Sometimes a stock tanks because it missed analysts' earnings expectations. Other times, it's because it missed revenue forecasts. Or sometimes the company's numbers are fine, but its guidance is weak. And then there are occasions when a company outperforms expectations and issues strong guidance, and shares tumble anyway. That's what happened to homebuilder LGI Homes (LGIH -0.45%) after it reported Q4 2019 earnings on Feb. 25.
The company's strong earnings somehow prompted a 14.3% drop in its share price. While it was a tough day all around -- the S&P 500 was down 3% -- LGI vastly underperformed both the market and the broader homebuilding industry. Here's the likely reason why.
LGI Homes specializes in starter homes, which is a top-selling area of the market. Image source: Getty Images.
By the numbers
| Metric | Q4 2019 | Q3 2019 | Q4 2018 | Change (YOY) |
|---|---|---|---|---|
| Revenue | $605.6 million | $483.1 million | $425.2 million | 42.4% |
| Net income | $64.9 million | $49.3 million | $42.7 million | 52% |
| Earnings per share (diluted) | $2.52 | $1.93 | $1.72 | 46.5% |
| Home closings | 2,515 | 2,003 | 1,852 | 35.8% |
| Average selling price per home | $240,815 | $241,179 | $229,568 | 4.9% |
Data source: LGI Homes. YOY = year over year.
These numbers are really impressive, even compared to the rest of the industry, which generally had a great Q4 across the board. The company's 42.4% revenue growth particularly stands out, since many rival homebuilders like M/I Homes, NVR, and PulteGroup saw double-digit earnings growth coupled with flat or single-digit growth in revenue from the prior-year quarter.
This may have been one reason the market reacted so strangely to LGI's strong numbers: While earnings exceeded analysts' average estimate by 7.7%, revenue only beat estimates by 2.6%. Perhaps Wall Street was disappointed not to see a bigger boost in earnings given the huge jump in revenue. But the market was likely more concerned with the company's 2020 forecast.
2020 outlook
LGI CEO Eric Lipar issued upbeat guidance for 2020 on the Q4 earnings call. Noting that the company had "exceeded its guidance in all areas" in 2019, Lipar forecast continued growth for the company.
Management expects to sell between 8,400 and 9,400 homes in 2020, which would represent growth of 9.2%-22.2% over 2019's 7,690 homes. The company is off to a good start, with 434 closings in January (a 61.3% increase over January 2019) and another 606 closings in February (a 54.2% increase over February 2019).
You probably noticed that the 22.2% growth in closings that represents the high end of the company's guidance is much lower than the 57.1% growth in closings it's seen during the first two months of this year. The market certainly noticed, and this is likely one of the big factors in the share-price drop.
In response to a question on the earnings call, Lipar explained that one of the chief metrics the company considers is home sales per community per month. For the last three years, that rate has been constant at 6.7 closings per community per month. While the company expects that rate to continue for existing communities, it's less certain about the new communities it's developing.
One factor in the guidance is location. LGI's strongest geographic area in terms of number of sales in 2019 was in the West, with an average of 8.7 closings per community per month in California and 8.4 in Las Vegas. However, most of the company's new growth in 2020 is going to be in Florida and the Southeast. So the company is hedging its bets and guiding for between 6 and 6.7 closings per community per month on average in 2020.
Now, LGI has a history of exceeding its guidance, and the Southeast has been one of the hottest homebuilding markets in recent months. Still, it's worth asking whether this is a case of conservative guidance...or the writing on the wall before a slowdown.
The right place at the right time
LGI has long been a major seller of entry-level homes, which is a hot market right now thanks to low mortgage interest rates and demographic shifts. And the company knows how to make money on those homes: Its 2019 adjusted gross margin of 25.8% is significantly higher than most of its peers' (something in the high teens is pretty standard). That puts LGI in the sweet spot for homebuilders right now.
However, the key words are "right now." Mortgage rates seem likely to remain low, which should continue to attract first-time homebuyers. But if the broader economy heads south, people are likely to delay major purchases -- like a home -- and LGI will probably suffer.
It's worth noting that the current housing market has been expanding for almost a decade, and that it's a cyclical market. If you're convinced that the economy -- and the residential home market in particular -- still has room to run, LGI seems like a good pick within the industry given its record of outperformance and its impressive margins. But when the market turns, LGI and its investors will be in for a rough ride.
