Description

LEGH

The bet is that you can pay 1.4x TBV and 10.0x 2019e EPS today and receive a stake in a company that historically compounds BV at 19% after-tax ROEs. The opportunity exists because, while the management team is scrappy and historically creates value in their niche industry, they are amateurs when it comes to being public company executives. These circumstances have created a temporary mispricing.

Downside is protected by the current proximity to (likely understated) book value and the fact that investor fears about management’s abilities to properly run a public company are now priced into the stock. We believe this company makes for a good multi-year investment as they continue to compound book value at high ROEs. This should eventually be recognized by the market. Illustratively, 2.0x BV or 14x EPS = $16.

Company Overview

LEGH builds, sells and finances manufactured homes that are distributed through a network of independent retailers and company‑owned stores and also sold directly to manufactured home communities. The company was founded in 2005 as a Texas limited partnership and converted into a corporation in early 2018. They completed their IPO in December 2018.

LEGH is the fourth largest producer of manufactured homes in the United States (behind Clayton, SKY and CVCO). With current operations focused primarily in the southern United States, they offer customers an array of homes ranging in size from approximately 390 to 2,667 square feet consisting of 1 to 5 bedrooms, with 1 to 3.5 bathrooms. The homes range in price, at retail, from approximately $22k to $95k (average ASP of $41k). During 2018, they sold 3,950 home sections (which are entire modules or single floors) and in 2017 they sold 3,274 home sections. They commenced operations in 2005 and have experienced strong sales growth and increased equity holders’ capital at a compound annual growth rate of approximately 28% between 2009 and 2018.  

LEGH was 100% owned by its two co-founders and their families prior to its IPO in December 2018 (now they own ~76%). The founders have no stock comp other than their equity stakes and only make $50k/year salaries. They have never taken money out of the business other than to pay taxes when the company was a pass-through partnership. The IPO was 100% primary.

In addition to the manufacturing detailed above, LEGH also finances the homes it sells to consumer borrowers at a high rate (14%) and to manufactured home park (MHP) owners who then rent the units to consumers (9.5%). Historical delinquencies are 2-3% on the consumer side and 0% on the MHP side. We believe the loan book is high quality:

-          LTV at origination on the consumer loans is 82%. Buyers put 15% down and the monthly housing payment (principal + interest) is limited to 40% of total monthly income.

-          The biggest constraint on growing the loan book is the ability to make loans to good borrowers (as opposed to balance sheet capacity, for example).

-          Repos only went from 2% to 4% during the 2014-15 oil bust even though TX is ~60% of their business.

-          Repo’d homes typically sell for ~80% of replacement (including cost to fix).

The company has 242mm of assets and 46mm of liabilities for 196mm of equity. 196mm / 24.7mm shares =  $7.92 BV. They only have 18mm of debt against the 155mm of loans in their two loan books.

LEGH has generated a 25% CAGR (pre-tax) ROE for the past ten years and they believe they can continue to compound at a +18% after-tax rate going forward.

Why The Opportunity Exists

The IPO came in December 2018 in the midst of the fall 2018 downturn. At $12 the company was valued at 1.5x TBV and 10x 2019e EPS (15% PF ROE).

The company delayed its 10-K in late March. Following that delay the company reported poor 4Q results and butchered their attempt at 1Q guidance. The stock has since traded as low as $9.00 and is currently trading at $11.00.

LEGH’s 4Q results missed both on the top line and on gross margin. We believe the reasons for the miss are one-time in nature.

As explained on the conference call, there were weather issues late in the quarter that prevented deliveries before quarter end. Indeed, MHI statistics show that December industry shipments were down 30% in LEGH’s key states (TX and LA). We believe part of the y/y miss was also related to lapping Hurricane Harvey in 4Q17 – while there were some FEMA sales in 2017, Harvey likely spurred demand for non-FEMA sales as well.

Gross Margin in 4Q18 was 16.6% which differs from historical results of 23-25%. We believe this occurred because the company underwent a full audit from Grant Thorton for the first time after year-end 2018. This audit was much more stringent than any other audit previously performed on the company. Because LEGH had historically not been as concerned with quarterly fluctuations in their business (versus annual results), it appears they under-provisioned in the 9m18 period for things like employee bonuses that were paid in the fourth quarter. The effect was that there was a catch up in 4Q18 that had the effect of depressing 4Q margins.

We believe this reasoning is credible because the overall margin for 2018 was 22.9% which is in-line with historical results. Importantly, it is highly unlikely 4Q margins are indicative of some new, lower run-rate and therefore the issue should be discounted on a go-forward basis.

We suggest reaching out to management to further discuss the above.

1Q Guidance

The company reported 4Q18 earnings on 4/9/19 so they were in a position to discuss preliminary results for 1Q19. A few things to note:

-          1Q18 is a tough comp. The company had 8.9mm of FEMA sales in the quarter (on 42.6mm total sales) which are higher margin than the company’s wholesale sales.

-          The CFO said on the call that preliminary 1Q19 results were for revenue to be up 11% y/y. Unfortunately, he was not clear that “up 11%” was not on the base of 42.6mm but rather on the non-FEMA sales of 42.6mm – 8.9mm = 33.7mm. Therefore, guidance was for sales of 33.7 * 1.11 = 37.4mm.

    o   We believe confusion around this topic is the largest reason the sell-off accelerated after the earnings call.

-          “We were operating at or near capacity at all three of our facilities for every day of the first quarter.” – p.4 of the 4Q18 transcript.

The issue was that the company bumbled through their explanation of all of the above at the end of the earnings call. Their answer to how 1Q went was unintelligible. (p. 9-11 of transcript).

Given the valuation support and the one-time nature of the issues in 4Q, we believe this is a compelling buying opportunity.

Valuation

Book value = 242mm assets – 46mm liabs = 196mm equity / 24.7mm shares = $7.92/shr. At $11.00, the stock trades at 1.4x BV.

The company should earn $1.00 - $1.10 in EPS this year (12.5% - 14% ROE, below historical 18%). At $11.00, the stock trades at 10-11x EPS.

Further, BV likely understates market value of assets: consigned inventory is held on the books at 71c on the dollar and the FV of the loan book is understated by 12mm relative to BV (p.42 10-k). This could add $0.50-$1.00 to BV and is not factored into any of the above calculations.

Risks

The bet ultimately comes down to whether or not the co-founders can continue to find inefficiencies in the manufactured housing market that allow them to generate outsized ROEs. At current valuation we believe the biggest risk is if problems appear in the loan book.

Risk to aggressiveness in the loan book is mitigated by the stringent audit process the company just underwent as well as the positive tone management used when discussing the loan book on the 4Q18 earnings call.

Catalysts

1Q19 results

Compounding over time

Catalyst

1Q19 results

Compounding over time