Chit Chat Stocks - LGI Homes (Ticker: LGIH) Not So Deep Dive

Episode Date: October 25, 2022

LGI Homes designs, constructs, and sells a variety of home types. The company sells entry-level homes, attached and detached homes, active adult homes, and luxury homes. At the end of the month, we will publish an Arch Capital episode that will cover the company: Consorcio ARA. Listen closely as Brett and Ryan go through the history, financials, and future prospects of LGI Homes. Enjoy the show! Need more information? Check-out our launch newsletter: https://chitchatmoney.substack.com/p/welcome-to-chit-chat-money-plus  Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (2:53) Industry | (10:26) Management & Ownership | (11:41) Earnings | (15:52) Balance Sheet | (20:07) Valuation | (23:36) Our Analysis | (25:17) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not So Deep Dive episode on Chit Chat Money. This show is only available to CCM Plus subscribers. So if you're listening to this, we appreciate you subscribing.

However, we have to say, or I guess announce that we're going to be ending the paywalled episodes in November. We appreciate everyone that signed up. But if you're listening to this, you're one of the few that signed up so the experiment did not go as we planned that's okay don't don't feel sorry for us or anything we appreciate you uh you know sure they don't yeah but we're gonna do the same exact things that we're doing uh except we're gonna make them free like they were in the past so we're gonna keep including the themes which i think people like and we're also going to include the newsletter as well they get sent out except it'll just be free for all the subscribers so the only reason we wanted to say this now is because the subscription

is going to end in November 1st is if you have some sort of payment that's going to renew between now and then, make sure you do not do that. And if you are worried about having the payment go through on November 1st

and giving us money when the subscription is going to end, don't worry because we will end it and we won't be having the system ask for any payments. But if there's any confusion, email us at chitchatmoneypodcast at gmail.com.

The spelling is in the show notes. Ryan, anything else I'm missing there on the update? content will be the exact same except we're just going to make it free and add supported now just not enough people wanting to do the paid yeah i think maybe just a a shout out or appreciation for everyone who signed up like brett said it did not work out and we didn't get quite as many subscribers as we thought we would but if you are listening we know that you really appreciate the stuff we do so yeah hopefully you keep listening it was we did learn that there's other ways to

provide value like that newsletter, a lot of people, a lot of our subscribers seem to get some enjoyment out of that. So we're going to continue to do that. We're going to continue to try to provide value beyond just the podcast, but we want this to be free. We want more people to hear us. So we're going to revert back to the old ways. And a little tease, we might be trying to do more video stuff because we know that charts can be interactive with the show on YouTube, Spotify as well. So look forward to that. We're always trying to work and improve the show, but let's get to the actual content of this episode. And that is LGI Homes. We're continuing the housing investigation, which I got to be honest, we got lucky on this time because the

housing market is in kind of one of the weirdest spots it's been since the GFC. So we're studying another company here. Going to be fun to talk about is LGI Homes. And Ryan, I'll let you introduce them and why they have a unique spin on the housing market and why they've done so well over the last decade. Yeah, it is kind of an interesting point in time. Not only is affordability at sort of the most difficult period in maybe American history. But the valuations or the trailing valuations on almost all the businesses we've looked at are cheaper than they've been in a decade. So it's an interesting point in time. And LGI is not an exception. So LGI Homes is a home builder that designs, constructs, and sells homes to first-time

buyers who are making the switch from renting to home ownership. It's actually a fairly unique model and they they've been able to generate i believe maybe the highest margins in the industry um they do yeah they do adjusted so even unadjusted unadjusted it's pretty high pretty high at least they're yeah yeah yeah so unlike two of the other home builders that we talked about nvr and gene finders homes who use that option-based purchasing models where they put up 10% of the estimated value and then pay for it after the sale has gone through. LGI doesn't function that way. They buy large plots of raw land outright, and then they convert them into residential

communities. So they really are the full system, the full process of buying the land, developing the land, getting the rights, turning it into houses, selling the houses. it's more holistic, but they keep that inventory or that land on the balance sheet. So they're going to have, it's not going to be quite as capital light as NVR. But the land acquisition strategy itself is kind of unique compared to other home builders. So they will buy cheap land that's like ways away from any major cities or typically outside of a major city where there's a large base of renters. And then they'll send out flyers with a photo of a new house on it

with the monthly rate that people will have to pay. And they'll say, tired of paying rent. And oftentimes, these communities that they're building qualify for what they call rural development assistance. So the buyers can get help with their down payments from the federal government because LGI is, it's incentivizing LGI to build homes out in these areas. So it's really, they look for areas with tons of renters, cheap land, they go out, build the communities themselves, often outside of the cities. And it's ended up being a pretty profitable model for them. Other things that are worth noting, these home prices are often, they're lower than what we've discussed before. So DreamFinders Homes, NVR, I believe they were in

the 440,000 average sale price. This is lower, typically high 200s to 350. I believe their average sales price in the last quarter was 357,000. So slightly on the lower bracket in terms of affordability. The other part is they're building much cheaper properties. So this means they're often looking for the cheapest land, which means they're mostly buying in markets where the land is not like a hot commodity. Their two most dominant markets are Central, which they classify as Central, but it's basically Texas and Oklahoma, and then the Southeast. So Georgia, Carolinas, Alabama, and Tennessee. And the homes are designed with a set number of floor plans, and they tend to have standardized finishes. And there's basically no customization in the

process. They're putting out a final product at a certain price. There's no haggling, no negotiating over the price, not a lot of customization, as I said. So it's really if you want the home, it's compatible with, or it's competitive, what you'd be paying for renting and you get to own the home. So for a lot of these people, a lot of the demand, they don't have to go out and really sell the product. These people want to buy it. So they're getting a lot of inbounds that way. While it's hard to pin down one thing in particular, LGI has spent, everything I've read basically brags or talks about how optimized LGI's processes are and really across the board. So from land acquisition to development to the actual sales process, it seems to be just an absolute machine.

And I think that's kind of what's led them beyond just the actual cheap land that they're buying themselves. That's what's led them to have that industry leading gross margin. So 32% gross margins last quarter, that's a little higher than they typically have. And then 17% net margins. If you look at a lot of home builders, that's going to be well above what a lot of them are earning. And as for history, LGI was founded in 2003 in Woodlands, Texas by Thomas Leipar. Leipar, he was working with a founder at the time.

They attracted some capital from private equity. Are you sure it's not Eric? That's the, or is that a brother of Eric? I thought it was Thomas Leipar. Yeah. Well, one of the founders is Eric, who's running it today, but maybe I got it wrong. Look it up. But here, anyway, LIPAR, let's start with that.

LIPAR attracted private equity capital. He began constructing their first community, which was Somerset Estates. Basically, they bought a large plot of land outside of Houston, developed it, had success with this model. Since then, it's basically been the exact same system over and over and over. They've constantly refined it. They've expanded into new cities, and that's really driven growth for LGI. I really can't do it justice on this podcast,

but we've linked to an article in our newsletter. So if you read that, it talks about the different opter, different operations and this quote unquote system that they've put in place. That's really streamlined the whole kind of playbook for them. Other things I'll note, LGI didn't go public until 2013. So we don't really have any data on how they fared during the financial

crisis. Unfortunately, I did say during the last conference call though, that, yeah, they were profitable through it so whatever that means um let's take their word for it so they said they've done well and they're kind of bragging about i mean they're here now so yeah and they actually i remember seeing that they were buying a good amount of homes or closing on a good amount

of homes in 2009 so they ended up faring pretty well and that was a point when not a lot of people were buying but um that's sort of the basics of the history and the business model do you want You want to talk about the industry? Yeah. And I'll just say that Thomas Lippard, it says he's the founder, but I couldn't find much about him at all in the SEC filings or the proxy statement. He's not associated with the company, I don't think at all anymore. But Eric Lippard, spelled L-I-P-P-A-R, was with the company since 2003 and is considered

a founder. And he is the chief executive officer today. So I guess the Lippard family maybe founded this. It's kind of hard to find. His name is Eric Thomas Lippard. Oh, is that really? that's what i'm seeing here okay that's thomas thomas e lipar so thomas eric lipar it's he's using his middle name all right well he's tricking us by using his middle name there i okay that's

where the confusion was they're the same person uh anyone listening just laugh at our confusion there all right industry competition keep this quick because it's the same as dfh and mbr and you're going to see me talk about the same stats here so the industry is approximately 129 billion dollars and that's the home building industry in the united states the same exact market opportunity as DFH or NVR. If we use that $129 billion number, that gives LGI approximately a 2% market share. Now, remember, like we've talked about before, and we'll talk about at the end, probably during the discussion portion of this episode, the industry can be affected by interest rates, demographics in the areas that they're building, and other cyclical variables in the economy.

The home building industry is highly cyclical, and we've seen that played on 2022 with mortgage rates soaring through the roof. Now, if we look at competitors, again, the competitors are anyone building homes. I mean, you have DR Horton, Lennar, NVR, DFH, many, many other home builders. I mean, the core business is commodity. I mean, anyone can go out there and buy land if they have the money. So the competitors are vast. And I don't think that is very important for a home builder like LGI. It's really their, say, process power, their culture, how efficient they are, their unique marketing strategy that they talk about a lot that seems to work really really well uh that ryan mentioned but let's move on to management ownership ceo

as we discussed and hopefully didn't confuse anyone is eric leipard founded lgi homes and has been running the business in some form since this day he is 51 years old which i think is i was like to mention the age because i think i and it depends but i really like seeing someone in their 40s or 50s um potentially 60s as well it kind of shows that they probably have you know at least a decade left um they're still in their prime years you know i don't like to see someone too young i also don't like to see someone too old hopefully it doesn't sound ageist oh that's not i mean i don't i look i'm an investor i want to make money uh he's also the chairman of the board though which is important so they have a combo of he's the ceo and the chairman so he has

a lot of control here however unlike at dfh lipar does not have a controlling stake in the business He owns just under 10% of the shares outstanding, but they don't have, it's all the same sort of voting stock. So he has a large stake, but it's not controlling like it was over at DFH, which is very important distinction. If we look at the rest of the executive team, they all have long tenures with the majority having stuck around at LGA home since 2013. So since they've gone public, a lot of this executive team is still there, which I think is a great sign. Now, if you look at total board compensation, it was only 0.1% of 2021 gross profit. No concern there. We look at total executive compensation. It was about 1.7%

of 2021 gross profit. So a pretty good number there. Nothing crazy like we've seen in the past at the 7% to 10% range that can really hurt someone's margin, especially for a lower margin business here. And now if we look at executive compensation, they have very standard stuff, base salary, annual incentive bonuses, and then long-term stock awards. I mean, does that just speak compensation consultant that we hear about on every episode who seems to just line up these three sort of plans for every single company out there. If we look at their annual bonuses though, which I think is important, 75% of them are based on pre-tax income and then 25% are on homes closed. And those are both like

goals they set at the beginning of the year. And as they hit goals on some sort of rate or a little bit lower, a little bit higher, they get a bonus. Now, some of the long-term stock awards are based on three-year cumulative earnings per share growth, which is pretty solid. One, no huge red flags there or anything. I mean, the management numbers section honestly found it pretty boring and straightforward, which if you're an investor, that's a good thing. Only two yellow flags it found was that the uncle of Lipar is on the board of directors. And it looks like another family member is on the executive team. Couldn't find the exact connection of the other one. I think His name's Jack Lippard.

And then the other one is since the annual bonuses are based on pre-tax income, I mean, that's not a bad one because it's not like adjusted EBITDA or anything, but it may incentivize them to not care about cashflow and returning cash to shareholders. It may lead them to a metric that's actually not as ideal as say cashflow. And yes, this is an industry with inventory buildup and it might not be the best one, but still. Yeah, there's no way. It's not.

there's no way they would attract any executives if they well uh put cash flow as and honestly they'd probably be worse off if that was the case they wouldn't have grown into the business that they are today if they optimize for cash flow maybe maybe i mean and i mean well i i can't remember exactly what mbr is but they seem to be able to generate cash maybe if they incentivize cash flow they'd have a more cash asset like asset like excuse me asset like model i don't have Yeah. Theoretically, they could have a windfall of cash flow. There's theoretical cash flow today based off the inventory that they've been able to buy and build. Yeah, I know. I just don't like that. This is just not anything against the executive team. It's just the business they're in. I just don't like that from a business perspective. I think it's always going to be valued on probably a pre-tax or an operating income basis.

Yeah, which, again, I guess it's not really a knock on management, but it's a knock on the business itself. If we look at their ownership structure, I mean, I already mentioned Liapar owns about 10%, really nothing else there. You got BlackRock and Vanguard, but nothing crazy on the management and ownership section. So let's hit earnings, Ryan. What do you got for us? Yeah, over the last 12 months, they've done about $2.8 billion in revenue and $541 million in EBIT. I would argue, I think management will say this too, that they're slightly over-earning right now. However, it's been negative cashflow. So we just mentioned that. And let me try to break it down

in maybe a more basic format for anyone that's not familiar with home builders, especially the ones that are not capital light builders. They are going to take pretty much any of the cash that they generate from their sales and likely reinvest it in land for new developments. And so you're really not going to see cash flow often get spit off of the business, like the Buffett's like, or how Buffett's always said he likes businesses that spit off cash. That's really not going to be the case here. A lot of that cash flow is going to show up in the buildup of inventory, like Brett kind of mentioned. And that's really been the case lately. Two years ago, they really started this inventory development plan, which may or may not be unfortunate timing.

I think we're going to talk about that. But cash flow looks even more hindered lately. And the supply chains make it way worse right now. Yeah. Yeah. So inventory has been, it's actually grown quicker than it has historically over the last two years. And I'll talk about that on balance sheet.

But most recent quarter, they had 2000, basically home closings. That's down 30% year over year. Well, 29%. And there's a couple of reasons for that. Yes, there was a bit of a demand drop. However, LGI was having, as Brett mentioned, some of those supply chain problems, and those supply chain problems were causing delays on the home closes. So they would say, all right, we'll get you in by September 1st, and they wouldn't be

able to get them in until October 15th. That was starting to kind of tarnish the brand. It was hurting operations. A lot of people were getting frustrated. So they started saying, we're only going to start selling homes if they're less than 60 days away from closing. They didn't see the visibility beyond that to build a home. So that also hurt home sales.

However, on the last conference call, management said they're going to extend that out to 90 days because supply chains are starting to normalize. So theoretically, you should see home closings start to ramp up a little bit steadily back up again. The average sales price was $357,000. That was up 29% year over year. they do have a the premium one what's called tarada marada something like that so that could be impacting it but that's still i mean that's been a big reason their margins have expanded they actually they mentioned in the conference call that they're that last year was an anomaly they realized it which is kind of good to see but and that their gross margin i believe was 33

but now they're with the industry going back to say normalizing which we hope it's you know just normalizing and not going into a big downturn. They said they're pricing everything into kind of the 25% to 28% gross margin range. So a lot of that's going to become from this average selling price probably coming back down. Right. Yeah. I'd expect average selling price probably to revert a little bit. Unless Zillow and Redfin, their data's all off. I mean, we're seeing it real time right now. I guess I didn't even mention that either. I believe a single digit percentage of their homes are more luxury homes. So there's like this subsidiary called, I think, Tarada is what it's called.

Yeah, second impact in the short run or one quarter, something like that. So volume is high there. It can boost average selling price more so than is probably indicated by what LGI homes that segment actually sells them for. But total homes revenue for the quarter was down 9% year over year. The only real stat that kind of concerned me was the cancellation rate jumped from 24.4% last year to 30 and a half percent this year um and that's way worse than dfh or nvr yeah and they are catering to a i guess they're selling to a uh poor income group so that's just a number to

keep an eye on i don't think management said what they expect like what their range is what they like to have but um if that continues to shoot up then you've got a problem let's talk about the balance sheet and the liquidity. I hope that gives a decent grasp on the earnings, but we'll talk more about that in a little bit. As for liabilities, they have $1.2 billion in notes payable. It's comprised of two things. So there's $300 million senior notes that they issued that accrue interest at 4% and they're due in 2029. So that's a pretty small segment of it. And then the lion's share of it is this $1.1 billion credit agreement. Now, not all of it's being used currently they have some that's unused but that bears interest at bears interest monthly

at sofr plus 1.75 and i think that's like so far is the replacement for libor so yeah same thing the overnight rate in london yeah except yeah well we don't need to go into libor but it's getting replaced with sofr uh it doesn't matter to us it's just that moving rate the there's a couple of covenants, though, in that credit agreement. So I'll go through, I guess, some of the important ones. They can't exceed a leverage ratio of greater than 60%. And leverage ratio for them is just net debt divided by total equity. So right now, they stand at about 43%. It's actually down. Their leverage ratio is actually down from last year, despite taking on more debt. Um, so they're comfortably in the right spot. They're not really a concern. They also require

liquidity of at least $50 million and trailing 12 month EBITDA to expense ratio of 1.75 to one time. So basically the lenders on this credit agreement just want to make sure that they're not, you know, getting to the point where there may be insolvent. And I, it doesn't seem like that's a concern at all. So they've got a lot of money to reinvest. They do have to obviously pay that down. But if they're earning anywhere near what they've earned the last 12 months, that shouldn't be a problem at all. As for the assets, this is where I think it's important. Maybe this is the most important segment of the business. So $42 million in cash, not a lot of cash at all, but all of their value is pretty much in land. So $2.6 billion in what they call real estate

inventory. That's up 52% year over year. And they break it down into three segments, the inventory. 70% roughly is raw land, land under development or finished lots. 25% are homes that are in progress of being built. And then 7% or mid single digits are finished homes for sale. So most of that right now is raw land that hasn't been built on. And they started this a few years ago. They started buying up a ton of new large land developments, and they haven't had the opportunity to sell through and build on it yet, assuming that they can sustain some reasonable level of demand. Cashflow should accelerate this year if they don't invest it back into the land. I wouldn't be surprised, and management, I believe, has alluded to this, if inventory

came down a little bit. That'd be a good thing, for sure. as they sell to those homes yeah and typically historically they haven't converted from say income to cash flow it's been cash flow has been slightly lower but right now it's way way lower than it has been because that land build up yeah yeah exactly all right we'll talk about that more let's hit valuation metrics real quick market cap uh let me get the numbers up because they're gonna update it in real time market cap 1.75 billion dollars and if we add on about net debt of $1.1 billion, their enterprise value gets closer to about $2.9 billion. And now if we look at their trailing 12-month numbers, I'm going to do EV to gross profit, EV to operating income,

and EV to free cashflow. Now EV to gross profit, 3.6, EV to operating income, 5.4. So on both those metrics, very, very cheap. And like Ryan mentioned, the home builders look very cheap on a trailing basis, and that's because they're over-earning. I think we can say that almost for certain now, now that we're seeing home prices down a bit at a significant amount over the last few months. Now, the big question is how- Home closings down as well. Home closings. Now, the big question is how far will home prices drop, which we'll probably talk about in another section. But yeah, look at those numbers. You think, wow, it's very, very cheap, but a stock is valued based on what it's going to earn in the future. So I don't know, are they

trading at. 10 times forward, 8 times forward, 12 times forward, whatever. Now, if we look at EV to free cash flow, it's negative 7.5. Not really relevant there, but I wanted to include that to make sure to harp on that they're not generating cash right now. This might sound obvious, but if you're looking to invest in this stock, that's probably the number one thing is over the next couple of years, how much are they actually converting into cash or how much are they sticking into inventory um especially because on their credit agreement that interest rate is going to rise so funding the business is just going to get more expensive because generally interest rates are rising yeah and why don't we just i guess move to anecdotal evidence yeah we can

kind of have discussions around what the outlook looks like here in a second it feels well i guess in terms of anecdotal evidence for this business i have nothing I've never bought a home and potentially this would be the kind of home that I look at as a first time buyer. But it feels like there's still a home shortage. And the reason I say that is rental supply is still tight. So it's come up slightly, but I mean, it's still like slightly like it's still very, very high homes in this affordability bracket to me feels like they'll always be in demand. Yeah, more for sure than the higher ones because you'll see people move down to this bracket. Yeah, that's kind of-

Which makes sense, yeah. I guess that's my anecdote. And it maybe takes like a year or two for people to realize, oh, I can't afford the home I thought I wanted to when rates rise. But I think eventually, yeah, they'll get comfortable with it and trade down. Now, on the supply thing, I get a little bit nervous on saying there's a shortage because I feel like we could be about to be whiplashed by a bunch of works in progress that are going to be finished. Like, for example, I mean, this is pure anecdotes, so maybe this is proof for this section. Right on the walk to the office, there's this apartment, giant apartment building that was supposed to be finished in early 2022, but it's nowhere near finished. It's probably going to be mid-2023.

I always thought in my mind, well, when this thing gets finished, all the supply will be done, at least in our area. And that is probably indicative of a lot of spots out there where you're getting these delays right now, keeping rental prices high, keeping supply low on housing. And when that finishes, I get a little bit nervous in my stomach about how that could impact the homebuilders because maybe it won't be that bad, but we don't know how bad it could impact. We don't know the downside there. And that's just, it makes me nervous because it's just- There's always a shortage at the top, I guess. Exactly. It always looks like there is.

now let's move uh to mine i mean i had an honest consumer like ryan uh if we look at their top line growth though it's clear they've been using an efficient debt strategy to grow this business and it's been really smart now i think in the low lights we'll talk about maybe the downside of a rising rate environment for them but really they're you just look at their numbers and compared to a lot of other home builders a lot of other businesses this isn't an easy industry to operate in, and they've executed extremely well. Now, Ryan, let's move to future growth opportunities. I want to talk briefly about sort of that demand

in terms of what LGI is seeing. So on the last conference call, they said, we are confident in our sales team. We are confident in our ability to spend marketing. Over 20,000 people inquired about home ownership in July. We know and got all kinds of data behind it. I believe that number was up significantly. Well, July, I'm in July.

I know it's a bit, well, yeah, we're a quarter removed now. It's almost coming up on the third quarter, but they aren't in their markets. They're still seeing plenty of demand for home ownership. Yeah. Kind of my point around anecdotal evidence is it feels like this bracket is better positioned. Yeah. It's fine right now. I think maybe a bear would argue 2023, we don't know how bad it could get, but yeah,

they're probably better prepared than the higher income ones. All right. What's your future growth opportunity? I've got an activist investor future growth opportunity, apparently. I mean, the obvious one here is build more homes, sell more homes. It's not really like, you know. Well, add a good margin. Yeah.

Add a good margin. I mean, over time, the future growth opportunity is quite obvious. But my short-term growth opportunity is not pouring money back into land and instead returning capital to shareholders. They've been doing this a little bit. Well, they did at a very high price at the end of 2021, but sorry, continue. So they just took a big swing on land and they've got 70% basically of their inventory right now, undeveloped. They trade at historically low multiple. So for reference, over the last 10 years, their average EBIT has been 10.5 times. Right now, it's about 5.5 times. if they're able to get if they're able to sell through their homes at any sort of a pace they have been or even like 10 percent less than they used to they're going to get a windfall of cash

and you're trading at what is essentially uh let's go conservative 15 percent ebit yield or five times well look uh let me just put a number behind this 1.75 billion market cap, you could easily see a world where they get $500 million in cash due to just the inventory dynamics. You return that to shareholders through buybacks that can be highly, highly accretive. I think my guess is right now you're getting a better return on your repurchases than on new land. Yeah. And that leads into mine. I think I had a similar one coming at a different angle. I mean, counterintuitively, I think the future growth opportunity in the short run is to slow down on the top of funnel, slow down on the land acquisitions. Why? Because there's just

so much uncertainty around the mortgage rates right now. And if mortgage rates stay high for many years, you could see LGI homes and they sprayed on the conference call that they'd never written down inventory. But I will say that we've never seen mortgage rates rise at this rate. So this time they could be wrong. If mortgage rates rise and stay high, well, they have risk. If they stay high for many years or at, say, whatever number, 7% or higher for many years, then LGA homes could likely be overpaying for the land. However, like we mentioned, they have the current assets, $2.6 billion, like Brian mentioned. A lot of that is in the land plots.

So if they get more cautious for the next few years, I mean, they've talked about not doing that. So maybe they totally disagree with the sentiment here. I mean, it can mitigate any of the potential risk over the next couple of years that the housing market kind of goes into a downturn. And then you'd have the firepower to come out on the other side when things kind of normalize and you're not taking that much risk because there's kind of two scenarios. One, I mean, housing prices aren't going to continue rising.

There's like, I see, maybe there's more scenarios, but say the two basic scenarios are that housing prices kind of stay similar to where they are because of the supply shortage, or they go down by a lot because of the mortgage rate affordability crisis. You don't want the risk of the downside there. and two to three years from now we're going to know the outcome and yeah maybe you won't be able to grow as fast as you can but you'd be able to you're larger you have the firepower you would be able to go faster on the other side if a lot of other people have kind of run out of the market and some people maybe in their minds are saying well isn't it better to be aggressive during that

but if you think about the land that they're buying if you're buying yeah i don't know 50 acres in eastern colorado i don't think the pricing is going to change that much in a down environment they're still getting that land pretty cheap yeah yeah and so they can be fine in a more in in waiting yeah exactly and like uh i don't have the number from the conference call they had a lot of plots i'm sorry i don't have it in front of me but they have a lot of plots for many, many years. And what did you say? 67% of the inventory is land plus.

They'll take multiple years to flow through. It's not like if they pause, they would have no homes to be built. It's just that they would stop, say the top of the funnel in the lot acquisition. I just think there's a ton of uncertainty with that right now.

What if prices go, you know, re-rate way, way farther downward. I agree. High lights and low lights. And we should say that as people that have no expertise in the homes industry, but sometimes it can be helpful for someone from an outsider look

to kind of take away. I mean, we're looking at it very, very simply, but let's move to highlights and all that. Ryan, what'd you like and dislike about this business? Well, kind of my future growth opportunity that I talked about of starting to allocate more capital to repurchases, they've bought back 12% of their common stock since 2020.

It seems like the management knows kind of, they have a good sense of what they want to do with their capital. The other highlight for me is their margins versus periods that just kind of validates. I've heard so much about, okay, they have a really good operational model. They're totally optimized, great culture, all this stuff.

I think the proof's kind of in the pudding there with the superior margins. And then the last one, we already kind of talked about this, but I think they're better positioned if there's this sort of, in quotes, affordability crisis because they sell starter homes. I would think people would trade down.

They want to be quite as affected on their home closings as say, someone in a bit of a higher bracket i say that but cancellations have also jumped uh pretty pretty quickly here over the last year so i guess that's one of my low lights the other one is with home builders the cash flow just always ends up back in physical assets uh well unless you're nvr and look at their shares outstanding that's i think that shows that advantage right there yeah i think god there was like a quote it's probably the one where he goes the this manufacturing this landfill or whatever he was talking about uh his friend was like pointing to

all the equipment in the yard he's like that's where all my cash flow is or whatever yeah so you can't like what what are the shareholders what are the owners of this business going to do with land plots not much yeah i mean obviously if the you know if they if they're generating good returns on those land plots eventually it'll be reflected in the valuation but you're you're not getting that cash flow that's yeah that's kind of what i like with a home builder or something in a similar amount i want a really big discount to book value yeah to be honest and then i mean honestly the inventory is a bit of a low light like they took this giant bet on land at what seems to be a bit of an unfortunate time so i don't think as i said

I don't think they'll be as affected given who they sell to, but if they are, they've taken this big bet and they're going to have to hold that on their balance sheet for a while. Yep. And that leads right into my highlights. I think the track record of growth is sound, sound strategy in a commodity industry and playing onto that affordability thing, I think what also benefits them is they go for cheaper areas around the bigger cities, maybe an hour drive away, something like that.

with the rise of remote work that are kind of flattening cities out, as we've seen the data around that, that could be a specific tailwind for LGI. They're not in, just using our home market as an example, downtown Seattle, but they might be an hour outside and actually look, they were like an hour outside. That is, I can guess on all their markets, there's going to be more demand for those homes with the rise of remote work. So I think that helps them as well. And then more importantly, outside of this weird short-term tailwind, I think management's long tenures, the CEO has been there forever and he's the founder, and then the rest of the executive team, I think only one of them was new, but the majority had been there since 2013.

It makes me think they have a strong culture. It makes me think that they know what they're doing in a commodity industry to separate themselves from anyone else. Very similar. And yes, they don't have the same strategy as NVR from the asset light model, but I kind of would give them maybe the second, the silver medal here in that regard. And what's nice is that people have stuck around and they're not paying them an egregious amount of money versus the amount of gross profit this business is generating. Low lights though, growth has been fueled by debt. I mean, this is a wonderful strategy when interest rates are low, but And to do a little addition here, if you're based on SOFR plus 1.75% when interest rates rise, the debt is more expensive, and that's not great.

So I wonder what their margins are going to be like from 2009 to 2021. They could have been an entirely different environment than what it'll be from 2022 to 2026, I guess, is maybe just to put a random number on there. let's see anything uh i have the cash flow one as well and the cyclicality of the industry we've talked about that don't need to harp on that anymore but let's move to bull case ryan what at these prices i mean let's just reference here 5.5 times operating income 3.6 times gross profit and what do you think needs to happen to this business for for shareholders to do well Well, I guess not that much. I put here kind of just to draw it out. Let's say three years from now, they've developed most of that raw land that they had on their balance sheet, and they sold

11,000 homes a year on average. Keep in mind for right now, they're selling, I believe they're projecting 7,000 to 8,000, but they sold more than 10,000 in 2021, and they're selling 7,000 to 8,000 while they have a lot of undeveloped land. So I think there's a possibility that if they get enough homes finished, they can sell 11,000 a year. If they have, and I put here the same average selling price, it's probably going to come down. You can kind of tweak the numbers how you want, but if they are basically getting to three and a half or more billion in revenue and they have 13% operating income or operating margins, they're getting pretty much the operating income that they had last year, which was slightly elevated over the next three

years. If that's the case, you're going to make money. Plus, they're hopefully buying back stock at these prices. EV to operating income, as we said, five and a half times roughly. Historically, it's always traded well above that. I think if you get a sense, if over the next three years, they show that they can sustain home closings like high level of home closings while the rest of the market is hurting a little more there's going to be probably a valuation re-rating here yeah yeah and the big concern i guess is the margin there and one thing that maybe helped me understand that their margins won't get impacted as bad as we think if selling prices come down because remember we talked about the big the big number they talked about 33 margins that are going

to come down to the 25% to 28% range. They said that the material costs have actually been a headwind that you really haven't seen in the numbers because the average selling prices have gone up so much. So that's coming down and that can be a benefit that can maybe counteract some of the falling prices. So I think if there's anyone that's super bearish on what the margins can be, and maybe if you listen to the other episodes, I've sounded pretty bearish on what their margins could be on some of these home builders, that could be a benefit. But again, And that is, there is some uncertainty there. I think, yeah, I think 13% isn't too crazy.

I think they had, what, 18% last year. So that's a huge number of versions. Yeah. And that's kind of what, you know, 33% down to the 25% to 28% range. Maybe it falls a little bit more, but still, you know, at this valuation, there would be a margin of safety unless they're just not selling that many homes. I mean, mine, it's similar. I mean, you know, the current operating income multiples 5.5 times and a large portion of

the enterprise value is in real estate and inventory. You don't need much from LGA Homes in order for this to be a good investment. I think if I was going to invest in this company, I would need to answer two questions. I'm pretty confident in management's competency. So I don't think that's a big question here, which is great.

That's a huge hurdle that you have to get over. But the two questions are, how far our margins goes down as interest rates rise? Well, we'll know in the next two years. And two, can the business start generating consistent cashflow? I know they're not, they're always gonna have the working capital stuff,

But eventually, we got to get some cash out of this thing. We'll go to the last. From 2017 to 2021, average conversion of operating income to free cash flow was negative 12%. I mean, that's not good. I mean, yeah, a lot of the value is still in the real estate inventory, but the business is not unprofitable. However, it's a big, big low light if you can't convert into cash flow, like that Munger quote we just mentioned. Now, let's move to the bear case. And probably don't need to talk to cashflow stuff, but Ryan,

what did you have for the bear case? I mean, demand declines, the cancellation rate jumped. I think that's probably pretty indicative of demand falling a little bit. Now maybe demand starts to increase as people trade down. Like I there's kind of this term in from real estate investors called a cap gap where when rates shoot up really quickly, people's expectations take time to switch or they take time to adjust. And so I've met a lot of people that thought they could afford homes at higher price last year that are potentially going to have to trade down are kind of anchoring

to that last year's price. They're going to have a hard time trading down, but eventually they will. So I think, and this is kind of speculative, but I imagine demand will stay generally where it's been i think they're going to be okay compared to a lot of other home builders so but i mean that's pretty much what the whole bull case and bear case hinges on if they can't sell through the homes that they develop well at a reasonable price at a more at a good margin at a real margin yes thank you um then this yeah this is gonna this is gonna suck because they got to pay down that debt too and they're just going to be holding a lot of the homes on their balance sheet or at service the debt and it's going to be more expensive to service the debt. So it's a double

whammy. Yeah. I mean, that's my bear case as well. The housing market in the United States could go into a major downturn and you have the double whammy of debt costs rising and home prices falling for this business that the company would continue to struggle to generate positive cash flow. It doesn't look like they're in a position where there would be any bankruptcy risk unless things get really, really bad, which who knows, maybe, but that seems like a low probability. I could also see this business if say, I don't know, interest rates are high for a long time and there's kind of just these, you know, commodity things that keep popping up, the energy stuff, transportation that has been high and maybe that continues.

And we are in a new kind of era over the next five to seven years or even longer. I could see them generating a lot of profits like they have in the past and never generating the cash flow to be returned to shareholders, which it just puts them in a tougher spot. And that's just my bear case, even though the earnings multiple looks really, really cheap here. Now, more or less interested, Ryan? I'm kind of on the fence. It just feels like you have to, it feels like you're making a bet on home buyer demand for LGI. And are you just making a bet on what the Fed does when it comes down to it? Yeah, potentially.

And it's just like the multiple keeps me like pretty attracted to it. Management's seeming competency keeps me attracted to it. Big highlight. But I just, I don't feel comfortable making that bet. And it makes, I feel like there's lower hurdles in the investing world right now where I don't have to like basically take this big bet on whether home buyer demand is okay. Yeah, I'm going to say I'm in the same sort of boat, but I'm more interested because I think management is good, like similar to NVR where I have a lot of confidence in them. And at a large enough discount, I would be interested in this. um i don't know what price to book or what whatever multiple it would be but and people

might argue at five times five 5.5 times earnings or operating income that is today but i just don't see it that way um i think there's better businesses to buy uh you know maybe a little bit more expensive but that that generated start generating that do generate consistent cash flow However, I think at a cheap enough price, I guess you could say that about any company, but this has got the quality management team that kind of keeps me interested. And their track record is really strong. That's the thing. Their track record of growth is very, very good. So since you're basically taking a bet on home buyer demand, there really has to be a heads-I-win-tails-I-don't-lose scenario where you feel like you're basically at the floor valuation-wise.

Yeah, or you're at the floor, like the housing downturn gets pretty bad. You can still make money. And I'm looking at Koi from here. The price to book might not be what they're referencing, but it says price to book 1.2. maybe i would want a scenario where you could still make money where that book value is actually overstated right now and they have to write stuff down because there is that risk for sure if mortgage rates stay at seven percent or higher for multiple multiple years but we've been talking about the same thing for a long time here so let's finish things out uh stock for next week well we're

actually doing the arch capital episode uh so we're going to do the final one uh on consortio which is a small cap Mexican home builder that kind of was the inspiration for studying the housing market because we have that in the fund and we wanted to look at other businesses and compare them. We're going to talk about why we own them and actually why it's the lowest on our list. It's the first one that we'd kick out, but we don't need to tease the episode too much. But then next week in November, we're going to kick out our engineering software week or excuse me, month with the so system. So a little sexier of an industry. Yeah, maybe. I know. Well, the returns of the industry have been phenomenal for some of the stocks. So what we're going to do

is Disso Systems, Autodesk, PPC, Bentley Systems. Really, really fun stuff there. All right. That's going to do us. Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next time. you