Is LGI Homes (NASDAQ: LGIH) Using Too Much Debt?
Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but the fact that you suffer a permanent loss of capital. “. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We notice that LGI Homes, Inc. (NASDAQ: LGIH) has debt on its balance sheet. But the most important question is: what risk does this debt create?
Why Does Debt Bring Risk?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash flow and debt together.
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What is LGI Homes net debt?
You can click on the graph below for historical numbers, but it shows LGI Homes had $ 413.9 million in debt as of March 2021, up from $ 744.4 million a year earlier. However, it has $ 48.2 million in cash offsetting that, which leads to net debt of around $ 365.8 million.
How strong is LGI Homes’ balance sheet?
According to the latest published balance sheet, LGI Homes had liabilities of US $ 118.0 million due within 12 months and liabilities of US $ 488.8 million due beyond 12 months. In compensation for these obligations, it had cash of US $ 48.2 million as well as receivables valued at US $ 59.2 million due within 12 months. It therefore has a liability totaling US $ 499.5 million more than its cash and short-term receivables combined.
Given that LGI Homes has a market capitalization of US $ 4.28 billion, it is hard to believe that these liabilities pose a big threat. Having said that, it is clear that we must continue to monitor his record lest it get worse.
We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we consider debt versus earnings with and without amortization charges.
LGI Homes net debt is only 0.83 times its EBITDA. And its EBIT easily covers its interest costs, which is 1,000 times the size. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. On top of that, we are happy to report that LGI Homes has increased its EBIT by 66%, reducing the specter of future debt repayments. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the future profitability of the business will decide whether LGI Homes can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, LGI Homes has recorded free cash flow of 35% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
LGI Homes’ interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. But frankly, we think its conversion from EBIT to free cash flow undermines that impression a bit. When zoomed out, LGI Homes appears to be using the debt fairly sensibly; and that gets the nod from us. While debt comes with risk, when used wisely, it can also generate a better return on equity. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. We have identified 3 warning signs with LGI Homes (at least 1 which makes us a little uncomfortable), and understanding them should be part of your investment process.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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