As my past article history will attest to, I clearly believe that most stocks that are associated with housing are quite frothy at the moment. This point of view certainly encompasses the homebuilder stocks. However, there is one of the top 10 publicly traded homebuilders that should see substantial upside if the builder rally were to continue. If you desire to have exposure to the homebuilder sector, the company to own today is M.D.C. Holdings (MDC). For a myriad of reasons detailed below, MDC is substantially undervalued when benchmarked against the other top builders. The company went through the same cycle of asset impairments, contraction, and survival mode as its peers went through during the past five years. There are no skeletons buried on the balance sheet, and the business model employed by MDC involves significantly less risk than its competitors. For all of these reasons and more detailed below, MDC is the builder you should buy today. This article will detail why MDC offers by far the most upside, in addition to the best risk/reward profile, in the homebuilding universe.
Background On The Company
As is the case with many of the homebuilding companies, what is known as M.D.C. Holdings today came together through a series of mergers and acquisitions over the years. The roots of the company can be traced back to 1972 when Larry Mizel founded a small development company with $50,000. Four decades later, that $50,000 investment by Mr. Mizel has grown into what is today known as MDC Holdings. Mr. Mizell has maintained his role of leadership in the company and is currently the Chairman and CEO. After four decades in homebuilding, it is a fact that Mr. Mizel has seen all the peaks and valleys the business has to offer.
M.D.C. Holdings is the parent company of Richmond American Homes. Richmond American Homes is the brand under which the company markets its home and communities. The company currently operates in the following three regions and 13 states. (1) West (Arizona, California, Nevada and Washington); (2) Mountain (Colorado and Utah); (3) East (Virginia, Florida, Illinois, Maryland, Pennsylvania, Delaware and New Jersey). The company also operates HomeAmerican Mortgage Company whose main purpose is to provide mortgages for Richmond American home buyers. Almost all of the top homebuilders have a mortgage company as a subsidiary primarily to support the homebuilding operation. The mortgage subsidiary of MDC differs from the other builders in that it currently generates significant profits, which is a notable point explored in more detail later.
Diverging Recovery In Stock Price
The rise and fall of the housing industry, as well as the homebuilders, should not be a foreign subject to any investor. Where the story becomes more complicated, is the divergent paths that the homebuilder stocks have followed since the crash. The Homebuilders ETF Index (XHB) provides a good barometer for tracking the group of builders. The chart below is over-layed specifically to compare the stock performance of MDC against the Homebuilder Index:
MDC data by YCharts
You see in the chart above that since 2008, when the housing crash was in its darkest hour the XHB Index is up about 38%, whereas MDC is down about 16%.
Here is another relevant chart comparing the stock performance of Toll Brothers (TOL) against MDC over the same period of time. Toll Brothers is widely known as a luxury homebuilder. Less widely known is that MDC is the builder closest (excluding NVR) to Toll Brothers in terms of the price point at which they sell their homes. The following chart compares the stock price action of Toll Brothers and MDC over the past five years:
MDC data by YCharts
With this chart, you also see the divergence in price action in almost the same manner when comparing MDC against the XHB Index.
The price action would lead you to believe that MDC operationally is vastly underperforming its homebuilding peers. This would be an incorrect conclusion. The stock price action represented above serves to form the foundation for why MDC has significant upside compared to its peer group.
What Will Drive The Stock Higher?
The long answer to this question lies in the financial analysis, tables and charts shown throughout the article. The short answer is a reversion to the mean valuation exhibited by the entire homebuilder group.
The table below shows selected financial data for the top builders by market capitalization. The data shown in this table will be used to explain why MDC is significantly undervalued compared to its peer group.
The first two columns of data to review are the "Reported Price-to-Book Ratio" and the "Adjusted Price-to-Book Ratio." The price-to-book ratio is an extremely useful tool in valuing homebuilder stocks. It measures how far above book value, or assets minus liabilities, the company is currently valued. The column that references the adjusted book value is the key column for the builder group. Without getting too deep into GAAP, the homebuilders generated massive deferred tax assets as a result of its losses during the housing crash. These tax assets are not always reported the same way by each company for wonky accounting reasons. However, they carry the same value to each company whether they are currently on the balance sheet or not. Thus, the need to adjust the reported price-to-book ratio. The graph below shows the adjusted price-to-book ratio by homebuilder:
If you focus on MDC, you will notice that it is trading at the second-lowest adjusted price-to-book value of the group. The companies that MDC compares to the most from a size standpoint are Meritage and Ryland. You will see that both of these companies are valued at about 50% more than MDC on this metric. There is no fundamental reason why these companies should trade at such a higher price-to-book valuation than MDC. This is one, if not the most fundamental reason that MDC has 50% upside if you believe the homebuilder rally will continue.
An additional catalyst for upside growth from MDC is the misunderstood Gross Margin % story. If you refer to the table above, you will see MDC has one of the lower GM%s of the group. This is one of the only reasons that the stock theoretically should trade lower than the peer group. However, I believe the GM% reported by MDC is misleading for two key reasons.
The first reason is shown in the table above in the form of the "Gross Margin Per Home" column. Although MDC has the second-lowest GM% of the nine builders shown, it is in the upper half of the group in terms of GM% per home. In a nutshell, this means that because it sells its homes at a higher price point it can still generate the same or more cash per home sold as its peers that may have a higher GM%.
The second reason is slightly more in depth but must be understood as it is also a key thesis as to why MDC has so much upside. I noted earlier that the mortgage operation is significantly profitable for MDC. For most homebuilders, the mortgage operation is focused first and foremost on making it as painless as possible to get its home buyers financed and closed. Having a mortgage operation that generates a material profit is just icing on the cake. My assumption is that MDC is choosing to differentiate itself by offering more competitive financing than competing homebuilders. What this means is that the homebuilding operation is essentially paying the mortgage operation. This is done so that the buyer either has a lower interest rate or less to pay in closing costs. As an example, assume the homebuilding operation pays a 1% mortgage origination fee to the mortgage company on behalf of a home buyer. This 1% origination fee, on an average selling price of about $320,000 that MDC is currently at, impacts the GM% by 320bps. Put another way, if MDC was to stop paying the mortgage company a 1% fee for each home its GM% increases from 16.7% to 19.9%. This is extremely beneficial point to note because analysts and investors alike do not give MDC credit for the success of its mortgage operation. They assume it is unsustainable. I am suggesting that there is a strong possibility that it is sustainable because the profits are actually just being shifted from the homebuilding line to the mortgage line. At the end of the day, the benefit to the company is the same if the profit comes from the homebuilding or mortgage operation.
MDC Also Offers A Safety Net As An Investment
Even without the boom/bust cycle that housing just went through, throughout history the housing industry has always been known as a cyclical one. For this reason, owning a homebuilder also entails understanding the risk associated with that particular company. They serve different price points, employ different land strategies, and have other critical differentiating factors.
There are a number of differentiating factors about MDC that also support why it is the safest builder to own.
MDC pays the largest dividend in the homebuilder sector as shown by the chart below. The current dividend is $1 per share, which yields about 2.7%. It should be noted that MDC accelerated its 2013 dividend payments into 2012 due to the uncertainty surrounding the changes to tax rates last year.
MDC Dividend Yield data by YCharts
Land Acquisition Strategy
There are two different tactics employed by homebuilders when it comes to purchasing land. The first tactic is to buy raw land and develop it themselves. The second tactic is to buy finished land, which entails buying land where you are able to, immediately, start construction of homes on that land. Both land buying tactics have their advantages and disadvantages. The advantage of buying raw land is that the land is cheaper and that the potential for price appreciation exists during the time the land is being developed. The main disadvantage to buying raw land is the holding risk that comes with the time required to develop the land and ultimately sell homes on it. Evidence of this dynamic was seen by the enormous land impairments taken by the largest builders during the housing crash. Those builders such as Pulte (PHM), Lennar, and DR Horton (DHI), which had the largest land positions, also had the largest land impairments. Conversely, a builder such as NVR (NVR), which almost exclusively owns finished land through option take-down structures, had minimal land impairments.
MDC historically has employed the tactic of buying finished land. The advantage of buying finished land is that your return on investment for these types of deals is typically higher. You are able to turn your assets much quicker because you hold the land for a short period of time. You also have less risk of having too much land when a down cycle for housing hits. The disadvantages to buying finished land are that your costs are higher and that you potentially lose out on land prices appreciating.
If you look at the stock performance of the homebuilders, you clearly see some beta chasing. The builders that have seen their stock price and valuations rise the most are those that speculate in land. Investors are in turn speculating that these large land balances will appreciate. This is a risky strategy considering the housing market is in uncharted territory right now because of historically low interest rates and the amount of investors gobbling up housing inventory. For this reason, a builder such as MDC purchasing finished lots has significantly less risk when the next down cycle in housing occurs. Mr. Mizel, the company CEO, summarized the risk-averse land strategy the best on the last quarterly conference call:
And even though one could say it's not a perfect alignment, I go back to the history of what we have done in prior years, maybe even several decades that we buy land in line with the market. We do not speculate in land. We're not a large developer of land. And we've been able to create reasonable gross profit margins and also a very good return on equity, which is ultimately the driving point of what we're doing.
One other significant reason MDC also offers one of the safest profiles in the homebuilder space is its capital structure. Most homebuilders report their debt-to-capital ratio as part of each earnings release. This is a measure of how much debt, as a portion of combined debt and equity, the company is using to finance its business. A lower debt-to-capital ratio represents a less leveraged operation. It also provides the company with the ability to add additional financing when times are good and growth opportunities are available. When times are bad it serves as a safety net to have less debt and thus less fixed obligations. You will see in the graph below that aside from NVR, MDC has by far the best debt-to-capital ratio amongst its peer group.
You will note that the above graph references net debt to capital. This is because the ratio is being adjusted to reflect the amount of cash that each homebuilder currently is holding. Additionally, the adjusted terminology is because the total capital base has been adjusted to capture the deferred tax assets noted previously in the article.
Recap Of The Investment Thesis
Opinions vary widely on the housing recovery and whether or not it is sustainable. If you are in the camp that believes it is sustainable then MDC is the homebuilding stock that offers the most upside as detailed throughout the article. The homebuilding sector is a beta play and many investors desire to have exposure to this sector at all times. It is prudent to understand that all homebuilders are not created equal. Investing in MDC offers the most upside potential without the downside risks that some of the larger builders carry.
With MDC, you also are investing in the highest-yielding dividend stock in the homebuiding universe. This is in addition to MDC being a company with a debt-to-capital ratio that provides opportunity in good times and bad. The ability to add additional debt to fuel expansion will be a key reason MDC will outperform its peers if the housing recovery continues. Further, this low debt-to-capital ratio serves as a buffer in the event the housing recovery stagnates. In this event, where land and debt-heavy builders scramble to sell assets and raise cash, MDC will have the financial flexibility to take advantage of their misfortunes.