thinking is probably a little flawed since I’m an outlier, having already owned two homes under the age of 30 and being very financially responsible.