Management for LGI Homes (LGIH) set aside an hour for its Q1 2018 earnings conference call. They only needed 37 minutes, including 23 minutes spent on Q&A. Perhaps they should have used the entire hour.
As the chart above shows, LGIH has had a wild two days following its earnings report. The first day alone shocked me given the wide range falling from a new intraday all-time high. The second day of violent selling made me buy some shares even as investors and traders in home builders went into automatic sell mode as the 10-year U.S. Treasury bond crossed over 3% again. LGIH is right back to support at its 200-day moving average (DMA). This trend line has held for a year and a doubling in the stock price.
Critically, given LGIH remains one of the hottest builders in the sector, I think of this stock move as a major test of the durability of builders going forward. If LGIH cannot hold support here, and even worse makes a new low for the year, then I will have to conclude that the market has truly nailed the top in builders as a whole. I have gone back and forth on this issue in the past several Housing Market Reviews. Right now, I am back to hoping that I do not have to wait until the seasonally strong period starts up in November to see builders regain at least some of the momentum they lost after the January peak.
I decided to check out the conference call to look for clues that upset the market so much. LGIH reported its typical exceptional revenue and earnings growth. The company also reaffirmed guidance – from the press release:
“…the Company reaffirms the following guidance for 2018. The Company believes it will have between 85 and 90 active selling communities at the end of 2018, close between 6,000 and 7,000 homes in 2018, and generate basic EPS between $6.00 and $7.00 per share during 2018. In addition, the Company believes 2018 gross margin as a percentage of home sales revenues will be in the range of 24.0% and 26.0% and 2018 adjusted gross margin (non-GAAP) as a percentage of home sales revenues will be in the range of 25.5% and 27.5% with capitalized interest accounting for substantially all of the difference between gross margin and adjusted gross margin. The Company also believes that the average home sales price in 2018 will be between $220,000 and $230,000.”
I listened instead of reading the transcript because I also wanted to hear whether the tone during Q&A would provide additional clues to sentiment. The tones were not revealing, but the questions and responses were.
The first analyst to ask questions wasted no time addressing the elephant on the call. This analyst pointed out that the stock was selling off and surmised that investors were disappointed that LGIH failed to lift the range of its guidance. Management acknowledged that it purposely delivers conservative guidance: they want to make sure to hit the numbers. I think this consistency hikes expectations and creates “resistant” analysts and investors who are no longer impressed by hitting the numbers.
That dynamic is important for LGIH because expectations are likely high given its relatively “expensive” valuation with a high price/book ratio at 2.8. Builders like KB Home (KBH) are still scraping by at 1.2. PulteGroup, Inc. (PHM) is at 2.1. LGIH’s other metrics are toward the high-end of builders but reasonable: price per earnings at 13.4 trailing and 8.6 forward, and price/sales at 1.1. LGIH also has a large crowd waiting for the stock to implode: shorts have sold short a whopping 38.9% of the float! In other words, the deck is stacked against LGIH when it “only” meets high expectations.
LGIH provided some additional moments of clarity for participants looking for excuses to sell. Management acknowledged the need to spend more on marketing to offset the potential demand suppression of higher rates. They explained this need to spend even as they tried to reassure the crowd that demand has been strong. LGIH also claimed that the impact of rates to-date has been neutral to positive. The positive impact comes from the pressure of rising rates pushing people to buy now rather than later in order to save money. LGIH also reassured the crowd that the conservative guidance gives them room to spend more on marketing. Translation: LGIH is not likely to deliver an upside surprise.
LGIH had a dual story on costs. On the one hand, LGIH said that the rising costs of materials and labor have been “less impactful” over the last 3 to 4 months in terms of frequency and amount. (I found this surprising given that lumber futures have been hitting records and tripping circuit breakers on the way up). Yet, rising costs going forward will force more price increases even as affordability issues are a headwind (LGIH raised prices in 80 to 90% of its communities in April). As a result, margins will stay consistent rather than “ramp up in the back end” of the year. Translation: LGIH is not likely to deliver an upside surprise.
Home builders continue to be a tough slog. Around every corner there is a negative catalyst to capture imaginations and deliver reasons to sell. For this trade, I am looking at a defined window of opportunity between the low and highs of the year. In the shortest term, even a 5-point rebound to 50DMA resistance would be a satisfying “victory.”
Be careful out there!
Full disclosure: long LGIH