Interview Transcript

Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

My understanding is that you've been in the home building industry for some time now. I'm curious about LGI Homes has evolved beyond just becoming bigger.

On one hand, some things have changed, but materially, no. Let me explain my answer. LGI Homes' number one cultural aspect is being a systems-based company. If you listen to their quarterly earnings calls and their CEO, it might seem like he repeats himself, but it's true from the top down. they are a systems-based company, meaning everything they do is a duplicable, scalable system with a high probability of success.

This allows them to create manuals, hire, and train effectively. They created a corporate training program for their purchasing team. They have a culture where they can take corporate training, manuals, and new employees, and not only duplicate them in their roles but also duplicate trainers to train others. This ability to confidently duplicate and scale their processes has remained unchanged since inception.

I imagine that's a huge advantage as they open all these communities they're working on right now.

It is a huge advantage. Additionally, being a true inventory builder, where they spec out homes entirely beforehand, is a testament to their systems and processes. They build the same home repeatedly in a neighborhood, making their trade partners more profitable. They can come in with their crews, know what to expect, bid correctly, and maintain proper profit margins. As long as they operate their business correctly, they'll be profitable too. In most respects, things haven't changed; they're the same business year after year.

However, their processes have evolved. While being process and systems-driven hasn't changed, how they function as a company has. As they've grown from 10 to 50, 50 to 100, and then 100 plus communities, they've had to adapt. More people mean more nuanced requirements. As their community count grows, where and how they build, including jurisdictions, municipalities, and soil types, all play a role. They've had to upscale and add different parts to the process as they grow, but the core way they run the business remains unchanged.

I understand that they focus heavily on systems and processes. However, it's one thing for higher-ups to discuss manuals and processes, and another for those processes to be implemented daily on the front lines. Can you explain how these manuals impact roles like someone in purchasing or sales within a community?

First, their understanding of systems and processes is crucial. They have some external process guidelines, but one of their cultural values is hiring the best. They aim to hire purchasing managers who are highly skilled or have the potential to become highly skilled at LGI Homes.

They don't dictate how they handle external interactions. It's challenging because you lead people and manage processes. A key component is teaching that you lead people but manage processes. Most of their systems and processes focus internally. Purchasing managers meet with trades, negotiate, find the right suppliers, and make decisions based on their expertise.

Internally, they disseminate information to the corporate team in a process-driven manner. This allows the departments, like marketing, accounting, finance, and land, to interact efficiently. The systems are internally focused, which is often misunderstood. They're not creating robots; they hire individuals skilled in social interaction, problem-solving, and creativity.

Internally, systems are crucial. If someone deviates from the system, it becomes evident through their internal communications. If there's a breakdown in standard procedures or errors arise, they first check if the system was followed correctly. A well-defined system naturally reveals problems without needing many stopgaps.

Could you clarify what you mean by systems and processes being internally focused? I know every employee has a manual for their role. I'm having trouble understanding the distinction between internal and external.

The manual outlines how they gather information from the field and communicate it throughout the organization. This ensures that decisions can be made, checks can be written, purchases can be made, and employees can be hired. For example, the manual for a purchasing individual includes step-by-step tasks to complete the process for this part of the budget to be communicated back to the corporate office.

The budgets for the purchasing team are in a specific format, executed and communicated in a particular way to ensure accurate and quick communication back to LGI. This information is then disseminated so the corporate leadership can make pricing decisions through finance, and the marketing team can quickly decide on new products or changes.

If systems and processes are followed according to the manual, everything runs smoothly. This allows them to operate very lean. Instead of having a purchasing team in each state, they have a purchasing employee in each state. Some states have more due to their size and geography. They can run efficiently because they are an inventory builder with systems and processes in place.

They don't have a section in their manual that dictates how to communicate with trade partners. They trust their construction and purchasing professionals and provide training on negotiation, but they don't create robots. The culture defines how they work externally, and their systems and processes, defined by the manual, guide how they get information from the field to the corporate office.

What I understand is that the process focus ensures information is standardized from each community and role back to corporate. This avoids chaos, like one person sending a text and another an email, leading to a big mess. Is that correct?

That is 100% correct. If you visit an information centers in Colorado and then in Texas, they would look very similar, if not identical.

Yes, I've experienced what you're describing.

So, if the schedules are built the same and all the systems are set, then the construction team can function seamlessly. For instance, if someone goes on vacation, another construction manager can step in, and everything should be in place. They should be able to take over the schedule, walk the homes correctly, and keep production flowing without missing a beat. Even the vice president of construction could step in and run the community. The safety binder and schedule should be in order, ensuring consistency. This way, they can run the entire system effectively without variations that lead to chaos.

It's obvious why this approach is beneficial, especially with their goals of reaching 150 communities by the end of this year and 175 or 180 by the end of next year. This kind of growth makes the approach you're describing extremely helpful. The benefits of this process orientation are clear. However, one potential downside of such a rigorous focus on systems and processes is becoming set in your ways.

I'm curious, though I know this isn't the case for LGI Homes, about how information or ideas for improvement flow from the field. If I'm working in a community or a region and see a process or protocol that could be improved, how do they go about making changes? How do they incorporate the valuable information coming from each community to constantly improve operations?

I would describe the difference between growth and maturity in both individuals and businesses. As human beings, we grow up and grow old, but not all of us mature. Maturity comes from self-development, gaining new perspectives, and developing oneself as an individual. This is where people become influential, persuasive, and powerful.

Similarly, businesses experience growth and maturity. This is an area where they have certainly matured. You asked earlier if things have changed as they've grown, and I explained that. I want to differentiate here by saying that they have matured as a company. At first, it was like a biblical approach—no change, no suggestion box. But as they've expanded, they've matured by listening more and asking good questions.

They understand that building in Colorado and Utah is different from Georgia and Florida due to different cultures, trade partner mindsets, and soil conditions. This doesn't mean they do things differently, but the things they do might be different.

Let me explain. How they set budgets, treat trade partners, and build in sets are fundamental to their success and don't change. However, where they were aggressive in putting slabs in Colorado eight years ago, they wouldn't do that now. They've matured by understanding the trade base, capacity, and soil requirements. Their land development team would build the site differently now.

This maturity has come from listening to feedback, like realizing that building a home in Colorado differs from elsewhere. This maturity involves listening to frontline workers and construction professionals to understand the best ways to build in each region.

There is a phrase from a management book. It talks about grandma's ham. Essentially, a story is told in this book about how a daughter is watching her mother cut the sweet part of the ham off the bone to put it in the oven. She asks her mother why she does it that way, and her mother says, "I don't know. This is how my mother did it." So she goes and asks grandma, and grandma says, "I've always done it that way too, but my mother showed me." So she goes to great grandma, and great grandma just laughed and said, "It was the depression and we didn't have a pan big enough, so we always cut the end off." So after all these years, all these generations, nothing had changed, and a practice had been in place because the pan wasn't big enough back in the good old days.

I suspect, given everything we've discussed and what I know about the business, that there is a formal process for challenging these assumptions and conventions. I'm curious if that's correct. You mentioned the way construction happens in different markets and regions. Could you provide some specific examples of changes that have resulted from this process?

The company is built from the ground up on the vision of the founder, Tom Lipar, and his goals from back in the day. The story goes that Tom Lipar decided to change his life, including some habits, to improve the future for his family. He attended a Stephen Covey time management program, where he learned to manage his time and set goals using the Franklin Covey planner. This tool is something every employee at LGI Homes uses and is trained on when they start.

They are very committed to this process. There's a lot of lore around Tom and his goals, how he built the company, and how he trained Eric, his son, who is now the CEO. Every employee meets with their manager monthly to discuss the next month's goals. Annually, they meet to discuss one-year, three-year, and "someday" goals, which can be both professional and personal. Personal goals are optional, depending on how much detail you want to share with your manager. Business goals are discussed so the manager can convey the company's goals for the upcoming period.

This allows the employee to grow individually and outline how they plan to manage their responsibilities. Both the manager and employee set expectations, and then the employee works independently for the next 20 to 21 working days before meeting again. This forum is also where employees can discuss ideas they are passionate about. If the manager is doing their job well, they should vet the idea to some extent and decide whether it should be explored further up the corporate communication chain.

There is a risk in this method due to potential miscommunication through management layers. However, experience over the years has shown that because of the culture they have cultivated, most ideas are correctly vetted. While nothing is perfect, the best ideas tend to rise to the top and are implemented swiftly. Additionally, the organization has matured to test ideas regionally. Vice presidents and division presidents can use their regions as incubators to further vet ideas before suggesting them on a larger scale.

This entrepreneurial spirit and increased risk tolerance have led to great results over the last few years. The formal environment where ideas are discussed, vetted, and potentially developed is through their goals process.

Once again, you've anticipated something I was going to ask about, which is the goals process. Do you have a personal example, an idea for trying something new or changing something that ended up being implemented through the process you described?

I have several examples, which is why I'm passionate about this subject. I'll give you a more tactical one, rather than a philosophical one, where they've changed something.

It can be both procedural or tactical, or strategic. This one was more tactical. A VP heard from some of their trade partners about a new HVAC system called Rheia. It's a new building science that had been developed, where they were using three-inch flex ducts as home runs to supply air throughout the home. At the time, they had a substantial amount of HVAC warranty issues and challenges they were facing.

Colorado is unique in that it's a four-seasons market.

Denver can be negative 10 or a hundred.

You're 100% correct, which creates a challenge for temperature control. This system was touted as being able to more effectively mix air, distribute, and balance the home.

The VP did the research, met with the team, and it all made sense. He felt good about it. He approached his manager and explained the situation, giving him a summary. He thought it sounded promising if it worked as promised. He suggested negotiating a test house. Their leadership, top fuel techs, and the top HVAC supplier were involved. They completed a test house with this system, finished the roughs, completed the house, and tested and balanced it. It performed exactly as promised.

It was said, "Okay, let's do more houses to ensure it wasn't a one-off." They wanted to see if the installation time and supply would be consistent. If successful, they'd expand it globally, meaning throughout Colorado. It performed well, balancing temperature differentials between upstairs and downstairs, meeting performance guidelines. They saw great success.

This led to full implementation in Colorado. They started sharing it with other markets, offering a solution for those struggling. As ideas spread, they informed the leadership team about the success. They asked for results, metrics, and performance data. They provided that, and now other regions are implementing the Rheia system. This is an example of identifying a problem, finding a solution, and allowing it to grow beyond Colorado's borders.

How would you describe someone who is a great fit for LGI versus someone who might not fit the culture? What determines whether a person will succeed at the company?

It's about willingness and capability. It's as simple as that. They need to find someone who fits that. When focused on recruiting, they're keeping their ear to the ground, finding good talent through referrals, meeting industry partners, or whoever it might be, and assessing capability. They need to have either the current skill set or the potential to develop it. Their capability doesn't have to be fully matured. They don't need an expert because they're going to undo a lot of the current training and redo it the LGI way. But they must have that capacity.

They're always looking for someone who can do what they want them to do. It's even better if they're already doing it, using the words, terms, and formulas they use. They just need capability. Willingness is the other key ingredient. You have to be open-minded and willing to be retrained. Success at another top builder, like a brand X builder, doesn't automatically qualify you for success here. But if you're willing to be trained, LGI believes you're the right person for the role.

If you're willing to embrace the culture and take the necessary steps, you can find a lot of success. With those two things, willingness and capability, it is 90% or more likely to have a high-performing employee because the systems are strong and well-developed.

Just being willing and able to embrace the culture and the system.

Yes, because if you only have willingness but lack capability, that's ineffective. If you have all the skills but a bad attitude or are unwilling to adapt to the LGI way, that's conflicting and won't last. If you lack both, you're done. But if you have both, they can determine capability from the outset through good recruiting. They've got the right person and systems to make them successful.

Anyone hiring an employee wants them to be capable. It seems the secret ingredient is being willing to do it the LGI way.

Absolutely. But let me clarify. They need to be capable of doing it the LGI way. They've hired purchasing managers capable of procurement, but they lacked the skills needed to do it the LGI way, like computer or verbal skills. It's not just about the task at hand; it's about doing it the LGI way. That's the qualifier. I wanted to add that to not oversimplify a great question.

Let's dig a little more into the LGI way, focusing specifically on purchasing. We can broaden out from there. When we talk about the LGI way, let's discuss how the company seeks to drive advantage through the purchasing function compared to other similarly sized or larger builders. I'm specifically asking because I want to take scale out of the equation, as it's the most obvious factor. If you're buying hundreds of HVAC systems in a market, you're going to get a better deal than if you're buying five. So, let's discuss how the LGI way drives advantages, focusing specifically on purchasing.

Here, predictability equals profitability, as an inventory. Take scale out of it, take economies of scale out of it. Being able to predictably plan the house, spec the house, set scopes of work, give trade partners proper expectations, build an effective schedule, sequence correctly, have the land team prepare the lots to allow the others to move quickly, set the towns and municipalities up for success, and set the inspectors up for success. Ultimately, in the question you're asking, it's about making sure you can get suppliers. Your job as purchasing managers is to ensure the right things show up in the right place at the right time, in the right quantities, for the right price. If you can do that predictably, you'll profit every single time.

You can math it out and know you're going to build this house on this lot, it fits. No options, no changes, be here on this day, have this stuff show up, have this person show up to install it. Because you can do that, and the better you do it, the more profit you make, the more profit the trade partners make, and the more profit the suppliers make because they can predictably manage their business around that. You have dwell time in storage and supply houses, hiring and scheduling predictability with trade partners. People can then say, "If I just knew what I had coming, I could predict my business." Other than interest rates, economies, and political ire, if you can just manage your business, predictability equals profitability. That's your competitive edge.

I know having a small number of floor plans and very few options, and everything being so much more standardized with the way they do things than a lot of the competition, feeds into the predictability you're describing.

Correct. That predictability also leads to the economies of scale you mentioned earlier. You can increase your economies of scale because you're buying the same items repeatedly for spec levels. While it's true that you have buying power, you can dilute that power with too many options and changes in customer sentiment and trends. But if you know you're going to buy a certain number of items, predictability equals profitability, right?

I didn't mean to downplay the importance of scale. I just meant not to focus on it because it's both important and obvious. I want to delve more into the nuances, the less obvious aspects of this.

I totally understand.

How should I think about quantifying this advantage, this predictability equals profitability advantage?

That's a good question. Without getting into the NPI of the scenario, your ability to predict build pace based on sales pace involves formulas for everything. LGI's releases are based on a formula that allows them, based on past sales, to predict that pace. I might not be perfectly answering your question, so feel free to clarify. On the earnings call, predictability allows them to make decisions based on what the leadership team says, given their history of predictable success. When you hear Charles Merdian the CFO, or Eric Lipar discussing past performance and financials, they're aiming for specific gross margins and absorption rates. They have over a decade of experience since going public, demonstrating that they consistently hit those metrics.

If they say something is going to happen, there's a very high probability it will. The proof is in the pudding. They are one of the few, if not the only, builders that puts forecast projections out there. They do this in the spirit of predictability, so the investors, partners, shareholders, and firms can trust that LGI will do what they say.

I don't mean company-wide, like predicting absorption for the year, multiplying by the number of communities, and then by 12 to estimate home sales at a certain gross margin. I'm talking more about negotiating with an individual subcontractor. How much cheaper or quicker does building a home the LGI way help compared to a competitor's method?

That's a fantastic question. LGI's construction team builds out a schedule. Let's say, for simplicity, they can build a house in 100 days. They build in sets, meaning if they release six houses, they might be built in two sets of three. Three houses will be on one schedule, and the other three on the next, usually staggered by one or two weeks. When they say they can build a house in 100 days, they can actually build three houses in that timeframe because they follow the same schedule. For their trade partners, this means very few, if any, dry runs. Crews don't have to be moved around unnecessarily, so they enjoy working for LGI, or whoever they're subcontracted by. They consistently pay, but they're not the highest margin.

Is that a company-wide thing?

Yes, it's company-wide.

It's also a good thing when moving into new markets and working with new contractors.

Correct. So, the subcontractor negotiates great hourly rates with the crew, and they don't charge LGI. That's because LGI is predictable, and they can ensure they have schedules.

Now, building in sets means that for materials like stone veneer, glass, and shower doors, the truck uses the same amount of gas to deliver to three homes versus one. Competitively and margin-wise, trade partners understand that if they can deliver or install for three houses in one trip, they gain economic value, which they pass on to LGI. Even if the margin per house is lower, doing three houses with the same effort or trips makes sense. That's where they see the economies for themselves. Quantifying it means showing up and doing the work when promised. Building in sets benefits LGI's trade partners from a negotiation and purchasing standpoint.

When negotiating, LGI start with what's most important to the trade partner. For instance, if a trade partner has a great crew for custom homes, which are high-margin but infrequent, they can work with LGI Homes. They provide competitive pricing and margins, complete three houses in a few days, and then return to their custom jobs.

They benefit from LGI's scheduling reliability. This keeps their crew busy, ensuring they always have foundations to work on. From a negotiation standpoint, this is advantageous. LGI identifies what's most important to them and uses it to help build their business while keeping theirs running smoothly.

Additionally, because of the advantages LGI implemented in their home building, they don't always need the most skilled trade partners. They can use less experienced framers or newer crews, which is also an advantage.

I know other builders have noticed LGI's success with this approach. Even some larger builders have started to emulate parts of what you described. Would you say that the "LGI way" encompasses everything we've discussed here?

The gap between LGI and some of the larger builders, like in the Denver market, has the competition shrunk over the last five or 10 years as more people have copied what they're doing because of their success?

To be completely transparent, to a certain degree, yes. Anytime you emulate success with professionalism and quality, you're going to experience some level of that success. However, no one has done it the way LGI has. They still remain the top dog by far. For example, I met with someone from Century, and they mentioned they're doing what LGI did. I acknowledged their beautiful home and great product, and we discussed their selections and approach. So, while there has been some erosion, I would call it negligible or insignificant. It hasn't significantly impacted LGI's business.

I'm sure there's a buyer who purchased from a competitor instead of LGI due to their implemented product or system. It's foolish to think there's no impact, but I consider it negligible. The reason I'm confident is because LGI's marketing and sales expertise set them apart by leaps and bounds. Building a house can be easily replicated, but LGI's sales and marketing acumen is unique.

It's about who they market to, how they market, how they treat individuals when they walk in, their sales systems and processes, and delivering a quality product on time and on budget to meet their affordability matrix. This is where LGI leads by strides. Even those claiming to do it like them have nuances. They might have a move-in package, but it's not complete. They might exclude certain features. So, even if others are trying, they're not doing it 100% the way LGI does it.

Like a lot of home systems, if you copy it but miss two or three things, it doesn't work because everything supports everything else, correct?

Correct.

In the last couple of minutes, I'd love to discuss the goals process and how goal setting drives the company daily, monthly, yearly, and beyond. We've talked about the monthly goals for each employee and the monthly review process. I'm also aware of the company's longer-term goals, like the top five builder goal.

I'll answer your questions in reverse. As long as they are framed and presented correctly, they are significant drivers. They influence many aspects of the business. Depending on your personality and belief in the company and your future success, these goals can be motivating. Having those BHAGs, big, hairy, audacious goals, as the author describes, is important. I believe that's from "Good to Great."