Scott Fearon on buying home builder stocks

I mentioned Fearon before, as someone who seems to me as someone who knows what he’s talking about. He’s “famous” for being a short seller (maybe because of his book “Dead Companies Walking”), but I think he makes most of his hedge fund money on longs.

In this article, he mentions two building stocks, LGIH and CCS:
https://seekingalpha.com/article/4011033-buy-housing-dips

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I mentioned Fearon before, as someone who seems to me as someone who knows what he’s talking about. He’s “famous” for being a short seller (maybe because of his book “Dead Companies Walking”), but I think he makes most of his hedge fund money on longs. In this article, he mentions two building stocks, LGIH and CCS:

Wow, Ed, he not only mentions them. He really plugs them:

LGI is growing even faster. While LGI is headquartered in Houston, last quarter over half of its 1,128 home closings were in communities outside of Texas. LGI’s average home price was an industry low of $197,450 last quarter, which means most of its customers are former renters buying their first homes. LGI projects 4,000 to 4,300 home closings in 2016, vs. 3,404 closings in 2015 and 2,356 closings in 2014. As I’ve written about before, its gross profit margin of 26.5 percent is the highest of all publicly traded home builders. LGI should earn $3.40 a share in 2016 and $4 in 2017, which means it currently trades at only 10.2x and 8.7x 2016/2017 EPS.

I have interviewed the senior managements of both companies at their headquarters in the last two months. They are both run by smart, competent people who own sizeable amounts of their own stock (the all important ‘skin in the game’). Unless the US enters an unexpected recession soon, I expect continued rapid earnings growth and inevitable multiple expansion will help both outperform in the next twelve months.

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I checked one item he predicted, and that was EPS, which was off by only a penny.

Is he more enthusiastic than you about LGIH? Overstating its appeal?

I mainly saw the article as a confirmation of your opinion, and another reason for me to buy LGIH, which I just did less than a week ago. I don’t think he’s trying to drum up interest in the stock to benefit himself.

Is he more enthusiastic than you about LGIH? Overstating its appeal?

Hey, if he interviewed management person to person, and likes what he saw, he knows them even more closely than I do. I like them a lot. They are my second largest position at 13.84%.

Saul

Anyone having trouble trading CCS? When I try to make a purchase in eTrade it says:

Opening orders for this security cannot be accepted online at this time. For assistance with placing this order, please contact Customer Service at 1-800-ETRADE-1

I have made a few other trades today without issue.

I belatedly entered data to determine LGIH’s inventory of lots expressed as years of inventory (total lots divided latest quarter closings). The number is 6.4 years. For the last 9 quarters the number has bounced around between 7.9 years and 6.2 years. Business as usual.

In the process of entering the data I became interested in the growth rate of closings and the deceleration of growth. Longer term followers of this board will remember discussions about deceleration of growth, particularly for SKX. That was a different situation as the deceleration of growth coincided with expansion of p/e. But, my question then was trying to read the tea leaves and guess the equilibrium (if there is such a thing in retail sales) growth rate. For U.S. sales, that turned out to be a negative growth.
For LGIH growth rate I used the current trailing 12 month closings divided by the trailing 12 month closing for year ago quarter. Here are the last 8 quarters’ numbers:

367%
157%
94.5%
82.5%
44.5%
40.5%
27.7%
22.2%

If LGIH meets its 4,700 closings target for 2017 the growth rate at year end will be 12.9%. In the meantime, inventory value increased 35%. Land inventory increased 50%, homes in progress decreased 13.5% and completed homes increased 41%. They are growing just as fast as they can. That may explain why they ran out of houses to sell in Texas but completed homes were reported up so much. They just shortchanged Texas while building up the new markets. That’s my interpretation. A temporary misallocation of capital. Thus poor January closings and the buying opportunity in February.

LGIH net income was $75 million and ending inventory was $718 million. In the spirit of being approximately right rather than exactly wrong, I propose that LGIH can increase inventory by 10 or 11% by investing net income in inventory. If I understand the lending covenants correctly, they can leverage that to 15 to 16% inventory increase. Beyond that, to achieve, say, 20% inventory increase they would need 3% shareholder dilution through ATM sales.

Slower growth is a mixed bag. Of course the average sales price is increasing and margins so far are stable. That is the good news. Part of that increase in ASP is due to higher land values in the new markets. Some is due to the hot real estate markets almost everywhere, which I suppose is allowing them to maintain margin. Our daughter bought a house in the Seattle area and for two years the value has compounded at 12.5%. And as a first time home buyer she leveraged the downpayment 23.5 times based on the purchase price. Ka-ching, ka-ching. Those things are favorable to LGIH, too.

So right now, LGIH has decent, but not great growth in terms of closings and a very favorable tailwind in average sales price pushing up revenue growth. As they pmove into the midwest, might the house prices be less than on the coasts? There would be multiple factors in LGIH’s choice of new markets, but one would be simply the addressable market as would be the ‘heat’ of that market. Will the newest markets be less attractive? How many communities will they support compared to Houston or Phoenix? I would note that the homes they advertise as being in the Portland, Oregon market are actually in Washington—and not just across the river in Vancouver but quite a bit north of that. O.k., this fits with the ‘further out, cheaper land’ approach that LGIH has and is taking. But across those bridges on Friday afternoon is a little different than another mile out Camelback in Phoenix. Just sayin’. Is there anything to be gleaned from that?

Conclusion? Don’t look at just 2014 vs. 2015 vs. 2016 year-over-year growth and extrapolate to milk and honey. Current growth is less. Think about the impact of home price increases decelerating (heaven forbid, leveling off). Compare the p/e to other homebuilders, not the S&P. Scott Fearon mentioned CCS. CCS ought not be news to LGIH investors. Anyone with significant investment in LGIH withoug knowing of CCS didn’t perform due diligence. The projection of $4 up from $3.40 is 18% which is better than a stick in the eye but of course it will be all about what is already priced in and what the outlook is. The market values it at 10.2 p/e now so why would it award a higher multiple a year from now?

I haven’t made my ‘final answer’ on LGIH. It is no longer my top holding. Still about average while I think it over.

KC

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Anyone with significant investment in LGIH withoug knowing of CCS didn’t perform due diligence.

Hi KC, I guess I didn’t perform due diligence. Can you explain to us what is CCS and why it’s important to LGIH?

thanks

Saul

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I also note than in the past 4 weeks and a couple of days the price of LGIH has gone from $28.70 to $33.48, which is higher than it’s been in 24 weeks, so perhaps the market’s hissy fit about the two months of low closings is past, and the market is looking ahead. Or perhaps it’s just that some smart investors like Scott Fearon have been taking big positions.

Saul

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Saul,

First, a more positive thought. Given that the year-end inventory of finished homes was up (even if in-process was down) and given that LGIH has commented on strong sales, I would expect very good report on March sales which should support the recent share price rise. Maybe some of the buying this week is anticipation of that.

As to why a LGIH investor should be familiar with CCS, CCS is a similar company in terms of its IPO date compared to LGIH; its presence in the first time buyer’s market (though lower %); presence in geographical markets (fewer markets but Colorado headquarters, SW presence); p/e; debt structure; stock price history. I think that good investing involves knowing not just about the company you own but other similar companies. Again, the “low” p/e of both companies correlates to their similar debt structure. Again, again,… knowing about the industry leads,to the conclusion that p/e expansion is not likely because the current ratio is consistent with the industry and correlated to a metric that the market deems important (or so is my conclusion based on my research–I could be wrong). As to the higher price, let me check LGIH versus builders ETF and CCS. I take terrible notes (as in, scribble on odd bits of paper and then…)
My memory is that this is industry related. Recent rise is 20 to 24% on my last buy after the poor January sales number but over 24 weeks, not sure.

KC

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Saul,

Since October 24 (roughly 24 weeks), LGIH is up 5%, HXB ETF +12%, ITB ETF +20%, Century Communities (CCS) +20%. Since the Feb 8 tissy-fit, LGIH +22%, ITB +5%, HXB and CCS +10%. You crushed it on that LGIH buy and I missed it, got just a little bit.

With CCS’s six month appreciation (or LGIH’s lag) it has p/e of 10.6 vs. LGIH at 9.6. Some room to expand there.

KC

With CCS’s six month appreciation… it has p/e of 10.6 vs. LGIH at 9.6. Some room to expand there.

KC, LGIH’s estimate for this year was $4.00 to $4.50. Say they make $4.25, right in the middle (not beating estimates). With a PE of 10.6 we’d see a price of $45.05 in a year. That’s up 35% from here, even after the recent rise…What can I say?

Saul

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Saul,

Even better argument is only $4 at current 9.6 p/e is 13.4% increase from here. That is, making low estimate and no p/e expansion, still 13% from here. P/e of 8 at current price requires $4.18 eps.

That’s why I post. Feedback. Seems the downside is limited. Risk/reward good for the next year. Market just doesn’t believe the forecast. Maybe a good time to buy back. Only miss one day price rise on a part of my holding. March sales numbers could give a good pop because nothing good is priced in.

I still expect analysts to be pointing out slowing growth in closings and resulting trashing of the stock price. But when and maybe from $40 or $45 or…?

KC, who maybe got off the tracks before the train even left the station

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