LGIH - LGI Homes: Cooling Inflation Is Building Optimism

2023-04-17 14:42:53 ET

Summary

• Higher mortgage rates have slowed LGIH more than competitors due to its focus on entry level homes for renters.
• New rental leases are normalizing and should bring CPI readings down significantly in coming months giving hope for lower mortgage rates.
• The economy remains resilient due to employment strength and several drivers of business and government investment.
• LGIH's full year forecast looks conservative given active community growth and we believe earnings of $350-450m are achievable.
• We lift our buy price to $110 and believe there is an opportunity to build a position in LGIH before mortgage rates decline to the mid 5% range.

Introduction

LGI Homes ( LGIH ) is a top 10 US homebuilder from Texas specializing in building speculative homes at entry level prices and selling to renters.

This stock, like its customers, is sensitive to mortgage rate movements in typical times. Unusually, so far in 2023, it has been defying higher rates. Why?

In this report, we will discuss some bullish factors:

• Macro Tailwind #1 - Inflation is likely to continue to cool based on rental leading indicators and moderate energy prices.
• Macro Tailwind #2 - Economic growth remains resilient due to strong employment and IRA driven investment.
• LGIH Recent performance - Sales have cooled in the last year whilst wholesale sales have increased and high margins have eased.
• LGIH 2023 Outlook - Should mortgage rates ease and the economy remain steady, then we explore the bull case for LGIH.

Whisper it, but the worst for the homebuilder market might have passed.

This view might bother the housing perma-bears determined to relive the housing crash of 2006-2010. But that's what the data shows. To be fair, most investors including ourselves, worried that 2023 could be rough for homebuilders. Those fears are starting to look overblown.

Help from cooler inflation, which would help ease mortgage rates, might mean the housing market bottom is close at hand.

Macro Tailwind #1 - Cooling Inflation

You've probably seen headline inflation is now 5% and trending lower. It's a good bet that trend continues over the coming months.

This isn't the first time we've made this argument this year. We've done it for an index fund for emerging markets and another for long term Treasuries . But let's check in with more recent data to ensure the argument holds water.

In a sentence, leading indicators for rent (the biggest bit of Core CPI) such as the Zillow monthly new lease survey show that rental inflation has now completely normalized to just below pre-COVID averages.

Recent inflation numbers continue to decline.

A lot of attention is paid to energy prices. While they do matter, they fell by 18% year on year in March, the biggest cause of the inflation spike has been housing/shelter.

CPI Components - No place like home

Usually, shelter is the boring ballast that keeps inflation low. That's not been the case the last couple of years as rents jumped. Shelter is the largest single component of the CPI.

Housing is 44% of the CPI - almost half the index. In fact, it's the main factor in keeping the CPI as high as 5%.

Other factors are mostly dragging the inflation down. These are significant factors such as regular gasoline, appliances, health insurance and vehicle rental.

Can we forecast the rent component of the CPI? That's where Zillow comes in.

Zillow Monthly Rental Index - Housing of the Future

The CPI survey measures rents from ALL current rental contracts. That gives a correct reading. But what about just new contracts? Zillow shows that.

Zillow's rental price index surveys only new leases of the last month.

Zillow's index showed unseasonal strength in early 2021 - see below. It is now cooling quickly and giving readings slightly below the seasonal norms.

You might look at the above and think, well neither 6% annual rate and 0.46% month-on-month are particularly low. Yet that misses the seasonal cycle of rents. March to June are the strongest for rental increases each year. March 2023 is weak by the normal seasonal cycle average.

To show this, we've used the month-over-month data from the bottom panel of Zillow's data, and turned it into calendar years.

Below you can see 2022 start high and then plunge to the bottom right.

To simplify the crowded image above, we've produced a cleaner one below that shows an average for 2015-2019 for month on month rent. We compare that to the last 15 months. Removing 2020-21 years as outliers.

The figure below clearly shows that monthly changes have cooled to noticeably below the average since October 2022. One month can be noise but six months in a row is no statistical fluke in our view.

In the period 2015-2019, the average annual change in rents was 3-4%. The last 6 months however look more consistent with a range of 1.5-2.5%. That's presuming it continues, and there's no obvious reason why it shouldn't.

If you learn nothing else from this report - the fact above still makes it valuable. In this analyst's opinion, it is a matter of when, not if, inflation cools to meet the Fed's goal of 2%.

Our guess is the goal is achieved somewhere about August/September 2023.

Put your guesses in the comments.

Macro Tailwind #2 - Economic Resilience

Recent bank problems have increased worries about recession. Wholesale funding markets have tightened.

Yet those worries began with the first rate rises, and continue despite employment staying strong and investment showing resiliency.

A recession with job openings still exceeding the unemployed?

Forgive us, but recession talk seems to ignore the obvious reality.

Despite well reported reductions by the technology giants, the US job market still added 236,000 new jobs in March. That's a long way short of recession and that "weak" number might mean the US is approaching full employment.

Further, investment is far from slowing. New jobs demand are being created.

• The Inflation Reduction Act - included $370b in clean energy and tax credits to stimulate green energy investment. Some reports put the investment committed so far as $32b of investment committed in the six months to February 2023. More will likely follow.
• Semiconductor investment might have reached $200b by December 2022 stimulated by the CHIPS act of July 2022 .
• Defense Spending - The Ukraine war has pushed spending with a December 2022 boost of an additional $816b in defense .
• China Reshoring - Some estimate that US multinationals re-shored as many as 350,000 jobs in 2022. Given continuing geopolitical tensions that trend looks only set to continue.

For all the reasons listed above it is hard to see any significant weakening in job demand.

How do you have a recession with business and consumer spending firm?

One of the weaker segments the last 12 months have been homebuilders.

LGIH 2022 - Slower by half

Higher mortgage rates have slowed sales sharply. In the 4th quarter, closings were down 42.7% over 2021 and net income was just $34.1m.

Usually, Q4 is the strongest quarter of the year, but the weakness of 2022, even when compared to pre-COVID sales rates is stark.

We have calculated the sales per community per month. This enables comparison in sales strength even as the company grows active communities.

For the last 15 months, we compare LGIH to their own average for 2017-2020 and can see how sales slowed from May 2022.

You should see a big jump in December closings, but 2022 did not deliver.

So far in 2023 it is closer to the average (see above), perhaps as mortgage rates leveled off, and dipped from time to time.

For earnings per share, we can see the cooling the last 2 quarters well below the long term trend line.

This decline was delivered with not only slower sales, but by a big fall in margins and average sale price dip.

The decline in margins was driven by a big jump in deliveries to wholesale investors in Q4 2022. The Q4 earnings call explained:

We closed 431 homes through our wholesale business in the fourth quarter, representing 29.8% of our total closings, compared to 369 homes or 14.6% of our total closings in the fourth quarter last year.

Encouragingly, LGI Homes management expects wholesale sales to return to modest levels in 2023.

We currently expect our wholesale business will represent between 5% and 10% of our total closings in 2023.

Which brings us to the outlook for 2023.

LGIH 2023 Outlook - Building Optimism

LGIH management forecast for 2023 on Feb 21 was as follows with our comments following in italics.

• Total Closings = 6,000-7,000 - vs 6,600 in 2022 .
• Active Communities = 115-125 - good growth over 99 in Q4.
• Average Sale Price = $335-350,000 - conservative, little growth.
• Adjusted Gross Margin = 22.5-24.5% - below average .

The key for us is community count. That's what LGIH can actually control. A homebuilder can't control mortgage rates nor sales volumes. They can only ensure they have stock ready to sell.

Here is what the active community forecast looks like for LGIH.

That's impressive growth!

At this point, you should have noticed that LGIH forecasts don't add up.

The forecast closings of 6-7000 represent zero growth over 2022 of 6,600 yet the community count will be 15-25% higher. That only works if sales per community per month slow dramatically from already low levels in 2022.

That doesn't add up. It doesn't match rates for Jan-March 2023 either.

The truth is LGIH is probably managing expectations with closings in our view. Active communities however are a better gauge of their plans.

Now it is up to the analyst. Our thoughts (in the first section) show inflation will keep easing to the 2% goal in Q3 and thus mortgage rates have probably peaked.

Given inflation trends we think mortgage rates could well ease to a mid 5% level in the second half of 2023. That's around Q2 2022 levels.

For us, that gives us a bullish mindset because LGIH is prepared for growth as the macro situation improves.

LGIH 2023 Forecast

To try for a conservative forecast, let's assume for LGIH in 2023:

• Active Communities Low End = 115 steadily grow over the course of 2023.
• Average rates of closings per community per month for 2017-2020.

The first attempt at a forecast gave us 8,381 closings in 2023. But that was with consistent community growth. It still seemed high.

So a second attempt, with community jumping to 115 at the end gave us 8,091.

That's still 15.6% above LGIH's 7,000 closing high end range forecast. Had we assumed growth to 125 and more steady community growth the number reaches 8667 closings. That's 23.8% above our 7,000 closings forecast.

Yes, LGIH can deliver this growth. Despite a fall in controlled lots, LGIH still has the assets to easily match either forecast in active communities.

We believe that cooler inflation and mortgage rates will deliver their part too.

So it's time to use a forecast of 8,000 closings to produce a valuation.

1. With 8,000 closings at an average of price of $340,0000 would deliver about $2.72 b in revenue.
2. In pre-COVID times net income was usually 13-14% of revenue.
3. That gives a 2023 net income forecast range of $350 - $415m.
4. With a current market capitalization of $2.57b that's a forward earnings multiple of 6-7.5 for 2023.

That's a good entry price for a company with a long term growth record.

Thus, we lift our buy price from $93 per share from last review to $110.

Conclusion

We follow LGI Homes because it is a high beta homebuilder with some of the best margins in the business.

High beta means when homebuilders do well, LGIH does extra well. A strong year can see the stock rise 50-100%. Of course, the mirror image is that LGIH can also halve when the market weakens like it did from 2021 to 2022. The last 12 months as mortgage rates doubled was one such occasion.

Those plunges and growth cycles create opportunities for investors.

The inverse relationship with mortgage rates is clear.

The worst for mortgage rates and the housing market looks past. There is an opportunity to build a holding before mortgage rates fall to 5.5% or below.

We are building a position in LGIH. A price target north of $150 over the next 12 months seems quite achievable.

For further details see:

LGI Homes: Cooling Inflation Is Building Optimism