Description

We have more confidence in LGI Homes as a multi-year investment, given its valuation today, than any other stock we know.  We can easily find stocks with more expected upside for their midpoint scenarios, but not with such low downside risk.  That was true in February when the economy was humming along, the reported virus case count was zero, and the stock was at $90; it remains true now when the economy is in its sharpest-ever contraction, the U.S. virus case count is still rising by 30,000 per day, and LGI’s stock is at $60-64.

Pluto posted an outstanding write-up of LGI 18 months ago, and I encourage you to read it for a full description and background on the company.  I will give a brief company overview but assume you will read Pluto’s for more detail, and then cover three new topics:

1. All homebuilders are at the start of a powerful 10+ year demographic tailwind from the “Echo Boomers” reaching home-buying ages.

2. Among economically-sensitive businesses, homebuilders should fare relatively well in the post-virus, post-shutdown world.

3. LGI is best situated among homebuilders to benefit from the tailwinds and to weather the virus and recession storms.

BUSINESS BASICS

LGI is unique among publicly-traded homebuilders in that it caters exclusively to first-time buyers who need cheaper homes.  LGI typically buys cheaper land further away from major city centers and builds less-expensive homes on smaller lots.  Most of its developments are located in cheaper regions of the country (Texas, Florida, the Southeast, and the Southwest).  LGI carefully selects development sites that can draw from a sizeable nearby base of current apartment-renters yet also usually qualify for federal government “rural development” assistance to help buyers with down-payments.  We have visited some of LGI’s communities and viewed many others on the company web site.  These homes are not where anyone would choose to live if they can spend materially more.  But at an average sales price of only $240,000, their required mortgage payments are often less than the target customers’ monthly apartment rent while offering a nicer place to live.

The low-cost niche is an underserved one.  Most large homebuilders focus on either the middle to high end or exclusively on the high end.  LGI’s business operations are designed from the ground up to serve the low end and differ from that of most homebuilders.  The relative vacuum has enabled LGI to grow revenues faster than most builders – 50% in 2017, 20 and 22% in the homebuilding industry’s relative bust years of 2018 and 2019, rebounding to 58% in 1Q20 as the industry rebounded.  Here is a graph of LGI’s growth in home closings each month:

About 15-20% of LGI’s growth comes from it steadily opening new communities of homes to be sold.  The period-to-period variation in closing growth comes from change in the number of closings per community per month (absorption rate), which is largerly driven by macroeconomic factors.  Here is the absorption rate over the same time period:

In the last several years, LGI has grown from a near-unknown to the tenth-largest U.S. homebuilder as measured by units sold.  LGI has obvious headroom to keep expanding.  It currently operates in only 34 markets in 17 states.  It could probably keep growing its earnings by 20% per year for a long time even if the industry didn’t grow at all.

DEMOGRAPHIC TAILWIND

All homebuilders are at the early stages of a long and powerful tailwind from years of constricted new-home supply and a coming demand boom.

Single-family housing starts have steadily increased since the 2011 trough but have not yet regained their long-term average level.  The industry built about 900,000 homes in 2019, still below the 1-million average for the last 50 years:

The industry has been significantly undersupplying the market for 12 straight years.  The historical 1-million average is, not coincidentally, the amount necessary to keep up with U.S. population growth.  Every year brings about 2.5 million new people, which is 1.5 million new households and, at a 65% homeownership rate, about 1 million new home buyers.  In the chart above, all the white space between the recent years’ bars and the red line represents undersupply that has more than soaked up the oversupply from the 2002-2006 bubble.  Even as housing starts have increased, inventories of unsold new homes have been decreasing.

This undersupply is about to meet a powerful, demographically-driven demand boost for the next 10-15 years.  Everyone is familiar with the Baby Boomer generation’s profound effect on demand for whatever products or services Boomers were consuming at a given stage of life – for example, baby food and toys in the 1950s, schools and colleges in the 1960s and 1970s, cars and investment products in the 1980s and 1990s, healthcare and Alaska cruises today.  Less well known is that the Boomers’ children, the Echo Boomers, are more numerous than the Boomers themselves and represent almost as much of a population increase from the preceding age brackets as the Boomers did in their day.

The Echo Boomers’ impact on consumer demand levels is just as large.  And starting roughly last year, the biggest item that Echo Boomers will need to buy is a home.  The average U.S. marrying age has risen to 29, and the peak Echo Boomer cohort turned 29 last year.  The first Echo Boomers turned 35 three years ago.  The homeownership rate jumps from 36% for households under age 35 to 60% for those aged 35 to 44.  As the Echo Boomers hit their peak home-buying age, the single-family home market should experience a slow-moving but unstoppable surge – the blue line on this chart:

This demand growth started appearing in 2017, when home sale volumes accelerated sharply.  But in early 2018, volumes fell back down and started contracting due to three changes that all boiled down to affordability.  The undersupply of new homes and the Fed’s years of zero interest rates had pushed home prices up faster than inflation and beyond the reach of many first-time buyers.  The new tax law restrictions on mortgage interest deductions made higher-priced homes even more expensive on an after-tax basis.  And rising interest rates started driving monthly mortgage payments higher.  Many people decide how much to spend on a house based on whether they can afford the mortgage payment, so rising mortgage rates can dramatically reduce buyers’ purchasing power. These trends largely reversed by mid-2019; the Fed reversed course on interest rates, the “sticker shock” of higher after-tax costs had time to wear off, and potential homebuyers got back to buying.  Thus LGI’s closing growth rebounded back to ~40%.

HOMEBUILDERS SHOULD FAIR RELATIVELY WELL IN THE POST-VIRUS WORLD

The virus has significantly worsened the short-term outlook for all homebuilders.  People sheltering in place are not out shopping for new homes, and recessions materially hurt the housing industry.  LGI reported its 1Q earnings today, and like many other companies, it withdrew its full-year guidance.  However, management also said on the earnings call that just ended:

• “[O]ur business was stronger in April than we had originally expected and we are seeing positive momentum in recent sales trends that leads us to believe the impact from the COVID-19 pandemic may be less severe than we had originally expected.”
• April closings were down only 1% YoY.  (But April closings still benefited from the sales pipeline that had already been filled during 1Q.)
• May closings will be down 12-27%, with steady gross margins.  New sales commitments were worst in April's first half, better already by April's second half, and better yet in May's first week.
• They have not increased selling incentives or promotions.
• They have not laid off our furloughed anyone and are planning to increase their headcount going forward.

We are not surprised by management's relative optimism, because several new factors should help rather than hurt homebuilders.  First, homebuilders benefit strongly from lower interest rates.  The Fed just dropped the Fed Funds rate back to zero, and longer-term Treasury rates are now at new all-time lows.  These lower rates have not yet translated into lower mortgage rates, because the mortgage funding markets remain relatively seized up, mortgage originators have pulled back, underwriting has tightened, and mortgage spreads to Treasuries have blown out.  We suspect that, over time (months not years), the mortgage funding market will unseize, underwriting will ease again, and spreads will fall while the base Treasury rates remain low.

Second, once people are willing to venture out, the virus will likely increase the demand for single-family homes relative to its pre-virus baseline.  Apartment dwellers who try to avoid virus contact by staying at home must still run a gauntlet of common areas shared with other tenants and surfaces touched by other tenants -- exterior doors, entryways, mail rooms, laundry rooms, elevators, etc.  Single-family homes eliminate all these points of contact.  The virus will also increase demand for driving over public transportation, which will further shift the relative attractiveness of commuting from a detached home.  Apart from the dwellings themselves, suburban environments are generally less dense than urban ones and make it easier to keep distances and avoid touching common surfaces.  We expect a meaningful exodus of people from apartments into homes and from city centers into suburbs.

Third, a home not purchased this month becomes pent-up demand for a home purchase next month or next year.  That is a very different situation than many businesses being hurt today.  A restaurant meal not purchased today is gone forever, but a young couple who wanted to buy a home in April still wants to buy a home this summer or fall or next spring.  The virus’s economic fallout may permanently cancel some purchases, but it will merely defer many others.

LGI IS THE BEST-SITUATED HOMEBUILDER

We believe LGI is the most attractive homebuilder to own in good times and in bad, including this double-bad time of virus and recession.  On the “good” side of that ledger, a disproportionate amount of those Echo Boomers will be buying entry-level homes of the type LGI sells.  Meanwhile their Baby Boomer parents will be selling their McMansions and thus flooding the market with a supply of what other homebuilders sell.  This point doesn’t need more elaboration, but it is a powerful one.

LGI’s future growth is also more valuable than growth from most homebuilders.  As Pluto laid out in detail, LGI’s profit margins and asset turnover are consistently much better than the average builder’s.  As a result, its return on assets, return on invested capital, and return on equity are all almost double the averages.  These higher returns make LGI’s future revenue and profit growth much more valuable than the same growth from another builder and boost its intrinsic value relative to its current earnings..

These days LGI’s strength in bad times is more top-of-mind.  LGI’s geographic footprint, largely limited to the country’s southern half, is the best one possible for limiting the virus impact while still addressing large populations.  Its core states have significantly lower infection rates and less-restrictive government virus-fighting orders than the Northeast or Upper Midwest states, which should translate into greater rates of house-shopping visits and shallower and shorter recessions for those states’ economies.  Even Texas, which will be disproportionately harmed by the oil industry’s implosion, is expected to have a shallower-than-average recession.

LGI’s affordable-homes niche is just as important.  It is a fairly good place to be during a recession.  On the one hand, lower-income workers (LGI’s core demographic) are usually the ones hurt most by rising unemployment, and they are also being hurt disproportionately by the virus shutdowns.  On the other hand, if greater economic constraints cause people to buy cheaper homes than they were expecting to buy, the homes they will turn to are LGI’s.  It appears that the positive effect is at least as great as the negative.  During the housing crash of 2006-2008, LGI was the only homebuilder out of the top 200 to grow its sales volumes and revenues.  In the industry’s trough year of 2011, LGI still maintained healthy sales volumes at a gross profit margin that was 50% higher than the average builder achieves today.

LGI will also benefit disproportionately from the tailwinds of lower interest rates and the flight out of apartments.  LGI’s customers make very low down-payments, as low as 3% after qualifying for the government’s rural-development assistance.  That makes their interest burden higher relative to their purchase price, which in turn makes lower interest rates benefit them disproportionately.  Put more tangibly, lower rates are more likely to turn a proposed monthly payment that looked beyond a potential LGI customer’s reach into one that looks doable.

Finally, any virus-driven shift in consumer preferences away from apartments into single-family homes is going to disproportionately benefit the home segment that is the closest-priced substitute for most apartments -- the cheaper ones like LGI’s.  (There are plenty of high-priced apartments for people to move out of, but average apartment rents in a given area are still well below average imputed rents for homes in the same area, and average incomes for apartment-dwellers are well below those for homeowners.)

VALUATION

Management was wise to pull its guidance without replacing it, and we haven’t made a new 2020 estimate even for our internal use.  (The numbers in the valuation box at the top are our pre-virus estimates.)  Like most other people looking at most other stocks, we are looking past it to the earnings on the other side of the virus and recession, assuming a vaccine comes.  If you’re bearish on the world and don’t want to own any cyclicals, you could have stopped reading this write-up after the word “homebuilder.”

Pre-virus, we expected LGI’s 2020 diluted earnings per share to reach about $8.45, and we calculated a DCF value of $150 per share thanks to those higher ROICs flowing through the cash flow numbers.  The world is a mess and highly uncertain, but our macro base case is that LGI can get back near its previously expected 2020 earnings level in either 2021 or 2022.  So how much should we reduce the valuation to account for the interim trough?  I’m not sure, but I am sure that the current level of 7.5x those earnings and 40% of the previous intrinsic value is far too low.

Catalyst

Home closings (released monthly) are better than feared.

I'll also insert a note on risks here.  The risk is that the macroeconomic situation plays out worse than the current consensus expects.  It is a huge risk, but it applies to most stocks, and a lot of this write-up's points generalize to LGI's macro sensitivity being closer to the average stock's than one would expect on first look.  Apart from the risk of a genuine depression, it is hard to come up with a credible scenario in which LGI doesn't thrive over the next 10 years.  That is why we believe its stock to be unusually safe.

The other risk is a shorter-term one that the stock falls back down, likely with the market.  Obviously every stock has this risk, but LGI currently has it more than most and more than usual.  LGI has a high beta and is more volatile than the average homebuilder stock.  Its price was $57 when I started drafting the write-up two trading days ago, $60 when I finished yesterday, $64 this morning when I uploaded it onto VIC and entered numbers in the valuation table, peaked at $69 this morning, and is $64 as I am finishing typing.  The odds are fairly good that you will be able to buy it at $60 or below in the near future.