Right now, LGI Homes (NASDAQ:LGIH) is like a store with nearly empty shelves due to a crush of demand, desperately trying to restock the shelves. This effort will boost growth over coming quarters. Community count had dropped by ~20% as they sold out and needs to be replenished. That's a good problem.
However, LGIH management have gone bigger than just returning community count to an upwards trend. They've increased the land bank, particularly raw land, considerably. They have also spent $300M+ on share buy backs over the last few years while their shares were at record highs.
As rates rise, they may wish they had this cash around to cherry pick small distressed competitors rather than having to access increasingly expensive debt markets. Long term investors (and management) may regret their timing of land and share purchases.
We will explain in more detail. Here is your quick guide.
LGI Homes, unlike most homebuilders, specializes in building a house and then selling it 'as is'. This enables prices to be lower yet margins to remain strong due to lower construction management costs of various option packages.
That big stampede of demand just destocked LGIH. You can see the impact as communities sold out and couldn't be replaced fast enough, below.
By this point, LGIH should have, if it kept to it's long term trend, about 118 communities operating rather than just 88. Returning communities to it's previous trend has, understandably, become a focus of management as we will see a bit later. That's because demand remained firm.
To see the state of the market, it is better to look at the sales per community per month. As the figure shows, for Q1 the sales rate remains slightly above the average for a Q1 but down on Q1 2021.
An absorption rate of 6 per community per month is quite decent for a first quarter. Normal market conditions produce a range of 5 to 8 per month. Typically, Q4 is the strongest, as demand pulls forward to get people into homes by Christmas. Q1 2022 was acceptable and it looks like April continued that theme.
In the 2022 Q1 earnings call The CEO Eric Lipar gave an update on sales following quarter end, "(For April)...on 91 communities...the absorption pace of 7.7 closings per community exceeded our eight-year historical average for the fourth straight month this year."
Let's give more context to this sales rate.
This is a solid result compared to the pre-boom average. LGI Homes prefer the 2014-2020 average of 6-7 closings per community per month. That does seem like a fairer benchmark than the 2020-21 boom.
As the figure shows below the Central region is a region of strength and monthly absorption rate is the highest. However outside of this region the trend is gently but noticeably negative.
The Central region for LGIH is by far the most important. Despite efforts to expand geographically it represents around 40% of the company. That's a good thing. Texas is a good place to be during a period of high energy prices.
From 2020 Q2 there has been a tremendous push to increase lots owned and controlled to well above the long term trend.
However this push might not see an immediate increase in communities as CFO Charles Merdian explained in the latest earnings call, " ...as we move inventory into owned, we are still predominantly seeing...raw land deals. So... (we'll have) to spend that cash to get those sections ready, as we've been talking about delivering community count into 2023 and 2024."
So expect both further cash costs before a burst of new communities in 2023 and 2024. It does make us wonder... what will rates be at that point?
LGI Homes is the 10th largest home builder by revenue* but by launching stock buy backs it seems keen to play with the big boys, despite being only about 10% the size of the leaders, D.R. Horton (DHI) and Lennar (LEN) by both sales and net income.
*By profits LGI Homes ranks around 7th.
As the figure above shows, LGI Homes has increased the repurchase payout ratio from around 30% to 73% in the most recent quarter.
We'd argue that combining stock buy backs in 2020 and 2021 with a big investment in land at this time of the cycle might not be the best decision. The repurchases that spent $330+ million in cash could be very handy soon.
It has also led to LGIH's debt load to rebound quickly.
To be fair, LGIH has always had a higher debt load than other large builders. A rate of 40% is not yet dangerously high either.
But other home builders are better placed should the property market slow drastically. Given the inflation outlook, this remains quite possible.
LGIH's debt levels are acceptable, but others are better placed for this cycle.
For example Lennar and D.R. Horton are far better placed to pick up troubled smaller homebuilders. Every cycle will create opportunities to buy a troubled company on the cheap. Just this week, Australia's largest homebuilder, Metricon, is suffering a liquidity crisis due to fixed price contracts while materials costs exploded. There will be US versions of this later this cycle.
If we were running a home builder, we would be preparing the balance sheet now to buy smaller builders and their land banks for fire sale prices, as this cycle matures sometime in 2023 or 2024. Tremendous profits will be had.
Instead LGIH is buying land, and it's own stock, at peak cycle prices.
LGIH still has some room to act, but compared to the leaders it will be more limited in how much it can take advantage of these opportunities.
Both components of housing costs are surging: Home prices and mortgage rates. Home prices have jumped by record amounts.
This rate of growth can't be sustainable.
It's worth pointing out that LGIH's average sales price of $341,000 is still well below the median US house price of almost $380,000.
Meanwhile, 30 year mortgage rates have also jumped past their recent 2018 peak. How high will they go? That depends on inflation and the Fed.
Like many, we worry that high inflation might stick in the 5-9% range for another year or two. A combination of problems with energy, food, supply chain shortages and tight labor markets make a potent combination.
Inflation might take quite a beating from the US Federal Reserve's interest rate stick before it succumbs. To us, a 2023 recession is an even money possibility based on present data.
Let's not get ahead though, right now there is an affordability crisis.
Will the housing market be OK if 30 year mortgage rates top 6% and get close to 7%? Already housing affordability is close to lows around 2007-09. Still, it isn't all bad news, as fundamental demand for housing remains very strong.
In case you haven't seen the headlines, the rental market is very tight. In fact the vacancy rate hasn't been this low since 1985.
This has resulted in rents jumping by record amounts in a year.
We believe rents are a better guide to fundamental housing demand because unlike owning, they lack the price surge due to rate decline dynamic.
Our guess is: with remote working now permissible, executives and white collar workers have moved closer to home (or another preferred place) yet have still retained their city house close to their office. We provide more evidence in our Lennar (LEN) article here.
With strong fundamental demand and rising rents, this will help a homebuilder that targets renters. Which builder? That's LGI Homes with it's more affordable entry level properties.
Of all major builders LGIH has the lowest average sale price. This is combination of two things. Mostly, it's the strategy of building entry level properties to sell to renters as a first home. It also reflects the dominance of the Central region for LGIH, with lower prices.
Homebuilders usually trade in a tight range of 9-12 but the whole sector has sold off in recent quarters. A PE of 4-5 puts us firmly in value trap range. Given rising rates, that's probably fair and a return to earnings similar to 2019 levels could happen once the market slows.
This means the sector has already priced in a significant slowdown. These might be bargain prices if that is somehow avoided. But we struggle to pick LGIH over other builders. Lennar and D.R. Horton have similar, if not lower multiples, yet provide advantages of:
Inflation and rising rate expectations should be respected for their ability to slow this housing boom to a near halt. Strong housing market fundamentals mean a crash is very unlikely. Yet an interest rate spike cannot be discounted.
In just the last couple of months forecasters have increased their rate forecasts significantly. February forecast is the dotted line with the jump to the higher hard line in May quite dramatic.
Inflation blame can be shared widely. Putin's invasion of Russia has caused chaos for energy and food prices. China's ongoing lockdowns have snarled supply chains more than most realize. Neither seem imminently fixable.
These have been the big changes on top of tight labor and rental markets. Higher rates than 2018-2019 means mortgage rates will correspondingly go well past 5% to 6% or more. That will bite, particularly if the economy cools.
So for us, LGIH is a hold.
This is a break from a few years ago when LGI Homes was one of our favorite homebuilders. A PE of 5 would usually have us keenly interested. We liked their market leading growth trajectory and unique model able to deliver strong margins and low prices. This is a company worth following.
The macro environment is mixed. Rising rents and LGIH's Texas dependence provide some protection. Due to this, this isn't a sell recommendation. However we can't escape the fact that rising rates and rising debt levels will limit LGI Home's options as the housing market slows.
Home builders like DHI and LEN are better prepared and are trading on similar or lower multiples and look better, if you are planning to buy a home builder.
Bottom-line: LGIH is a hold.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.