May 12, 2017

LGI Homes – This homebuilding stock has a strong foundation for equity upside


  • Markets expect LGIH to see UAFRS-Adjusted ROA fade from current stable 11% levels to below corporate-average levels of 4% over the next 5 years
  • Management is confident about demand, strong economic momentum, and their improving credit health, which should help them maintain current profitability levels
  • The firm currently trades at a 1.2x Adjusted P/B metric, which is slightly discounted compared to its peer group, and with material expectations for growth, this discount is not warranted
  • If the firm is able to maintain profitability at current levels, while sustaining growth in-line with analyst projections, 100%+ upside would be warranted

 

Embedded Expectations Analysis

As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.

LGIH is currently trading at an 11.5x UAFRS-based P/E (Fwd V/E’), which is near historical averages. However, even at these levels, the market is pricing in expectations for UAFRS-based ROA to compress dramatically, from 11% in 2016 to 4% in 2021, accompanied by 18% UAFRS-based Asset growth. These bearish expectations, combined with short interest at +30% of outstanding shares, imply the market continues to doubt LGIH’s ability to sustain profitability.  However, several indicators, including recent profitability trends, valuation relative to peers, and management sentiment signal that these expectations are likely too negative.

Performance and Valuation Prime™ Chart

LGI Homes, Inc. (LGIH) is a Texas-based homebuilder and land developer. The company is engaged in the design, construction, marketing, and sale of new homes through their five segments: Texas, Southwest, Southeast, Florida, and Northwest. LGIH’s products include entry-level and move-up homes, as well as luxury homes under the Terrata Homes brand. Although the firm has historically maintained a high concentration of their portfolio in Texas, they have taken significant steps to diversify their geographic reach as economic conditions in Texas have become increasingly stretched. Since their IPO in 2013, they have decreased their concentration in Texas consistently, and in 2016, closings in Texas fell to just 51% of the firm’s total closings.

Additionally, LGIH has historically seen strong profitability, with Adjusted ROA consistently above cost-of-capital levels. In 2011-2012, Adjusted ROA was in the 25% range, before compressing to 8%-11% levels since, as the firm has aggressively grown its Adjusted Asset base over the past five years. Specifically, Adjusted Asset growth has been consistently strong, ranging from 36%-316% over the past five years.

Given LGIH’s stable, above cost-of-capital profitability over the past several years, paired with their recent efforts to diversify their exposure away from a potentially troubled Texas housing market, the market’s current expectations for profitability to fade below cost-of-capital levels over the next five years are likely too bearish.

For context, the PVP chart above reflects the real, economic performance and valuation measures of LGI Homes, Inc. (LGIH) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.

Peer Analysis – Valuations Relative to Profitability

A major benefit of adjusting as-reported financial statements is to clear away accounting distortions to allow for more accurate peer-to-peer comparisons. To this end, we have included a scatter chart below that plots LGIH against its peers based on their Adjusted Price-to-Assets ratio (V/A’) and Adjusted ROA (ROA’).

Looking across industries, markets, and time, there has been a very strong relationship between a company’s ROA’ relative to the corporate average (6%) ROA’, and the multiple the market will pay above the value of the company’s Asset’ base, in terms of a UAFRS-based P/B (V/A’) multiple. A company that generates a 6% ROA’ will tend to trade at a 1.0x Adjusted P/B, and a company that generates an 18% ROA’ will trade at a 3.0x Adjusted P/B, etc.

Relative to its peers, LGIH is likely undervalued, with its 1.2x UAFRS-based P/B  (V/A’)and 10% Adjusted ROA (ROA’), placing it at slight discount to its competitors.  This is without even considering the firm’s robust growth potential based on their historical growth trajectory. In order to justify current valuations, LGIH would need to see their potential growth opportunities completely dry up, while their profitability would have to fade to near cost-of-capital levels.

Analyst and Management Expectations

Analysts have far less bearish expectations than the market, projecting Adjusted ROA to remain at current 10%-11% levels through 2018, accompanied by 18% Adjusted Asset growth. Analysts appear to believe the firm will have success in geographically diversifying their exposure away from Texas, while sustaining strong pricing and closings growth.

In addition, Valens’ qualitative analysis of the firm’s Q4 2016 earnings call highlights that management is confident about their ability to have 75-80 active selling communities by the end of 2017, and about the strong leads and office traffic they are seeing. Additionally, they are confident that the increase in interest rates is being offset by strong economic conditions, and that they increased their total credit facility to $400m.

Given management’s confidence about demand, strong economic momentum, and their improving credit health, LGIH appears poised to maintain current levels of profitability, and should they do so, equity upside would be warranted.

Performance Drivers – Sales, Margins and Turns

It can be helpful to break down Adjusted ROA into its DuPont formula parts, UAFRS Earnings Margin and UAFRS Asset Turnover, which are cleaned up margins and turns metrics used to calculate Adjusted ROA. The chart below details both Adjusted Earnings Margin and Adjusted Asset Turns historically, to help us better understand the drivers of the firm’s profitability and performance.

Recent stability in Adjusted ROA has been driven by consistent UAFRS-based Earnings Margins and stabilization in UAFRS-based Asset Turns following declines in 2011 and 2012. Adjusted Earnings Margins have help fairly constant since 2011, ranging from 8%-11%. Meanwhile, after compressing from 3.1x levels in 2011, as a result of their previously mentioned aggressive growth strategy, Adjusted Asset Turns have stabilized at 1.0x-1.2x levels in 2013-2016. At current prices, market expectations may be for a resumption in declines in Adjusted Asset Turns, which appears too bearish considering how the firm has stabilized asset efficiency lately, and the fact that the driver of declining Adjusted Turns is the firm’s aggressive growth rather than declines in the efficiency of existing assets.

Valuation Matrix – ROA’ and Asset’ Growth as Drivers of Valuation

When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for LGIH at various levels of profitability (in terms of Adjusted ROA) and growth (Adjusted Asset growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.

To justify current prices, LGIH would need to see Adjusted ROA fade to historically low cost-of-capital levels, accompanied by just 7% annual Adjusted Asset growth over the next five years. Given the fact that the firm has never grown its Adjusted Asset base by less than 36%, and management sentiment indicates that demand for new communities is still high, markets appear to be pricing in the worst-case scenario, limiting near-term equity downside.

Moreover, should the firm sustain profitability at current 8%-10% levels, while growing at rates in-line with analyst projections for growth, which is likely considering management communication and fundamental tailwinds, warranted upside would be material, and potentially north of 100% going forward.

 To find out more about LGI Homes Inc. (LGIH) and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Research Committee, which is responsible for this article. Professor Litman is regarded globally for his expertise in financial statement analysis, fundamental research, and particularly Uniform Accounting, UAFRS.