Reply from LGIH Investor Relations

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I asked for clarification of leverage generally and “capitalization” in particular in the context of the Well Fargo credit agreement. I received a prompt reply from Charles Meridan, cc to Eric Lipar.

“Leverage Ratio” means, for any fiscal quarter of Borrower, the ratio of (a) Consolidated Debt on the last day of such fiscal quarter to (b) Total
Capitalization on the last day of such fiscal quarter.

Page 32 - “ Total Capitalization ” means, for any fiscal quarter of Borrower, Consolidated Debt plus Tangible Net Worth.

Page 31 - “ Tangible Net Worth ” means, as of a given date, the stockholders’ equity of the Borrower and its Subsidiaries determined on a consolidated basis
minus the aggregate of all amounts appearing on the assets side of any such balance sheet for franchises, licenses, permits, patents, patent applications,
copyrights, trademarks, service marks, trade names, goodwill, treasury stock, experimental or organizational expenses and other like assets which would be
classified as intangible assets under GAAP, all determined on a consolidated basis.

So it has nothing to do with market capitalization which, if it did, would not make any sense.

Well, on the latest balance sheet, stockholders’ equity is $406,361 which already excludes treasury stock. Goodwill and (to be safe) other assets are $12,081 and $6,453 which leaves $387,890 for tangible net worth. If you do the math, debt divided by debt plus tangible net worth being less than 0.6 results in a debt limit of 1.5 times tangible net worth. Anyone interested in this, please check my math. 1.5 times TNW of $387,890 equals $581,835. Liabilities are $525,316, leaving $56,519 available on the credit line. Somebody please check that? Because, in the last quarter LGI Homes borrowed $60,000 and burned through $22,218 of cash in order to increase real estate inventory by $116,654. O.k., the inventory increase adds to TNW and allows borrowing more… The additional $116,654 allowed the borrowing of $174,981. Sounds like a perpetual motion machine. Borrow to add inventory which allows more borrowing to buy more inventory. That explains why there is a covenant that limits the amount of real estate inventory based on some other formula which I have not parsed.

thanks to LGIH Investor Relations, and thanks to Fellow Fools who have persevered this far.

KC, who hopes to not have to go back to IR to check my calculations…

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That explains why there is a covenant that limits the amount of real estate inventory based on some other formula which I have not parsed.

That limit is 145% of tangible net worth, or $570,440. Land inventory at quarter end was $466,526 leaving $103,914.

Now, one further covenant restricts the number spec homes. That limit is 45% of unit sales of previous 6 months. LGIH sold only 2272 homes the first half, thanks to the low January and February sales, so that limits them to 1,022 including the information centers. The new credit agreement just modified the previous agreement and I suppose that old agreement will define whether speculation homes are just finished homes or include homes in progress (more likely). This gives a sense of the tightrope LGI Homes is walking with the rapid growth in number of active selling communities and high demand for houses. This may explain the conference call comments on sales projections. There was some caution that they might not be able to meet all the existing and projected demand, even though they have historically high backlog entering Q3. In fourth quarter they would be able to have more spec houses as that first quarter gets replaced by second quarter and they could ramp up to 1,300 to 1,400.

KC, wondering if I really want to dig out the old credit agreement.

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KC,

A very impressive level of digging you’re doing in your due diligence. There can be nuggets of gold buried in places that most aren’t looking; I bet virtually no analysts (and even fewer retail investors) are reading these covenants and debt agreements.

I’m less worried about the covenants right now. Perhaps I should be, but I look at their growing sales numbers and growing ASP, and I don’t see debt service as one of their yellow flags at this point. Lenders use those covenants as an insurance policy of sorts–to flag potentially troublesome warning signs and allow them to claw back their money (less the future interest payments) before the walls come tumbling down. They’re not intended to hinder responsible growth. I can’t see any of those ratios being a line in the sand where the lenders are just waiting to pull the trigger on calling the debts. They would rather keep that money invested and earning LGI’s interest payments … as long as they have confidence they’re going to get repaid on time.

In this period of LGI’s growth, I’m guessing the lenders are pretty happy with their prospects of being repaid. If so, they’re probably not looking to strictly enforce any covenants that would restrict LGI’s responsible growth.

Should things slow for LGI, should the housing market cycle down, should the lenders fall into a cash crunch of their own … then the finance types start scouring those covenants for an escape hatch. If/when that happens, you’ll be ahead of most all of them with your understanding and calculation of these ratios. Not to mention your understanding of how each of those metric restrictions could impact LGI’s growth.

This is not at all a wasted effort on your part; the rest of the LGI owners on this board and I appreciate your digging AND your generosity in sharing your results/concerns. But since I always have more things to worry about than I have capacity to worry about … this is one thing that’s falling off my worrying priority list. But if things go south in a hurry, I’ll probably regret that.

They call me,
MrTBS

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MrTBS,

Thank you for the reply.

A little more ‘color’:

The start point for all this was a concern of a need to issue more shares. I missed the gorilla in the room, or rather the information in the quarterly. LGI Homes is already regularly issuing shares under a shelf registration, selling ATM. The first half of 2017 they sold 154,900 shares or added roughly 0.6% to shares outstanding. They have ability to sell $10.9 million more. Along with my additional understanding of the credit agreement, I am not currently concerned about share dilution.

As to being able to cover the interest payments: Interest expense for Q2 was $6,028,000 up from $4,604,000 in Q2 2016 (+31%). Without digging into the cash flow statement, just using net income, that represents about 19% of net income. Even if it assumed that G&A are fixed, the interest represents 33% of some sort of “adjusted” net income. So, interest coverage seems pretty good.

Finally, limitation on speculative housing units: These include any unit for which “construction has begun”, but does not include model homes and does not include homes in the backlog (under contract and qualified for mortgage as they are no longer “speculative”).

Oh, and a final finally, the credit agreement amount has been increased from $300M (2015) to $400M (2016) to $650M in 2017. Willing lenders.

KC

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I have to correct myself again.

That limit is 45% of unit sales of previous 6 months. LGIH sold only 2272 homes the first half, thanks to the low January and February sales, so that limits them to 1,022

The limit is 45% of unit sales of previous 6 months on an annualized basis.

So the limit is 2,044. As of June 30, 2017, the housing units were 3,043 with 1,545 in backlog leaving 1,498 speculative units. They could increase speculative units by 546.

KC