LGI Homes: Hold Given Inflation, Interest Rate Pressures (LGIH)

Three multi-ethnic construction workers chatting

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Peak inflation is in, but low inflation isn’t assured

LGI Homes (NASDAQ:LGIH) is a leading homebuilder with a strong history of growth and higher than average margins, despite having the lowest average sale price amongst the top 10 builders.

We have regularly reviewed LGIH favorably over the last few years.

Like many builders, LGIH’s recent sales have cooled. This looks a combination of higher mortgage rates and supply chain issues. Construction and availability of houses to sell will normalize over the next 6 months.

The big unknown is rates, so we will look at the bull and bear cases for interest rates.

Currently, we lean more to the bear case of “higher for longer” inflation and interest rates due to rent costs, labor shortages and ongoing energy crunch. This demands that investors in LGIH and other homebuilders understand that another dip is probable and patience is required.

LGIH sales are cooling, probably from mortgage rates

No matter how you cut it, sales are cooling.

Monthly Closing LGIH

Monthly Closing LGIH (Caterer Goodman)

Monthly sales are very seasonal with a big spike each year in December.

July *should* be about average, but July 2022 was weakest result since 2016.

Below is the rate of closings per community per month. Seasonality means that things are pretty stable for a month in different years. Of course, we see a jump in the boom of 2021 but 2022 is noticeably lower than the 6.5 average.

Closing Rate - July

Closing Rate – July (Caterer Goodman)

It wasn’t just July.

So far this year every month has seen 30-50% year on year cooling.

LGIH Monthly Closing Change

Closings Change Year on Year LGIH (Caterer Goodman)

It’s worth noting that above represents is an overall number and doesn’t allow for a lower number of communities. It partly represents lower inventory.

This was a result of both higher construction costs and material delays. To manage this, LGIH reduced the sale of properties to only within 60 days of completion. As CEO Eric Lipar explained in the Q2 earnings call,

Our orders are up four consecutive months, because we are bringing more houses on that are within that 60-day period and gave us more inventory to sell in four consecutive months and we are confident, August will be an increase over July and that will make five consecutive months of order increase.

…we decided to with construction and pipeline and supply chain easing starting this weekend, we are going to start selling houses within 90 days of closing (instead of 60 days).

So it is possible that July is a one-off aberration where a narrow 60-day window combined with fewer properties at that level of completion.

Still, affordability and mortgage rates are a big driver.

Affordability of housing is suffering even before we consider the inflationary impact on homebuyers of higher gas and consumer prices.

Housing Affordability

Housing Affordability (NAR, UBS)

Wage growth that is negative 4-5% in real terms (aka adjusted for inflation) makes things even worse.

The biggest component of affordability is mortgage rates. The first rule before you decide on an entry point into in a homebuilder, is that you should understand what your outlook is for interest rates.

Make it explicit. The market sure pays attention.

LGIH has recovered on expectations of a Fed pause

The market’s expectations for future rates has pivoted in July.

The 2022 downtrend for LGIH was much like the wider market except more so. It broke in early July as many felt the Federal Reserve’s comments as implying a rate pause wasn’t far away.

The inverse correlation below is pretty clear.

Chart
30 Year Mortgage Rate data by YCharts

Almost immediately as the 30 year mortgage rates (the blue line above) starts to head down the recovery in the LGIH price begins.

Before we get into future interest rate expectations (further below), let’s have a look at the current valuation based on current mortgage rates.

LGIH’s valuation is fair (if the slowdown is shallow)

The last few years have been odd, to say the least.

We think it is fair to assume 2019 earnings for 2022 and in fact, that’s what LGIH’s CEO/Chairman Eric Lipar estimated during the Q2 2022 earnings call.

..we expect to report that we close 470 homes in July. We now expect to close between 7,500 and 8,300 homes for the full year.

While lower than our original guidance, this new range assumes the closing pace of 7.5 to eight closings per community per month for the rest of the year, which is in line with our strong performance during the back half of 2019 and we had a similar number of communities.

Eric was very close – it was 469 in July. The rest of the forecast is fairly optimistic and assumes that demand stays firm.

Using 2019 as a base for 2022, financials look like:

LGIH Revenue and Net Income

LGIH Revenue and Net Income (Caterer Goodman)

Besides softer selling conditions than 2021, LGIH is affected by a lower number of communities, again like 2019.

Active Communities

Active Communities (Caterer Goodman)

These will slowly rebuild towards 100 this year and growth further in future years. But they only support 2019 as a model year.

Thus, assuming net income of $180 M on a current market capitalization of $2.6 B gives a 2022 forecast PE of 14. Although this multiple appears reasonable homebuilders often trade at multiples in the 8-11 range.

LGIH is strong in energy rich states like Texas

LGIH’s HQ is Woodlands to the north of Houston, Texas. Despite growing into a top 10 homebuilder nationwide, it remains overweight in Texas.

The Central Region below is almost all Texas with Oklahoma.

LGIH 2021 Rev and NI by Region

LGIH 2021 Rev and Net Income by Region (Caterer Goodman)

This regional unit is 41% of revenue and 43% of net income.

High energy and food prices benefit Texas and help insulate LGIH’s financial performance and profitability.

Still, other regions combined matter more, and their mortgage rates matter. So will the Fed get on top of inflation quickly?

The Bull Case: Inflation eases quickly

Mr Market is currently buying a belief that inflation has peaked and will return, relatively painlessly to the Fed’s 2% goal.

Here is why inflation might ease quickly:

  • One time spikes in car prices are now easing.
  • Supply chain interruptions seem to be fading quickly, for now.
  • Vehicle gas prices are falling below $4 a gallon falling.
  • Flight costs and apparel are also falling.
  • Over-ordering retailers have met softening demand, leading to the “bull-whip effect” and falling prices for many items.
  • The comparison effect, particularly for gas prices gets easier in early 2023.

Used Car Prices

Used Car Prices (Manheim)

Still, the official CPI of 8.5% just reported includes shelter cost inflation of 5.7%, yet that estimate seems far lower than reported rent increases of 14%.

In other words, those who are renting are likely to feel worse than inflation at 8.5% and are likely to be keen to negotiate pay rises.

The Bear Case: higher rates for longer

Can the US Fed achieve victory over inflation without unemployment rising?

History suggests that this doesn’t seem possible.

It is entirely possibly for inflation to fall and then get stuck in the 5-7% range for the next couple of years unless rates are further hiked. Will the US Fed consider that mission accomplished if inflation is 5%? That seems unlikely.

Vast number of job openings leave workers in a powerful position to negotiate “catch up” pay rises.

Job Openings

Job Openings (Washington Post)

Many people forget that because labor doesn’t show up in this graph, it doesn’t matter to inflation measures. It most certainly does.

Components of Inflation

Components of Inflation (BLS)

Rising labor costs put pressure inflationary pressure in every business.

And note housing is 42% of CPI. Rent increases matter both to statistics and even more to workers who will be forced to look for higher pay.

Rents are hot and are the biggest component of CPI

Are shortages of rental properties, reported everywhere, a sign of fundamental shortage of housing? Or are they sign of speculative excess, where families own and occupy two properties, that higher interest rates will cool?

Rents Surge

Rents Surge (Bloomberg)

To misquote the immortal Homer Simpson: “A big chunk of column A with a little of column b”.

Column A is supported by record low rental vacancies. There does seem to be a shortage of properties, perhaps from a decade of under-building.

Us Rental Vacancy Rate

US Rental Vacancy Rate (St Louis Fed)

It’s about 40 years since rental vacancy rate was this low. Interestingly about the period Volcker got serious about defeating inflation. More on that below.

But as we’ve mentioned before, we think a noticeable portion of the population now occupy two properties. One where they want to live for lifestyle. Another close to the office.

Will interest rates unwind that? Probably not for those who already made the jump, but it might slowdown those who seek to join this group. So it will help.

But a red-hot 14% rental increase is likely to continue as occupancy rates remain close to historic lows and more leases come up for renewal, allowing landlords to play catch up. It’s an inflationary cycle that doesn’t look broken.

High rents aren’t all bad news for homebuilders of course. They make buying a home, seem relatively attractive. But they will keep inflation higher for longer.

Cost pressures are making workers unhappy and keen for pay rises

Rent and cost of living pressure is making workers unhappy and motivated to either quit, negotiate or go on strike.

Labor unrest is rising overseas. For example, in the UK, strikes are suddenly back for trains, postal workers and bus drivers amongst other. In the US the result is “the great resignation” where more than 40% are planning to quit their job. Google ‘staff shortages’ and you’ll get plenty of stories today.

Real Wages are Falling

Real Wages are Falling (Bloomberg)

What other decade had lots of labor unrest? Yup, the 1970’s.

Let’s explore what happened then for lessons we can learn today.

How did Volcker beat inflation? With a nasty recession

The inflation of 1970’s commenced with an energy supply shock, which sounds familiar. This time it is Russia and not an Arab-Israeli conflict.

Then inflation stuck about for almost a decade (or longer if you consider 4-5% inflation excessive) due to a wage-price spiral until lasted well into 1980’s.

Many investors today forget why it took so long to break the spiral.

Here is how economic historians describe the failure to slow inflation.

Inflation continued to remain in the double digits through April 1975. The Fed increased the benchmark rate to 16% in March 1975, worsening the 1973 to 1975 recession. It then reversed course, dramatically lowering the rate to 5.25% by April 1975.

These sudden changes were part of a “stop-go” monetary policy. They weren’t sustained enough to either end inflation or spur growth.

The emphasis above is ours.

Eventually President Carter brought in Paul Volcker in August 1979.

Federal Reserve chair Paul Volcker ended the Fed’s stop-go policy in 1979. He instead raised rates and kept them there to finally end inflation. That created the 1980 recession, but it thoroughly ended double-digit inflation, which hasn’t been a threat since.

Early 80's Recession

Early 80’s recession (Reed College)

That’s a nasty double dip recession in 1980 and 1982.

As The Economist explained earlier this year.

The wage-price spirals of the 1970s were contained only after tight monetary policy induced a global downturn in which American unemployment peaked at nearly 11%.

Will unemployment need to hit 11% this time to cool inflation? Probably not. But they will likely need to be higher than today. That spells recession. Rates will also likely need to reach at least 4% or more and stay there for a while.

Jerome Powell might not publicly cite the experience of Fed Chair Arthur F. Burns in the 70’s, but you can be sure he is aware of the history.

Now let’s jump back in our time machine and return to the present. Decoupling from China and reshoring is only going to add wage pressure.

Reshoring will create yet more labor market pressure

It started with COVID in 2020 and COVID lockdowns earlier this year, but we’d argue political tensions will keep driving pressure for reshoring.

Recent earnings calls in Q2 show a huge spike in mentions, see below. In fact, it is at least 50% higher than height of the COVID panic in Q2 2020.

US Companies Reshoring

US Companies Reshoring (Bloomberg)

Recent Taiwan tensions will only add pressure to boards and management.

Where will workers come from for all these planned re-shored operations? Not from other countries. Immigration is the lowest in decades and visa backlogs run to more than a year.

If companies and government are going to invest billions in chips and other industries, there just isn’t enough workers.

Want some more reasons inflation pressure will remain? Here’s a couple:

  • US population growth has never been so low, while the population ages.
  • Oil prices might bounce back because drawing on the strategic reserve has left it the lowest in decades. A pause might arrive the end of September.
  • Plus, Russia’s huge trade surplus means it can afford to cut oil exports to gain political leverage and OPEC+ probably doesn’t have extra capacity.
  • Food price inflation continues to be higher than expected due to changing climate conditions like heatwaves in Europe and drought in the US west.

Conclusion: Hold but higher rates will create opportunities

We continue to hold LGIH but we aren’t adding to our position at current levels. We think LGI Homes is a better bet at a buy price of $93 per share.

On the plus:

  • LGIH remains a well run builder with a track record of growth and good margins and solid finances.
  • Almost half of LGIH’s operations and sales are still in Texas, which benefits economically from high energy prices and interstate migration.
  • Supply chain disruptions delaying construction also seem to be slowly easing allowing capacity to build faster and cheaper.

However:

  • There remains a significant risk that when the market realizes that inflation is stickier than expected. When long term rates respond, pushing up mortgage rates, then homebuilders like LGIH will fall correspondingly. Better entry points will occur if this happens.

Perhaps markets are right and inflation has been vanquished. But we feel that is jumping too far ahead to interest rate cuts. Peak inflation might be in, but it is hardly close to 2%. Tight labor, continued spiking rents and risks of another oil price spike might keep inflation higher for longer.

Arguably LGIH is worth a PE of 14 given it’s long term growth track record. However, it is equally true it has regularly traded at cheaper multiples in the PE of 8-11 range and investors will be better rewarded for their patience.

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