Introduction
LGI Homes (NASDAQ:LGIH) has seen a relatively good amount of share price volatility over the past 12 months going from low-$100/share to over $130/share down to mid-$80/share, back up to over $130/share, and now down to mid-$90/share. I can’t say I’m totally surprised – my casual observations have been that homebuilders are more volatile than general, trading largely with “macro” factors like interest rates.
In the end, however, what ultimately matters are cash flows, and to this end, at mid-$90/share, investors can take advantage of LGIH’s price. That is, I think at mid-$90/share, a lot of their potential growth isn’t fully priced in. While there are obvious macro risks here, the attractive angle about LGIH is that a relatively larger portion of their future is in their hands.
Sales: Uncertainty Clouds Long-Term Opportunity
I think most of us are familiar with LGIH, but for those who aren’t, I’ll provide some quick context. LGI is a Houston-based homebuilder building entry-level (mid-$300K ASP) homes across the U.S. – they currently have operations in 21 states to give a sense of scale. They do have some smaller, niche sales though to be mindful of – they’ll sell homes in bulk to institutions for rental purposes, and they also have joint ventures where they offer mortgage and insurance services – but the bulk of sales is to individual buyers.
Q4 2023 sales increased ~25% to $608M. Broken out, unit home sales increased 21.4% to 1,758 homes (up from 1,448), and ASPs increased 2.6% to ~$346K. Within that $608M, $84M of sales were Wholesale sales versus $124M in the prior year Q4, a decline of ~32%. Implicitly, their non-Wholesale business went from $364M last year to $524M today, or growth of ~44%.
Let’s hold aside Wholesale. Regarding sales to individual/non-institutional buyers, part of the growth simply came from opening more communities – in Q4 2022, they had an average community count of 92; today, that was 104. Or said differently, they started Q4 2022 with an inventory of 4.1K homes (including homes in progress as they’ll begin the marketing/selling process for those too) compared to 4.47K homes at the start of Q4 2023. Implicitly, they sold 16.9 homes per average community in Q4 (~5.6 per month), and sold 1,448, or ~15.7 per average community (~5.2 per month) in Q4 last year. With the wholesale business down too, this pressured their efficiency a little.
Unpacking this efficiency growth, I don’t think the macro helped. Consumers have clearly pulled back on discretionary spending, particularly for high-dollar items. We can see this by looking at residential R&R exposed businesses like Home Depot (HD) and Lowe’s (LOW) who are both seeing demand declines.
Now, this behavioral trend is not necessarily a net negative for LGI (although it is for Wholesale). Housing is oftentimes a non-discretionary purchase. LGI could have individual buyers purchasing for rental purposes, however my suspicion is that this is a very small percentage of buyers, particularly given rental restrictions from FHA loans (of which 75% of their buyers use).
What I suppose could be happening, however, although I don’t have clear data on this, is that if we’re in a period of strong economic demand/activity, there’s generally more people with more income and likely more people able to find new/more attractive jobs in new locations. As such, the willingness to purchase a home is higher and the overall living turnover is higher. But if unemployment rises, which it has, resulting in fewer people able to afford a new home, and you have existing renters or homeowners unable to find new jobs elsewhere that would necessitate finding a new home, that’s going to reduce the market size. And there’s likely some wealth effect too.
Anyways, they didn’t take down their home prices to drive this – ASPs were ~$346K, up just shy of 3% versus last year. Now, this isn’t a perfect measure – they have a home brand called “Terrata” which sells higher-priced homes which grew mix-wise. Terrata sold ~15% more in 2023 at a ~4% higher sales price (which got to ~$570K). Net, then, for the non-institutional and non-Terrata home buyers, their ASPs were likely flattish – nothing materially different. And that’s net of incentives, too.
From a mortgage rate perspective, consumers can get a 30-year mortgage rate today in the upper-6% range, about flat with rates at the end of 2022. Now, as Eric noted at a conference, about 75% of their buyers utilize FHA loans, with creeps up to 90% when you add in VA and USDA loans. Mortgage rates for FHA loans specifically are similar to the data referenced earlier, though.
I find it likely that they might have taken some market share. See, LGI operates at the entry-level price point and so given this, on the one hand, it’s very possible that prospective buyers have decided to just continue renting. However, on the other hand, it’s also very possible that they benefited from a trade-down from higher-priced homes, which Eric discussed in 2018. I don’t know what the net of these are, but it’s hard to think this is not happening.
Any share gain on a direct basis, I think, is going to be marginal. Homes are fairly commoditized – there’s nothing really unique/differentiated about LGI’s home design and quality than someone else’s that I can tell. Price can shift the value proposition, but that there hasn’t been a widening gap. Actually, DHI, LEN, and PHM all posted lower ASPs, although MTH, KBH, and TOL were higher.
For 2024, they’re guiding for 7,500 home closings at 150 communities at year-end. They ended 2023 with 117 communities, so their average will probably be something like 135, implying an absorption rate of ~4.6. The range they gave on the call was something between “4.5 to 5.3”, which would be a decline versus 2023’s 5.4. However, it’s not clear that they’re less efficient or losing share. One, they’re expecting their Wholesale business to see volumes down 50% from 2023’s volumes, so that’ll ding them (Wholesale closings are included in the 7,500 figure). And then two, the increase in communities will add a higher mix of “new” communities, which carry lower absorption rates.
They’re expecting an average sales price of $355K thereabouts, which would be low-single-digits higher than Q4. We’ll address this in the margin section, but incentives are increasing, however, LGI prices to a margin, not to a certain demand level. In other words, the absorption rate is at more risk than the guided sales price. Net, they’re guiding for sales of $2.66B in 2024, up from $2.358B posted in 2023.
Putting everything together, regardless of whether their absorption rate is at the lower end or higher end, I think, misses the bigger picture. LGI has what appears to be a sizable runway to grow community count over time, which is reflected by their guidance. For reference, pre-COVID, they went from 52 communities in 2015 to over 100 in 2019. And then up until 2022, they were battling supply constraints on getting more communities built, but that’s now behind us.
For context, they have about 8 or so communities in D/FW and then another 6-8 in Houston, thereabouts. If they can do something like 5 communities across the top 50 MSAs, which doesn’t sound too unreasonable, that would get them to over 200 communities over time. Of course, there’ll be a distribution – e.g., D/FW will have more communities/demand than New Orleans, say – but assuming 5 communities isn’t unreasonable, which is seemingly sufficient capacity to cover the ongoing flow of renters-to-home demand.
So, when I add all of this up, if we get into a situation where absorption rates get to something like 5 in 2026, which looks appropriate considering they’d have a lower mix of less efficient communities, and we assume they’re able to add ~10-20 new communities per annum, even if home prices rise low-single-digit to $360K, they would have an average of ~170 communities in 2026 resulting in ~10K home sales – at $360K, that’s sales of $3.6B. (They went from over 3K home closing in 2015 to just shy of 8K in 2019.)
Margins: Stable With Near-Term Risks
Q4 adjusted gross/EBITDA margins were ~25%/~12.8% versus ~22%/10.8% in the prior year Q4, so growth at both levels. As noted earlier, home prices are ~3% higher than the prior year, but concurrently, I don’t think their costs are rapidly rising. They called out “moderating” inflation, for instance, and if you think about what’s in their COGS, it’s going to be the cost of land, the subcontracting costs, and then homebuilder incentives. But they’ve talked about their input costs (in Q3 2023) being stable.
Now, on the one hand, incentives have increased since last year, as LGI is seemingly offering more rate buy-downs to get the monthly payments down (giving more consumers the ability to qualify for loans). And they talked about their competitors increasing their incentive levels too. However, on the other hand, last year’s comp isn’t comparable as they “decided to move older, higher cost inventory resulting in lower overall margins.” As they point out, if we look sequentially to adjust for this, gross margins declined 230 basis points sequentially from higher incentives.
From an operating leverage standpoint, gross margins are largely unaffected by this, with COGS being primarily variable. But despite selling ~25% more in sales versus last year with absorption rates ~7.5% higher, G&A grew at 25%, thus remaining flat as a percentage of sales, and selling expenses grew ~50% and increased from 6.8% of sales to 8.2%. I’m not sure what’s going on G&A-wise because they didn’t elaborate, but at least on the selling expense side, this seemingly had to do with increased competitive intensity/lower demand.
As noted on the call, the increase in selling expenses resulted from increased “spending on advertising and higher outside commissions.” With respect to the higher outside commissions, this might reflect an increase in the commission rate, but they’re investing in more people to support their growing community count in the same way retailers would have to staff a new store location. Now again, absorption increased, so on a net basis, there should be leveraged here notwithstanding the added people costs.
Evidently, then, what increased their selling expenses as a percentage of sales was increased advertising costs, which they confirmed started in mid-2023. There could be some “upfront advertising” – i.e., I suppose there could be a dynamic where if they have a 200 home community, they may spend more on advertising as a percentage of sales to capture demand for the first 100 homes, and then less for the latter 100. As such, if they’re growing – for which they grew their community count by ~17% since last year’s Q4, and expect to grow it to 150 by 2024 year-end – they may be fronting selling expenses today with a higher mix of “new” communities. At least in 2018 and 2019, they spent ~7% of sales on selling expenses, so we’re at a higher rate today. But all in all, this is what partly offset the gross margin growth.
As far as mix goes, their wholesale business carries lower margins as expected. It’s not disclosed precisely what the margin is, but either way, with total sales up ~25% and wholesale sales down 30%+, this was a mix tailwind.
Looking ahead, they’re expecting the incentives environment to be consistent with what they saw in Q4, so they’re not contemplating material degradation from this. We’ll see. It clearly had an impact from Q3. From an input cost perspective at least, most of this is controllable margin-wise via increased sales prices, and I’m not seeing anything out there that’d disrupt the present stability they’ve seen. So, to the extent incentives are stable, today’s gross margins of ~25% are reasonable going forward. And indeed, they’re guiding for adjusted gross margins of ~25.5%.
At the operating level, from what it seems, as absorption rates grow, they should experience SG&A leverage. They’re guiding for SG&A as a percentage of sales to be ~13% in 2024 (versus 13.1% in FY23), implying ~12.6% EBITDA margins (adding in D&A) which is marginally down from Q4 levels, although they’re also guiding for absorption rates to be slightly lower. But over time, at least, with more communities driving higher sales, this should result in G&A leverage, a trend that’s evident during the pre-COVID period.
Added together, their guide amounts to ~12.6% EBITDA margins on ~$328M of sales. Historically, they’ve posted EBITDA margins north of 14%. However, this occurred when their absorption rate was over 6, so I’m not assuming they get back to this level since we’re assuming their absorption rate is 5 in FY26. Net, something like 12.75% EBITDA margins on $3.6B in sales is reasonable in FY26 as they’ll capture G&A leverage notwithstanding flat absorption rates, or ~$460M in EBITDA. That would imply a CAGR of high-teens from 2024 to 2026.
Valuation: Attractive
At today’s price of ~$95/share with 23.58M basic S/O, that’s a $2.24B market cap. Net of $48M of cash and $1.248B of total debt, that’s an EV of ~$3.44B.
Looking ahead, annual cash flows, in terms of magnitude, will be relatively unpredictable because it depends on how much they decide to reinvest back into the business via inventory growth. But considering they’re not in a cash crunch position today, unless you thought they wouldn’t earn profits on the inventory they’re acquiring, this all nets out in the end. To this end, then, I’m OK valuing them on a GAAP EPS basis.
Summarizing what I concluded earlier, I think they do earn $3.6B in sales and $460M in EBITDA (12.75% margins) by FY26. Subtracting out D&A at 0.1% of sales, 1.5% in capitalized interest to sales (not accounted for in adjusted margins), $40M of “other income” tied to their JV, and a 25% tax rate, this gets me to a net income figure of ~$272M in FY26.
A key nuance here that shouldn’t be overlooked is capital allocation. To this end, what’s interesting is that considering where inventory as a percentage of sales is today (~130%) versus where it was pre-COVID (~80%), they may see a material release of cash flow in the coming years, which would have a very material impact on valuation.
It’s not so much a function of if it’ll slow, but when – they obviously won’t gobble up all of the land inventory in America (to use an extreme extrapolation). They haven’t been clear that they’ll slow their purchases, but my understanding is that the outsized growth post-COVID of inventory had to do with their perceived attractiveness of prices. With the world normalizing economically, I think it’s reasonable to see a slowdown in the coming years.
Should this happen too, it’s likely they’ll repurchase stock – see 2021 and 2022 – which’ll result in a material amount of accretion to current shareholders. If they’re able to bring down their real estate inventory level to, say, 90%, they’d need to spend another $200M of FCF from 2024 to 2026 to cover the required inventory levels. Well, they’d cumulatively generate something like $600M thereabouts FCF from operations during that period, so that leaves another $400M left to redeploy.
If the stock doesn’t rise from the levels today of $95/share, they’d repurchase something like 4.2M shares. This means that at the end of 2026, instead of doing $272M on 23.58M shares (EPS of ~$11.5), they’d post $272M in FCF on ~19.4M shares (EPS of ~$14).
What’s that worth? Well, the market seems to really dislike giving any home builder an EPS multiple higher than 12x, but it’s clear that LGI would deserve it given their growth rates and differentiation. Either way, at 12.5x, that would result in an implied fair value of ~$175/share – discounted back 3 years to today gives me a fair value of ~$130/share.
Conclusion
At today’s share price in the mid-$90’s, I think the LGI risk/reward is rather attractive. The key valuation risk that I worry about is a deterioration in incentives (increased usage) which would most likely reduce sales instead of margins (per how they price their homes). The other risk is changes in the interest rates, which affect them for obvious reasons. I find both of these risks capable of materially bringing down their fair value.
On the other hand, what gives me a good deal of comfort with LGI is their operating model, which no one has successfully replicated to my knowledge. And indeed, like we pointed out earlier, they’re likely still taking share. Furthermore, their growth opportunities via increased community growth is totally independent of “the market” – this is purely an internal execution initiative that I believe is achievable for them as they’ve demonstrated historically. Under the scenario we laid out, which assumes this, I find LGI to be worth much more than they’re trading at today.
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