In the second quarter, LGI Homes (LGIH -1.68%) management took the bold step of raising its guidance for the full year even though a slowdown in housing was staring it in the face. This past quarter, we saw some of the effects of this slowdown as total units sold declined and it saw an increase in net income almost entirely from a more favorable income tax rate.

Even though the company faced some stiff headwinds this past quarter, management stuck to its guns and said that it expects to hit its updated full year guidance. So let's take a look at LGI Homes' most recent results to see if the company can still hit these ambitious goals in the face of this market slowdown.

Several new homes in a row.

Image source: Getty Images.

By the numbers

Metric Q3 2018 Q2 2018 Q3 2018
Revenue $380.4 million $419.8 million $365.9 million
Operating income $48.9 million $62.1 million $50.8 million
Net income $37.7 million $47.6 million $33.7 million
Diluted EPS $1.52 $1.90 $1.40

Data source: LGI Homes earnings release. EPS = earnings per share.

Before delving too deep into the bad news, it's worth noting a few positives in this past quarter. One thing that stood out was that the company reported a gross margin of 25.6% in the quarter, so even though it saw a significant unit sale decline, it didn't have much effect on price. It also saw a significant uptick in average selling price as more of its sales came from its Northwest region, which has a considerably higher price point than every other region.

Now let's look at the slow sales. LGI's bread-and-butter region has been its central region for years, as it is where the company got its start. While the community count was higher for this particular region, the absorption rate (total homes closed per community per month) was down from 9.9 to 7.9. As management noted, 9.9 is incredibly high and well above the company's longer term average of around 6.0. 

The company saw higher unit sales in its Northwest and Southeast regions. Gains in the Southeast were largely attributed to its recent acquisition of Wynn Homes, while management noted a higher rate of investors buying homes in the Northwest.

LGIH closings by region for Q3 2017, Q2 2018, and Q3 2018. Declines in central and Florida regions partially offset by Southwest and Northwest.

Data source: LGI Homes. Chart by author.

Were it not for the addition of Wynn, LGI's community count would have been more or less flat compared to this time last year, so the decline in unit sales was almost entirely attributable to the company's absorption rate falling back to a more normal range for the company. With several new communities set to open in the fourth quarter, it should help to drive sales. 

What management had to say

On the company's conference call, CEO Eric Lipar addressed some of the reasons for the recent slowdown in sales, the issue of affordability in the housing market today, and how that should help the entry-level home buyer:

Affordability continues to remain a focus. As mentioned in prior calls, we expect our absorption rates to normalize after record-breaking results from the prior year. Interest rates and higher prices have begun to stretch affordability. Historically, we have seen buyers in this type of environment shift down in size of homes purchased and we would expect similar results in the near term and believe we will be in a position to capitalize. As [CFO] Charles [Merdian] mentioned, our net orders were similar in the third quarter this year compared to the second quarter and we continue to see strong demand in traffic and our information centers from renters wanting to convert to homeownership, proving that buyer interest levels are still high.

As we have said all year, we are on track to end 2018 between 85 and 90 communities, continuing to expand our footprint in our current markets and adding new ones.

You can read a full transcript of LGI Homes' conference call here.

LGIH Chart

LGIH data by YCharts.

Big promises for the rest of the year

According to management, it thinks it will be able to meet its full-year guidance of more than 6,400 homes closed and net earnings per share between of $6.50 to $7.25. Including its October sales, LGI has closed 5,128 homes, and earnings per share for the first nine months are $5.07. So, to close out the year, it will have to close almost as many homes in the last two months as it did in the third quarter. If it can get there, earnings per share will likely get there. Still, 1,400 homes in two months is a tall order for the company, even though Lipar did mention that December is historically one of its best months. 

If management can meet those targets for sales for the rest of the year and continue on its plan to build its community count by 20% to 30% while maintaining its historical absorption rate, then the recent stock slide seems incredibly overdone, and the stock looks incredibly cheap. Hitting the low end of that guidance range for 2018 means its stock trades at 6 times earnings, and growing sales for 2019 would ease a lot of concerns about a housing slowdown.

That, of corse, depends on management delivering on its promises. It has been able to do that so far in its short life as a public company, so it's worth giving management the benefit of the doubt until it doesn't deliver. Whether it can or not will depend largely on this upcoming quarter.