Description

LGI Homes, Inc. (“LGIH”) is a very attractively valued low-cost homebuilder that is likely to generate ~20%+ CAGRs from current share price levels for the next 5-10 years as LGIH becomes one of the top 5 U.S. homebuilders. The market is fundamentally misunderstanding LGIH’s operating philosophy, which together with the recent rates move as well as widespread building material shortages plaguing the wider industry has created this opportunity. LGIH is trading at a very attractive ~7x P/E LTM and 2.3x P/B, with earnings likely to inflect significantly higher in 2023 as its landbank is being replenished from their land development initiative that started around 2 years ago. LGIH has been written up by Rearden, Pluto, and Katana, which provide fantastic background to the company. I will provide a brief outline of the company and then address topical issues.

Unique Operating Model

For a homebuilder, LGIH has a unique operating model centered around providing a low cost yet high-quality starter homes, which they achieve via process optimization and a deeply thoughtful management style. I strongly recommend reading this article, which neatly outlines the quirks of LGIH’s development and sales process. Their obsessive focus on streamlined processes, their near reckless disregard for industry norms and conventions, as well as their uncompromising commitment to offering value to customers make me want to draw analogies to early days’ Costco or McDonald’s.

Before we address the shortcomings of LGIH’s operating model, I want to emphasize how consistent LGIH’s management has been, in terms of sticking to their operating model with all the advantages as well as disadvantages. Up until early 2020, their process-driven culture enabled LGIH to grow at a breakneck pace whilst maintaining industry leading profit margins and industry-beating returns-on-capital. Yet, LGIH’s resolve was never truly tested until they were faced with the post-pandemic construction boom, which drove up prices for finished lots. Instead of just increasing prices and maintaining short-term growth, LGIH decided to sacrifice sales growth for around 2-3 years and to get back into land development. This way, LGIH will have a large pipeline of low cost finished lots ready for construction for 2023 and beyond.

Cost-Plus High-Frequency Builder

LGIH targets a 25% homebuilding margin, but what really stands out is LGIH’s build time of 45-90 days, which has a number of positive side effects. Generally speaking, LGIH runs with 3-4 floorplans and only builds spec homes, which are naturally quicker to build than custom homes. Few floorplans combined with LGIH’s sell-as-you-build philosophy means that LGIH turns inventory much faster than competitors, translating above average homebuilding margins into significantly higher ROCEs of 15-20%

Its short build time also means that LGIH has a pretty good handle on its construction process and costs. This enables LGIH to price the homes relatively accurately, which is obviously quite important in today’s inflationary environment. Unlike some competitors, LGIH has not struggled materially with regards to availability or pricing of building materials or labor, which is testament to (a) how well LGIH is managed in general, and (b) how much suppliers and contractors value working with LGIH given its consistency and reliability. However, excellent management alone doesn’t fundamentally resolve the widespread shortage of finished lots and I believe the market is failing to understand that LGIH has been planting the seeds to return to volume growth within the next 24 months.

Contrarian Landbank Management

The widespread homebuilding boom since the onset of the pandemic posed very interesting challenges for LGIH’s management and their operating model, and I believe LGIH will emerge stronger rather than weaker from this. As competitors bid up prices for finished lots in order to capitalize on rampant housing demand, LGIH management decided to buy up unfinished land instead. Unfinished lots can take 18-24 months to be ready for construction, and as a result, LGIH’s unit sales growth for 2021 and 2022 is falling short / likely will fall significantly short of historical levels.

By focusing on developing unfinished lots, LGIH will have access to cheaper development land relative to competitors. Given its cost-plus operating pricing strategy, LGIH’s future developments are likely to continue to be sold out given LGIH’s inherent operating cost advantage is amplified by its access to cheaper land means that its homes are likely to be materially cheaper than competitors’. This landbank strategy has come at a cost of deteriorating unit sales, contracting rates, and even declining community counts in recent months, however, this is really the result of a deliberate strategy as opposed to a sign of deeper fundamental issues.

Macro Tailwinds

The market trades homebuilders inversely to interest rates due to the debt-financed nature of most home purchases, however I think it’s a red herring for LGIH in particular. I have no great insights into future interest rates; however, I do want to observe that (a) 30-year rates today at 2.2% have only been lower in 2020 and 2021, and (b) with real interest rates still well negative given inflation rates in excess of 5%. In this environment, buying real assets / real estate that you can finance using cheap fixed rate mortgages is a no brainer, which a number of VIC members have noted too. In the next 3-5 years at least, I don’t think we’ll get a Volcker-like inflation slayer with nominal rates going above 10%+, and until then, I’m not overly worried about rates risk.

Affordability is a more salient issue in my mind, although relative to other homebuilders, LGIH is almost perfectly positioned in this regard. As a builder of starter homes, LGIH generally caters to people with salaries, and recent news on inflation and higher wages should bode well for such buyers. Furthermore, given their aggressive management of land cost, LGIH is likely to enjoy an advantaged cost position relative to other homebuilders even if affordability starts to become a biting constraint overall.

Key Risks

Interest Rates

As outlined above, I think only high real rates are a concern for investors in LGIH, however, I think the risk is relatively low in the short- to medium-run.

Inflation

At the margin, I think moderately high levels of inflation standalone bodes well for a “manufacturer of real assets” like LGIH. Given their 25% target margin and high operating efficiency, I’m not more worried for LGIH than for other investments.

Housing Affordability

This is a bigger concern in my mind, although hopefully inflation, rising wages, and access to cheap land will help LGIH, again relative to other homebuilders.

Capital Misallocation

Unlike the better part of its history as a publicly listed company, LGIH is now producing excess cash as it isn’t recycling all profits into buying more land. LGIH has relatively quietly been buying back its own shares for the past 2 years, and given management’s fantastic discipline and operating management, I think it’s relatively unlikely that they will squander their hard-earned money.

Disclaimers

The author and affiliates may or may not have material positions in issuers and securities mentioned in this note and will not be obligated to give notice of any changes in their views or positioning. You agree to hold the author harmless and to waive the right to any legal action against the author in relation to this note. The views expressed here reflect the author’s personal views about the issuers and securities and do not constitute investment advice. The author makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information. This note is for information purposes only and should not be construed as either projections or predictions. Before making any investment decision, you should seek independent investment, legal, tax, accounting or other professional advice as appropriate, none of which is offered to you by the author in this note. The author accepts no duty of care to you in relation to investments. Past performance cannot be relied on as a guide to future performance. You should not assume that the performance of any specific investment or investment strategy will be profitable or equal to corresponding past performance levels. Any investment or investment strategy can be impacted by numerous factors, including market and economic conditions, and may result in a loss to investors. As with any investment, there can be no assurance that any investment objectives or strategies will be achieved or that an investor will not lose a portion or all of its investment.

Catalyst

Share buybacks, return to organic volume growth