Earnings Call Transcript - LGIH Q2 2022

Operator, Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the LGI Homes 2022 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker’s presentation there will be a question-and-answer session. At this time, I would like to turn the conference over to Mr. Josh Fattor. Sir, please begin.

Josh Fattor, Senior Vice President

Thank you and good afternoon. Before we begin, I will remind listeners that this call will contain forward-looking statements that include management views on LGI Homes’ business strategy, outlook, plans, objectives, and guidance for 2022. Such statements reflect management’s current expectations and involve assumptions and estimates that are subject to risks and uncertainties that could cause management’s expectations to prove to be incorrect. You should review our filings with the SEC including the Risk Factors and cautionary statements about forward-looking statements sections for discussion of the risks, uncertainties, and other factors that could cause actual results to differ from those presented today. All forward-looking statements must be considered in light of those related risks and you should not place undue reliance on such statements, which reflect management’s viewpoints as of the date of this conference call and are not guarantees of future performance. Additionally, on today’s call, we will discuss non-GAAP financial measures that are not intended to be considered in isolation or as a substitute for financial information presented in accordance with GAAP. Reconciliations of non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be found in the press release that we issued this morning and in our quarterly report on Form 10-Q for the quarter ended June 30, 2022, that we expect to file with the SEC later today. This filing will be accessible on the SEC’s website and in the Investor Relations section of our website. Our hosts today are Eric Lipar, LGI Homes’ Chief Executive Officer and Chairman of the Board; and Charles Merdian, Chief Financial Officer and Treasurer. I will now turn the call over to Eric.

Eric Lipar, CEO

Thanks, Josh. Good afternoon, everyone, and welcome to our earnings call. I will open with highlights from our second quarter, and then Charles will provide details on our financial results. Finally, I will provide an update on our performance to date in the third quarter and our outlook for the rest of the year. I am pleased to share the record results delivered by the LGI team in the second quarter, continuing our track record of operational excellence and industry-leading profitability. We closed 2027 homes at an average selling price of over $356,000, resulting in over $723 million in revenue. Absorptions for the quarter came in at 7.4 closings per community per month above our historical second quarter average of 7.1. Houston was our top market with 13.6 closings per community per month. Charlotte was second with 12, followed by Dallas Fort Worth with 11.8, San Antonio with 10.7 and Tucson rounded out the top five with 10.3. Congratulations to these teams on their outstanding performance last quarter. I am also pleased to announce that in June, we had our first closing in the State of Maryland and are now operating in 35 markets across 20 states. Despite fewer closings compared to last year, our commitment to our systems, combined with continued pricing power, allowed us to deliver our most profitable second quarter ever and we set new company records in every profitability metric we track, including gross margins, EBITDA, pretax income, and net income. While the housing market outlook is uncertain, we are confident in our positioning and path going forward. We enter the remainder of the year with a solid balance sheet and attractive land pipeline, our proven expertise in land development and marketing, and the most experienced, well-trained sales force in the industry. Regardless of what the market does in the near term, LGI is on solid footing and well positioned to succeed. Now I will turn the call over to Charles for more details on our financial results.

Charles Merdian, CFO

Thanks, Eric. During the quarter, we closed 2027 homes. Of our total closings, 146 homes were sold through our wholesale business, representing 7.2% of our total closings, compared to 430 homes or 15.1% of our total closings in the same quarter last year. The year-over-year decline in wholesale closings was driven by our decision to write fewer wholesale contracts in the second half of 2021 when cost inputs were at their most volatile, our prioritization of retail sales, and the timing of closing. Revenue in the second quarter was $723.1 million, a decline of only 8.6% from last year, as the decrease in home closings was offset by a 28.7% increase in average selling prices to a record $356,719. Selling prices increased in all of our reportable segments, primarily driven by continued strong demand that enabled us to pass through cost increases. Gross margin this quarter was a new company record at 32%, a 500-basis-point improvement over the same period last year and a 300-basis-point improvement over our prior record. The increase resulted from our success at passing through cost increases, lower capitalized interest expense, and lower lot costs as a percentage of average sales price. Adjusted gross margin this quarter was also a new company record at 33.1%, a 460-basis-point improvement over the same period last year and a 280-basis-point improvement over our prior record. Adjusted gross margin excludes $5.7 million of capitalized interest charged to cost of sales during the quarter and approximately $2 million related to purchase accounting, together representing 110 basis points. Combined selling, general, and administrative expenses for the second quarter were 10% of revenue, compared to 8.6% during the same period last year and 11.5% in the first quarter of this year. Selling expenses for the quarter were $43.3 million or 6% of revenue, compared to 5.7% for the second quarter of 2021. General and administrative expenses totaled $29.1 million or 4% of revenue, compared to 2.9% last year. The 110-basis-point increase was driven by lower overall revenue, increased overhead, and other personnel costs. EBITDA for the quarter was $169.1 million or a record-setting 23.4% of revenue, a 320-basis-point improvement over the same period last year, which was also our previous record. Adjusted EBITDA was $167.1 million or 23.1% of revenue, a 310-basis-point increase from the same period last year and also a new record. Adjusted EBITDA excludes $4 million of other income and $2 million related to purchase accounting, together representing approximately 30 basis points. Pretax net income was $163 million, a record-setting 22.5% of revenue and a 370-basis-point improvement over the same period last year, which was also our previous record. Our effective tax rate in the second quarter was 24.3%, compared to 20.8% last year. The increase was primarily due to the expiration of benefits related to the 45L Tax Credits. Our second quarter reported net income was $123.4 million or 17.1% of revenue, also a new company record. Finally, earnings in the second quarter were $5.24 per basic share and $5.20 per diluted share, both representing year-over-year increases of 10.3%. Second quarter gross orders were 1,244 and net orders were 864. The 57.3% decrease in net orders was primarily due to last year strong comp, as well as our decision to divert sales to later in the construction process. Our cancellation rate for the second quarter was 30.5%, compared to 24.4% last year, primarily due to the moderation in demand experienced in June, as mortgage rates increased and some buyers chose to cancel their contracts. We finished the second quarter with a backlog of 1,266 homes, representing over $445 million in value. As of June 30th, our land portfolio consisted of 9,984 owned and controlled lots, an 18.5% increase year-over-year and a 3.5% decrease sequentially. We added over 4,800 new lots to our owned inventory and ended the quarter with 61,893 owned lots, an increase of 45.7% year-over-year and 4.8%, sequentially. Of our owned lots, 49,595 were either raw land or land under development and only a third of those lots were inactive development. The remaining 12,298 of our owned lots were finished lots, of which 7,481 were vacant lots. During the quarter, we started over 2,400 homes, and at June 30th, we had 4,817 completed homes, information centers, or homes in process. Excluding information centers, we had just 603 completed homes. And finally, at the end of the quarter, we controlled 28,091 lots, a decrease of 15.9% year-over-year and 17.8%, sequentially. Turning to the balance sheet, we ended the quarter with $42 million in cash, over $2.6 billion in real estate inventory, and total assets of nearly $2.9 billion. Total debt at quarter-end was $1.2 billion, resulting in a debt-to-capitalization ratio of 43.3% and a net debt-to-capitalization ratio of 42.4%. We expect our leverage ratio will remain in the range between 35% and 45%. As of June 30th, we had total liquidity of $245.7 million, consisting of the $42 million of cash on hand and $203.7 million available to borrow under our credit facility. In the last year, our shareholders' equity has increased by $228 million to over $1.5 billion, and we delivered a return on equity of 29.6%. During the second quarter, we repurchased 417,861 shares of our common stock for $37.4 million, and we ended the quarter with 23.3 million shares outstanding. Since 2020, we have repurchased approximately 12% of our common stock, and as of June 30th, we had $211.5 million remaining on our stock repurchase program. At this point, I will turn the call back over to Eric.

Eric Lipar, CEO

Thanks, Charles. As highlighted in our press release, we are adjusting our full-year guidance to reflect our current outlook for the rest of 2022. Pending verification of funding, 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 8 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 when we had a similar number of communities. We continue to experience headwinds on the development side and now expect 100 to 110 active communities at year-end. Additionally, we still expect community count growth of 20% to 30% next year. Based on our results to date and current backlog, we expect an average selling price between $345,000 and $360,000 for the full year. Additionally, we now expect our SG&A expense will range between 10% and 11%. We maintain our guidance for gross margins in the range between 27% and 29%, and adjusted gross margins between 28.5% and 30.5%. After a two-year boom market unlike any other in history, the new home market is at a crossroads. From a short-term perspective, homes are more expensive, consumer prices are up, and mortgage rates have nearly doubled. However, the longer-term outlook reveals a solid foundation for multiyear growth. Demographic trends remain supportive of demand, strong labor markets are fueling wage growth, tight rental supply is pushing up rents, and the inventory of homes available for sale remains historically low. At LGI, we are taking the long-term view and remain optimistic about our business for several reasons. For the first half of the year, we were mainly focused on closing the homes in our backlog. Now we are back to focusing on sales and closings, and our marketing faucet is turned on. While others may be cutting expenses, we have been increasing our advertising spend with favorable results. In July alone, nearly 20,000 people inquired about moving from renting to homeownership, a 54% increase over last year. Additionally, our orders have been up for four consecutive months. These results give us confidence that there is still a large pool of qualified buyers for our homes and we expect these numbers to grow as we connect with more of those target buyers. We have removed the restriction on our sales process. For the last few months, we have only sold homes that are within 60 days of closing. That was the right decision at the time given the supply chain disruptions. However, with supply chains now normalizing, we are adjusting accordingly. This weekend, we will start selling homes that are within 90 days of closing. These homes will be at a phase of construction where we can have confidence in our delivery times, a clearer view of costs, and certainty that we can provide a great experience for our homebuyers. Prices are normalizing. While we are proud of the 33% adjusted gross margin we just delivered, it is not a sustainable expectation and that is not our target moving forward. As we bring new communities online, we are offering them at prices that will deliver normalized margins in the 25% to 28% range. Additionally, we are seeing input costs decrease in almost all of our communities, which will enable us to offer homes at monthly payments that are more affordable for our buyers. Finally, as we right-size our inventory to meet current levels of demand, we expect to generate additional cash flow that will position us to capitalize on opportunities to accelerate our growth. To conclude, I want to congratulate our employees on our record-setting quarter and thank them for their commitment to our continued success. The days of retail investor demand, shifts in housing premises, work-from-home migration and low interest rates filling sales offices are behind us. What matters now is an unwavering focus on connecting directly with customers, educating buyers on the benefits of ownership, building homes that offer a compelling value compared to renting and delivering the industry’s best customer experience. LGI homes was built to thrive in challenging markets and we believe our people, systems, culture, and 100% spec focus model will continue to differentiate our company as we navigate this dynamic period. We will now open the call for questions.

Operator, Operator

Our first question or comment comes from the line of Trevor Allinson from Wolfe Research. Your line is open.

Trevor Allinson, Analyst

Hi. Good morning. Thank you for taking my questions. First question I just want, you touch on what you ended with there on your gross margin outlooks in the back half of the year. It sounds like the main driver there is going to be new communities coming online at lower margins. Are there any other factors that are major drivers of that, maybe increased wholesale closings or still higher costs flowing through in the back half of the year, it’s going to drag that sequential decrease from Q2 strong levels?

Eric Lipar, CEO

Yeah. It’s a great question. This is Eric. I can start. I point to three things talking about our margin guidance and also with the caveat that our gross margin guidance midpoint will be the best year in company history. So still a very strong margin for the year. But the margin that we just came off, our adjusted gross margin on how we priced our house, 33.1% in Q2 and 31.9% year-to-date is phenomenal. It really shows how strong the market dynamics were and phenomenal results. I think going forward the three things I’d point to are, one, new communities coming online. We are pricing at normalized margins, 25% to 28% and we have seen those communities get off to fast starts with more normalized orders and sales pace, which is very positive. I’d also point to the wholesale business. Wholesale is only 7% of our closings last quarter. We expect that to get normal, probably 10% to 15% of our closings in the back half of the year. And then also, as we have closed out the pipeline, our costs are going down. So even in our existing community, we are going to be able to adjust our pricing to normalize margins, in addition with the costs coming down and to offer a more affordable payment to our customers.

Trevor Allinson, Analyst

Okay. Great. Thanks. That’s very helpful. And then, second, looking at your option lots, they took a step down sequentially, I was hoping to get an update with what you are seeing as a landmark in general and then with your option agreements, given the slower demand environment, have you seen sellers become more willing to negotiate on terms or pricing? Have you seen any actual price declines? And then, with your option lots moving lower sequentially, have you actually walked away from any of those option deals?

Eric Lipar, CEO

Yeah. I think it’s a great question. I think what we are seeing in land market is probably consistent with whatever else has been saying, haven’t seen a lot of price decreases on land yet, when I say land, I mean, raw land or paper lots per se. But it’s early. I was in Colorado last week for a Board meeting and spent some time in the field with our acquisitions team. And for the first time, in a couple years, we had a couple of finished lot opportunities we were looking at. So there’s a lot of developments going on across the United States and we are pretty excited about the potential opportunities that may come about with a more normal market. For the last couple of years, it’s just been an unbelievable market where all the builders are taking orders, everybody is having phenomenal success, everyone is having phenomenal margins. But a lot of the land coming to market and a lot of developments that are ongoing have been financed with more expensive debt, more expensive land banking, and as those communities come online, we will see. We are starting to see some of those opportunities, but it’s early. So I think rather than focusing on raw land, we may see some opportunities for finished lots.

Trevor Allinson, Analyst

Okay. Great. Thanks for taking my questions. Good luck in the next couple of quarters.

Eric Lipar, CEO

Thank you.

Operator, Operator

Thank you. Our next question or comment comes from the line of Trevor Allinson from Wolfe Research. Mr. Allinson, your line is open.

Eric Lipar, CEO

I think we got Trevor’s first question.

Trevor Allinson, Analyst

Yeah. I guess I will hop in with one quick one then we can move on. I am just hoping you guys could discuss demand by geography here. Your West region was really strong and I got some community account growth there. So I will just ask one quick one there and I will hop back out.

Eric Lipar, CEO

Yeah. Yeah. I think I can take this, again, the demand question in general, Charles can add to it if he wants to. I think demand is consistent across the country. And what I mean by that is really our focus on the first half of the year was really focused on our backlog and getting that closed. We made a decision in March to only sell houses within 60 days of closing, because supply chain challenge, we weren’t having great experiences with the customers, as we were missing closing dates, which is not good for us, not good for the customer. So we really focused through Q2 closing out our backlog and did not focus on sales, because we did not have a lot of finished inventory to sell within a 60-day period. That has started to change. In fact, that’s one of the things in the scripted remarks we talked about, 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. Also, like we talked about in our remarks, we decided to start construction and pipeline and with supply chain easing starting this weekend, we are going to start selling houses within 90 days of closing. And we also think that’s going to add to our orders and produce a really good solid month of orders as well. So that’s pretty consistent nationwide, Trevor, what we are seeing and our focus is now entirely shifted to start selling more houses. We are going to have more available inventory. We are going to spend more money on marketing. And we are going to be hiring a lot of salespeople and opening up these new communities at normalized margins. So we are real optimistic about the second half of the year.

Charles Merdian, CFO

Trevor, this is Charles. I just add specifically to the West. You are correct. It was increased community count, specifically in our Phoenix and Northern California markets.

Trevor Allinson, Analyst

All right. Thanks, guys.

Operator, Operator

Thank you. Our next question or comment comes from the line of Michael Rehaut from JPMorgan. Just a second. Mr. Rehaut, your line is open.

Michael Rehaut, Analyst

Thanks. Thank you. Good afternoon. Thanks for taking my questions.

Eric Lipar, CEO

Good afternoon.

Michael Rehaut, Analyst

I just want to circle back and make sure I am understanding the gross margin comments well, as it relates to the back half. You are talking about opening up new communities in a 25% to 28% range and just want to be clear, that is pre or post-interest?

Eric Lipar, CEO

Pre, that’s adjusted gross margin.

Michael Rehaut, Analyst

Okay. So, with the guidance that you have pre-interest currently, it looks like, you would have to get to around the closer to like 28% or less, that’s coming off of the 33%. So, still at the high end of that range. So number one, I just wanted to make sure, my math is roughly correct. If it’s going to be all of us step down in the third quarter or if it could go even below that 28% average in the fourth quarter and how quickly might we see the 25% to 28% range flow through, because obviously, there’s a certain element of community count turnover?

Eric Lipar, CEO

Yeah. I think, the only clarification, Mike, I’d make is, the adjusted gross margin, what we are saying, new communities, it’s not only new, that community added a community count, it’s also our replacement community. So we have got a lot of communities nationwide that are in the process of closing out and that we are bringing the quote replacement online, which is an additive to community count, but does have an impact on this gross margin discussion. Charles can weigh in, but I personally think gross margins in the third quarter will probably be higher than in the fourth quarter because our backlog percentage gross margin is still really strong and we think that’s going to gradually go back to normalization and then we factor that in when we provide at the year-end range that we did.

Charles Merdian, CFO

I agree with Eric’s comment that it's likely the third quarter will be higher than the fourth quarter. Therefore, we expect the decline to occur in the fourth quarter.

Michael Rehaut, Analyst

Right. Right. Okay. Also, if you kind of run some of the math on the absorption for the back half of the year, your comments around absorption 7.5 to 8 and getting to a midpoint of the community count with a kind of stepped it up gradually over the next several months, even keeping sale closings pace between 7.5 and 8 or even at the lower end of that, get you actually towards the higher end of your closings range. So just curious any thoughts on that, if there’s anything we are missing here, because it does seem like, based on, again, a gradual move towards the community count getting to the middle of the 100 to 110 by the end of the year and 7.5 to 8 seems like you are coming up at the higher end. So just any thoughts?

Eric Lipar, CEO

Yeah. I think that’s, my comment on that is really, that’s why we get ranges, anywhere in that 7.5 to 8 a month range in the second half is going to put us in our guidance range. And it really depends, a lot of it’s going to depend on what happens in the economy the next three months or four months, a lot of it’s going to depend on getting these new communities open, where we are at in the range of community count, high end versus low end. So that’s still a challenge for us. How many houses we can deliver? What the supply chain looks like? So I don’t know if I have any more comments other than that’s why we give the range. We are confident in our new closing guidance range. We had to adjust that down based on where we were and what we are seeing on construction, development, and sales, but we are confident of being in that range.

Michael Rehaut, Analyst

Okay. One last one, if I could, you gave the 10% to 11% for the SG&A for the year. Is that something that all else equal, we should expect going forward into 2023 or if the market remained soft, you are not kind of getting the results that you would want, would we see that come up a little bit more or can we see further adjustments on the gross margin side?

Charles Merdian, CFO

Yeah. It’s a great question, Mike. This is Charles. Not necessarily giving specific guidance on 2023. But I think what we have been talking about as it refers to SG&A is that we generally think that our increase in marketing and advertising is going to return back to normal. So we have seen over the last year and a half or so just the benefits of not having to spend as much money. So I think I’d break it into the selling portion. We are expecting it to increase as a percentage of revenue over time to get back to normal ranges. And then the G&A portion in our income statement is generally more fixed. So I would say, depending on where our closings end up in 2023 and how the pace that community count goes, is there some opportunity for leverage there to offset some of the increase in selling expenses. But I think overall, I think we are kind of trending back to this 10% to 11% range for the near term.

Michael Rehaut, Analyst

Right. So selling expenses were 7% to 7.5% from 2017 to 2019 is that a good reference point?

Charles Merdian, CFO

I don’t know that I would go quite necessarily that high, but probably the lower end of the range is what I would say.

Michael Rehaut, Analyst

Great. Thanks so much. Appreciate it.

Charles Merdian, CFO

You bet.

Operator, Operator

Thank you. Our next question or comment comes from the line of Jay McCanless from Wedbush. Mr. McCanless, your line is open.

Jay McCanless, Analyst

Hey. Good afternoon, guys. Can you remind us on the community growth that you are expecting for fiscal 2023, when is the bulk of those communities coming up?

Eric Lipar, CEO

Yeah. That is a great question, Jay. And after the last couple years the probably the correct answer is I am not sure. But we are confident that 23%, 30% number, I mean, those communities are just getting delayed, they will be there, so we are confident community count is going to grow - grow next year. For modeling purposes, yeah, I think, an equal amount coming through the year would probably be appropriate.

Jay McCanless, Analyst

Okay. And that was actually going to be my next question. If you could talk about what type of delays you are seeing on horizontal development and have the supply chain issues gotten any better for that side of the business?

Eric Lipar, CEO

It doesn’t seem to be getting any better yet. We are still having challenges with electrical transformers, some other supply chain issues, getting the start of the development process, getting the plans recorded, getting the necessary approvals from the city. All the engineers are still busy. So supply chain on the development side, I would say is similarly challenged. Now we do expect that to get better, because we believe and other builders have said, as well as us, probably not doing as much development near-term, probably adjusting development sizes of the sections for today’s normalizing market. So just like on the construction side, we do see that improving but we have not seen that yet on the development side.

Jay McCanless, Analyst

Okay. Going back to a more historical gross margin range suggests that there may need to be significant price reductions compared to your initial plan for these communities. Is that line of thinking accurate, and what percentage are we discussing? Have you determined how much you plan to lower your initial base prices for these communities?

Eric Lipar, CEO

Yeah. It’s a great question. I don’t think we are looking at it as having a lot of price cuts, Jay, because we increased prices so rapidly over the last couple years we are just going back to normal. And we have not been focused on price cuts because we haven’t had a lot of finished inventory and I think our reaction is probably similar to that of a lot of builders and so you have a lot of standing inventory. There’s not going to be a lot of discussion about price cuts per se. But that’s changing and we are looking at our pricing on a community-by-community basis nationwide and all everybody can tell by our backlog, and the fact, we have only been selling 60 days in advance, we describe it as we do need to normalize our pricing. Some of our communities had unbelievable gross margins, we were able to increase pricing a lot like in markets like Austin. While markets like Austin, we are not going to be able to keep selling, we don’t believe that 35% plus gross margins and we have seen some pushback on those type of pricing. We will normalize our pricing. Yes, we will probably be selling the same floor plans in the future for less money than we were over the last 24 months. But it’s going to be similar to what it was two years and three years ago, because the last couple years have just been an outlier as far as pricing goes. I mean, a 33% adjusted gross margin, we are very unlikely to post that again in our history. It’s such an outlier in gross margin. And we are just going back to normal and in a normal market, we believe we are going to thrive and there’s going to be great tremendous opportunities for LGI and we are pretty excited about it.

Jay McCanless, Analyst

Got it. And then one more quick one, it’s interesting that you are starting to see finished lot deals again, do you think with the pace of what you are seeing that you could potentially buy enough of those communities to make up for some of the shortfall that you are expecting relative to your previous guidance for this year?

Eric Lipar, CEO

Yeah. Not necessarily this year, because I mean, even they are just starting to see opportunities. I mean, closing them, it certainly wouldn’t relate to any home closings in 2022. We think it may create opportunities for community count growth and closing growth in 2023. And I gave a couple of examples, but it just really depends on what happens with the industry. The more challenging the industry becomes, whether it’s a recession, whether rates pricing, supply chain, any of the headwinds that we potentially face as an industry, our attitude and what we are talking about internally, the more challenging environment it is, the more opportunities it’s going to create. Yeah, you have to remember our company and we haven’t talked about this last couple of years. But we have never lost money in any year, including the greatest downturn anyone’s ever seen in 2006, 2007, 2008. We have never taken an inventory impairment in the company history. So if it’s a more challenging environment going forward, it’s going to create more opportunities for finished lots. If it’s a more normalized market or things get really good and rates stay down or whatever the tailwinds may be, then that’s fine as well and LGI will thrive in that market.

Jay McCanless, Analyst

Okay. Sounds great. Thank you.

Eric Lipar, CEO

You are welcome.

Operator, Operator

Thank you. I am showing no additional questions in the queue at this time. I’d like to turn the conference back over to management for any closing remarks.

Eric Lipar, CEO

Thank you. And thanks everyone for participating on today’s call and for your continued interest in LGI Homes. Have a great day.

Operator, Operator

Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may now disconnect and have a wonderful day.