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MDC Holdings, Inc. (NYSE:MDC)

Citi 2013 North American Credit Conference Call

November 6, 2013 11:00 AM ET

Executives

John Stephens – SVP and CFO

Analysts

James Finnerty – Citigroup

James Finnerty – Citigroup

My name's James Finnerty. I cover homebuilding industry on the credit side at Citi. It's our pleasure to have management team from MDC Holdings with us today. Today's presentation is – format is in the form of a fireside chat. The management will make some opening comments, after which we will try to lead an interactive discussion. Hopefully, some questions from the audience will be part of that. And with that, I'll hand it over to John.

John Stephens

Thanks very much, appreciate it. Welcome everybody. Hope you are enjoying the conference here. I’ll go ahead and run through a few slides. Give you a little update on MDC. I am not sure how familiar you are with the company. MDC, well, first before I get started, there is forward-looking statements that I might make throughout the presentation and you should take the caution and there are number of risks and what not that lead to coincide with that.

At MDC, we’re based in Denver Colorado. Been in business for over 40 years. Our company is led by Larry Mizel, our Chairman and CEO and David Mandarich, our President and COO. Been together, they’ve been partnered for over 37 years and obviously a lot experience in the homebuilding side.

One of the largest homebuilders in the country and we’ve built over 175,000 homes over the period of time we’ve been in business. Currently operating at 11 states and as of the end of the third quarter, we had 134 active selling communities and that is on the rise.

So some industry data that we’ve included in our presentation. I am not going to spend a lot of time on this other than the fact that things are improving and have been improving new home sales have been improving, coming off obviously very low levels.

We’ve seen new single-family homes at pretty low levels and we are seeing that lot of markets we are in where there is the resale inventory is coming down quite a bit, the months for sale is quite low which is really helped – I think the new homes side of the business over the past 12 to 18 months.

Here is the footprint of where we operate. You can see Denver, obviously that’s our home base for actually down in the Colorado Springs a little bit too and then heavily in the west.

You can see that we have a big presence in Arizona, in Phoenix and Tucson also in Las Vegas and California, we are pretty heavy in Southern California with a big presence in the eminent part there. We do have some more coastal operations that are in play.

Now we are in Orange County in a few sub-divisions. We are looking at some opportunities down South in San Diego and then we’ve kind of expanded our footprint up in Northern California really over the last couple years. So, we are looking to expand there. We feel good about those markets. We are also in the Mid-Atlantic.

We’ve been in Virginian Maryland for a number of years and down in Florida, our home base was in Jacksonville, but we’ve recently entered into the Orlando markets earlier this year with a handful of new projects there and then we also have a new project down in South Florida in the Boca Raton area that we are excited about.

We are getting close to opening our model there and there has been nice interest there. And then also in the upper left quadrant of the slide is Seattle, we entered that market a couple of years ago and we feel like that’s a good market as well.

So that’s kind of an overview where we operate. I am not sure anybody can read this, but the point here is that, we’ve had seven consecutive quarters of profitability. We’ve really seen growth in our top-line and our bottom-line over the last 12 to 18 months and for the quarter, we had another very positive quarter.

We generated about $36 million of net income. A pretty significant increase over the prior year. We continued to see increases in our sales absorption pace on a year-over-year basis. We sold 2.3 sales per community. One of the things we look at as a homebuilder is how many sales per community or store front are we generating.

And so that's something we pay very close attention to. We have also seen, increases in our average selling price and a lot of that's been with an uptick just in general pricing and we’ve been very disciplined in looking at our communities clearly on a weekly basis to determine whether there is opportunities to raise our prices if we are seeing pretty strong demand at each of our communities.

So, that’s something that we’ve seen kind of forming through our top-line, our revenues and our gross margins which kind of leads me to my next point. Our gross margins are up pretty significantly, there is about 270 basis points, third quarter this year versus third quarter last year and a lot of that is having to do with us really managing our pricing and the increased demand we’ve seen in our markets.

Moving on, this is just some more information on the quarter year-over-year data. We’ve also seen our, we’ve really improved our operating leverage. I think we’ve increased our gross margins as low as reduced our SG&A percentages. So, we’ve been able to generate obviously a much better operating leverage with increased revenues and demand on the order delivery side.

This is just some graphical information on our orders and cancellations. Again, this is obviously a key metric for a homebuilder and as you can see in the middle part of the slide, kind of what the quarterly progression. We typically see stronger order activity in the first couple quarters of the year and then it tapers off in Q3 and Q4 from a seasonality perspective.

But you can see from this graph our sales absorption pace for the third quarter compared to last, were still up on a year-over-year basis. And same with our cancellation rates. Our cancellation rates are typically slower as a percentage of gross orders in the first couple quarters of the year and then typically it creeps up as we move into Q3 and Q4.

Although at these levels a 26% cancellation rate it’s really kind of where we’ve been ranging historically. So it’s nothing that what we see is problematic at this point in time.

This is an overview of our SG&A expenses, and our percentage of revenues. It has been growing. I think part of it is, we’re waiting for a lot of these communities that we purchased a lot of land over the last several quarters, coming to bear.

And we talked about in our earnings conference call that we’ve seen an uptick and are soon to be active communities which is a metric that communities whether we’ve opened or just getting ready to open, the models are about complete. Maybe we have a few sales, we don’t really count communities open until we have five sales or more.

So the point is we’ve got, we were at a plus 16 in terms of soon to be active communities versus our soon to be inactive communities. So we believe that, before the Spring selling season, we’ll have significant increase in our community count.

MDC has got a very, very strong balance sheet and that’s one thing that the company and the board and obviously our founders have predicated the company on and we’ve got a very strong balance sheet – a strong liquidity position. As of the end of the quarter, we had nearly $800 million of cash and marketable securities.

And we also have very low leverage ratio. Our net debt to cap at the end of the quarter was about 20% and then we also carry a lower land supply. We would generally like to keep about a two to three year land supply.

We believe that if we are able to purchase lots and kind of keep that three year land supply we are able to get in-and-out of communities very quickly, and be very targeted in our land strategy in terms of putting capital on markets where we see better opportunities.

We would prefer to do more finished lot deals just those were available but of course, we’ve also been very comfortable doing land development deals as well in the fact about more than half of our lots we purchased in the last couple quarter have required some sort of development.

So we’ve seen a shift away from that. One thing to note on our inventory is we really have no – what we call mothballed communities, communities that are a sweep or currently not after. Everything we have is currently selling, delivering houses or getting ready to develop and sell houses.

So I think that’s a very strong point about MDC’s balance sheet again. Not a lot of dead assets on the balance sheet. Everything we have is active and transparent. All three rating agencies we ranked very highly with them. We have investment grade rating with two of the three agencies currently.

And most recently in the second quarter of this year we benefited $185 million deferred tax asset that we put back on our books for some of the assets and NOLs that were created during the downturn we are able to shelter our income substantially from a cash flow perspective. And we put that asset back on our books in the second quarter.

Just a couple comments on our gross margins. This is an area that is very high focus for obviously the investor community as well as the company. This graph kind of depicts us going back to 1997. You can see the period of time coming out of the last downturn where the company was able to really increase its gross margins pretty significantly over a four, five year period.

You can see on the graph here we grew our gross margin by 870 basis points during that period of time. And you can see on the right hand side, we want to show comparison of where we were really at the bottom that’s 2011 what we would considered, probably the bottom of the last cycle here and you can see our gross margins are up 420 basis points in just under a two year period.

So, we’ve really made nice progress here with our gross margins, and being disciplined from an execution as well as pricing standpoint. This next graph kind of builds on that and it shows, where our gross margins have been historically if you go back to the early 2000, before you get to a period of time where things maybe a little over-exuberant in 2004 and 2005.

You can see that we generated low north of a 20% gross margin. You can see kind of the 22% range with operating with a three year land supply. So, we believe that – and we can continue to operate with a three year plus-or-minus land supply and still generate pretty healthy gross margins.

And you can see that on the right hand side of the graph where we are currently operating from a year supply and you can see the improvement in our gross margins. And during the last ten years, we really had pretty strong margins and again with operating with this level of land supply.

This is just the graph that shows an overview of really, we’ve been very active in the land market over the last really 18 months and this shows the last five quarters, the number of lots we purchased in each quarter and you can see our land supply growing. We grew our lot count by over 50% on a year-over-year basis.

We got nearly 16,000 lots that we own or have under our control right now. Just some more graphical information on our lot supply. And then the other thing to point on our lot supply, again as I mentioned earlier, our preference would be to have finished lots for lots we can take the market quickly and we can – we generate a sale we can get a house started and convert that into cash in a pretty quick manner.

You can see that our finished lot supply of what we currently own and control is just under two years that’s at 1.8 years. So we’ve got plenty of lots to build on now and you can see that it’s higher than where the peer average is about 1.3 years. So, it’s really important not only to your supply but – what is the makeup of those lots, how many are kind of raw versus ready to go.

So we feel like we’ve got a good lot supply for 2014 and really a large portion in 2015. So a lot of what we are working on now is for 2015 and beyond.

So with that, I will open it up to questions or back to James.

Question-and-Answer Session

Unidentified Analyst

So we’ve been asking all the companies that presented today a couple questions that are topical. Like I have mentioned earlier, we are hosting a Housing Finance Panel later today just after this actually. And, we know that’s got the changing landscape of housing finance and what impact it could have on the industry.

So, just a couple brief questions is that, do you believe that there will be change in housing finance and in terms of Congress actually getting together and having the will to do something with Fannie and Freddie and FHA or do you think that the political will really isn’t there on that more likely that’s close where we are going to get into 2014?

John Stephens

Well, obviously, the recoveries I think is very important on the housing side and I think that, my sense is that, we want to be – the administration and Congress and government wants to make sure that, hey we have a reasonable recovery here and we don’t stall at or pull out the rug from underneath that.

Such that it would have a negative impact or a significantly negative impact. I think you’ve seen FHA, they’ve raised their insurance premiums which to increase their reserve balances and what not.

I think we’ve seen a shift as a result of that is that MDC where we’ve seen more home buyers move from maybe an FHA product to – well, still a large percentage of our loans over to more of a conventional – and obviously you’ve got the QM rules to go into effect I think in early January.

So I think there is some change there but I think that, I think that are going to be or it would be prudent to be cautious there and not change it too dramatically, too quickly.

Unidentified Analyst

And then – and a related sort of topic, that’s everybody always wants to know what’s happening with mortgage availability and will it be a headwind or a tailwind for the industry? What are you seeing in your businesses, have buyers gotten or benefited from better mortgage availability?

John Stephens

Well, currently the mortgage market is tighter than it was during the mid-2000 period of time which made sense in terms of tightening that up a little bit. We’ve been able to – most of our buyers have been able to procure a mortgage.

What we’ve seen recently with the refinance business kind of drying up so to speak that we see more competition from some of the larger institutions that maybe on the purchase side of the market where we haven’t seen it to go back a year or so ago, maybe not as much.

So, we have seen more competition there which is, I think good from an availability standpoint. And we've seen buyers come back to the market that have had maybe a short sell or foreclosure and if you have a FICO and you have a job, generally you can get a mortgage.

Unidentified Analyst

It seem that myself in that – looking at purchasing a house and I sort of let it – lie for with it and actually the bank called me up and asked me what happened. We want to give you mortgage. They are actually chasing down leads instead of having people come to them. So it’s like with that refi business.

Moving to order growth, another topic that’s been on investors’ minds just past earnings season with orders coming in below what people were expecting, maybe investors, maybe analysts and the pace of order growth was decelerating.

People point to price appreciation, citing mortgage rates, the government shutdown all that leading to sort of a weaker consumer confidence. If you were to rank those three topics, I don’t know three drivers, which one do you think most, is most likely the reason for order growth actually slowing?

John Stephens

I think it’s a combination of the magnitude of rates increasing at a short period of time, the fact that you’ve seen 100 basis points movement in the mortgage interest rates in the short period of time, really coupled with the sharp level of price increases we’ve seen, a lot of the other builders have seen as well in terms of 10% to 15% increase in prices on top of a 100 basis points increase in mortgage rates.

And I think also, that was during a period of time, where it’s generally a seasonally slower time of the year. This summer is – typically it does slowdown from the spring selling season and I think all those things couple together.

Really, I'd say rates and price. Price increases were probably the biggest factor that slowed order activity a little bit. I think, buyers maybe took a step back and paused and reassessed where they were at, and wanted to see if rates were going to come back down, we just have all that.

Unidentified Analyst

And another question we’ve been asking is that, have you noticed in areas where you’ve raised prices more of that order growth was materially different from areas where you didn’t have that price inflation?

John Stephens

Well, we typically raise prices more where we’ve seen the better pace. So, the West and Colorado are the areas where we’ve seen better price appreciation and higher demand. So we’ve been able to kind of have a more systematic raising of prices.

But, if you look at our order activity for the third quarter, the West and the places where we did increased prices the most, really over the last 12 to 18 months had the highest absorption pace.

So, one way, it did slow down absorption from, let’s say Q2, from Q2 to Q3 which again, part of that's typical and normally what we'd expect. We did see higher absorption pace like in our Arizona, California and Nevada markets.

Unidentified Analyst

Interesting. Now, in terms of price increases, you had stated that they moderated in the third quarter. Would you expect a more normal live kind of situation where you have 3% to 5% price increases going forward on an annual basis versus the 10% to 15% to whatever teens percent increase that we saw in some of the areas over the last 12 weeks?

John Stephens

Yes, we would expect a probably a more normal pace of appreciation in that 3% to 5% range versus the 10% to 15% that we saw most recently. I think that – what we’ve done is we pulled forward some of the pricing increases earlier in the process as things have bounced back.

But, yes, and we don't think that’s necessarily sustainable at those levels but I think a more normalized pricing environment probably makes sense. And you know, it's good for us in the long run.

Unidentified Analyst

In prior revamps, were there price increases so large to what we’ve seen with 10% to 15%, 20% on an annual basis.

John Stephens

I think, there is a period of time where you’ve seen that where there has been a significant bounce back or mortgage availability was really trying to fall, we’ve seen significant price increases there. But again, is that a sustainable model and probably we are better off having a more kind of normalized.

Unidentified Analyst

And as soon as there is better mortgage availability, it would be a lot different.

John Stephens

Yes.

Unidentified Analyst

Okay, better. In terms of gross margins, we’ve seen, despite the falling pace of order growth gross margins have expanded as you pointed on your side. So, is it safe to assume that over the next couple quarters given that you have all those backlog which has price increases and that your gross margins to be where they are actually continue to expand?

John Stephens

Well, I think it’s a lot of factors involved there. I think, as we see more demand and more volume, I think obviously there is opportunities for us to increase our gross margins. As we see more demand in turn of our inventory, we start to see reductions and things like your interest as a component of cost of sales.

And your indirect construction spend, you start to get some more volume efficiency there. So I think if demand does continue to improve there is an opportunity for us to continue to improve our gross margins. And as I showed in the slides, we would like to get back to levels where – at kind of the 20% range gross margin.

Unidentified Analyst

And now moving on to land. We’ve seen certain West Coast, you’ve seen price appreciation in terms of lots and there is a lack of finished lots et cetera and it’s driving many buyers looking for a limited quantity, it’s driving price appreciation. During the third quarter, did land prices seem to actually appreciation stabilized at that? Did the market sort of taken a breather as well?

John Stephens

I guess that the rate of increase to what we’ve seen in many of the markets we’ve in has kind tampered as well. And we are seeing, maybe some resetting in certain markets or locations where perhaps other builders have – maybe filled their plate and their appetite is full for now and maybe we've seen a pull-back on moderation out there.

But I think what contained kind of evaluate that as, as home prices have maybe, perhaps they are leveling out little bit more that we would expect to see the land sellers also adjust their pricing accordingly too. Because again, they are going to set their pricing based on where they see the demand from the builders, and what type of home-price appreciation is out there.

Unidentified Analyst

And specifically, for your business, Steve, when you are purchasing land, do you have a price functions and in terms of price increases to get to your targets, whether it be gross margin or internal capital?

John Stephens

We are really not putting in price appreciation or models we are doing or underwriting. I think what we want to do is underwrite what type of gross margin and internal rate of return can we generate from what’s currently be installed in the marketplace. Whether it’s a competitor’s sub-division, one of our other’s sub-divisions in the market.

And then you don’t have an understanding of maybe what directionally, which way these markets are going and if you do have left, what that might do to your returns. So we are really not underwriting with that assumption in there. We have to have depreciation to get the underwriting done.

Unidentified Analyst

Then moving on to cash, most of the builders have generated lot of cash on the way down and started utilizing it to replenish their inventory. How would you rank between debt reduction, returning cash to shareholders, and just investing in the business whether it be buy acquiring lots or builders et cetera. How would you rank those in terms of reporting trends you see?

John Stephens

Well, I think right now, really what we’ve been doing over the last year and a half is really reinvesting in the business. So, we’ve grown our inventory by over $300 million on a net basis from the beginning of the year. And we would like to think that we would continue to invest in the market as if we're seeing good returns and adequate inventory turns. So our first priority would be back in the business.

We do have some debt maturities that are coming due in the next 13 and 19 months, I believe, respectively. So that would be another source of capital use. And then obviously the company has paid a dividend over the last several years and although we accelerated our 2013 dividend into 2012 that would be tightening that.

Yes, for tax reasons and for some of the uncertainty with the fiscal cliff issues that were percolating at the end of last year. I think that would be something else the company would consider uses of capital for it.

Unidentified Analyst

And in terms of your liquidity, you have cash in your revolver availability and part of the downturn builders tend to use the revolver and in turn the revolver out with permanent debt. Do you have any different viewpoint in terms of utilizing a revolver post the downturn or is that you…

John Stephens

Well, currently, we do not have a revolver. We have – really haven’t had the need, so we’ve extinguished that a few years back ago.

Unidentified Analyst

I was thinking that when I say that.

John Stephens

Yes, so, but that is something that the company has done historically over a period of time where if you have an adequate level of liquidity in a revolver in place and feel more comfortable. I think that we always want to make sure we have an adequate amount of cash and liquidity on hand, in addition to have any revolver?

Unidentified Analyst

Right.

John Stephens

But I think if you have a revolver in place, you are more comfortable bringing that cash balance down over time.

Unidentified Analyst

Down.

John Stephens

As the market continues to grow.

Unidentified Analyst

And what would be a normalized cash balance if correct recovery continues that you’d like to have either on minimum cash balance or…

John Stephens

Well we’ve really haven’t set kind of targets in terms of – what the cash balance we want to have on hand, but we want to make sure we have enough liquidity again in the form of a revolver and cash.

Unidentified Analyst

Right.

John Stephens

But, I’d say, probably don’t want to go too much below $100 million, $200 million. I think in the past, we have gotten much lower on that and have operated with much more minimal amount of cash. But we will just have to kind of evaluate that as we go through the cycle here.

Unidentified Analyst

And in terms of uses of cash with the M&A, has MDC historically participating in M&A throughout its history?

John Stephens

Well, the company has done some acquisitions. We did a much small acquisition a couple of years ago into the Seattle market as I mentioned earlier. Also prior to that, there were some acquisitions that were completed I think in the early 2000.

Unidentified Analyst

Right.

John Stephens

I was not at the company then, but there was some activity there to kind of supplement our existing operations and, we’ve done a lot of Greenfield expansion as well, like Orlando and South Florida. So I think that would probably be our preference, but would look at opportunities that makes sense, if that was a right market or right fit from a land portfolio perspective or perhaps management team. But the company hasn’t – has been more of a Greenfield kind of expansion versus pure acquisitive.

Unidentified Analyst

And, I guess, we have about ten minutes, if there is any questions in the audience, we’ll take them now. All right.

Unidentified Analyst

(Inaudible)

John Stephens

Well, we thought, July and August were slower months for us in the quarter, September actually picked up a little bit and it was our highest order month for the quarter. So, we did see a little bit of pick up there and I think the comment on our call, October the tone, the traffic was pretty good.

We didn’t really give an order number out because, we didn’t have one at that time. I think it did improve throughout the quarter. It starts by an interest rate during the period of time on top of pretty significant price increases and I think as rates kind of came back down, people started coming back a little bit.

Unidentified Analyst

And moving back to couple credit specific questions, you highlighted that, now you have investment grade ratings through the agencies and maybe one will happen – get three given the market is recovering, do you have targets in terms of what you might willing to be – is it just to be investment graded and that’s Triple B? Do you have credit metrics that you specifically state that you would like to maintain?

John Stephens

Well, I think in terms of the investment grade rating it’s so important to the company. I think the company is part of the way we operate our company we want to be conservative and have good discipline, how we go about our business, whether we buy a land or price a product or how long do want to go out on the spectrum on the land side.

So it is something the company works very, very hard to get and maintained its ratings for the most part with two of the three during the downturn and it’s something that we are in continuous contact with the rating agencies to make sure that we are giving them the right level of information they need to do their analysis.

And it is important to us and I think in terms of credit metrics, I mentioned earlier our debt to cap is about 20%. If you go back and look at where we kind of operated over the last 10 years, that was probably in that 35% to 40% range.

Unidentified Analyst

That’s on a net basis?

John Stephens

That’s on a net basis, right. So I mean it was lower for a period of time and then obviously with a downturn some impairment it did spike back up a little bit, but we want to kind of keep our focus on maintaining an investment grade rating and to make sure we are balancing that with the range of business appropriately too.

Unidentified Analyst

And another topic we’ve been discussing today has been optioning lots and there is more availability to option lots now. How is that impacting your business? And historically what did you – what’s your percentage of owned versus…

John Stephens

Well, I think right now, the amount of lots we’ve optioned is so much smaller percentage. Lot of the markets that we are in like in California, perhaps, Phoenix, even in Colorado we are not doing as much optioning as, maybe we did in the past.

I think over time as more developed lots become available, as the markets improve, there would be more opportunities to option and we like options. I mean, options are great. It allows you to maximize your capital and turn your inventory quicker. But, and so we’ll do options where we can, but it’s a much smaller percentage now more it’s been historically.

Unidentified Analyst

Just based on availability of having…

John Stephens

Yes, and it’s really a market-by-market thing too. So, for example, in Florida we tend to see more option opportunities there and maybe we would see like in the California.

Unidentified Analyst

And you mentioned Florida, I was curious about this. There has been several builders that have announced that they’ve gone into Orlando. What’s attractive about the Orlando market that it’s sort of taking people coming there to open new operations?

John Stephens

Well, I think there is good permit activity and good job growth and good demographics that we see there. It’s also friendly to a merchant builder versus some markets maybe aren’t as friendly in that regard. So we see an opportunity to kind of grow our community count there and actually get some pretty good volumes there.

Unidentified Analyst

And is there also demand potentially from outside the country, in terms of people wanting second homes in and around the Orlando area?

John Stephens

Well, I think there is – in my understanding, there is kind of a heavier English buyers there that – there is some demand there from that side from a second home perspective in that market. I know in South Florida you have the South American buyers from time-to-time at those…

Unidentified Analyst

Just like the results.

John Stephens

Yes. That drives that market a little bit, too. Yes, so we have some demand in those markets.

Unidentified Analyst

Right. Any other questions in the audience?

Unidentified Analyst

(Inaudible)

John Stephens

I think, with the fact that as we came out of the downturn we converted a lot of land into cash and we had a very high level of liquidity. So, it really wasn’t a need to have a revolver in place during that period of time.

We had well over $1 billion of liquidity and so to have a more restrictive maybe package in place with paying fees didn’t make sense at that time. But again, as we are starting to redeploy our capital and as the markets improve, that’s something that we will continue to evaluate and look at.

Unidentified Analyst

(Inaudible)

John Stephens

I don’t know that it’s necessarily held us back per se, but I think that it’s something that we do discuss with the rating agencies and we have a very open dialogue with them and this is a matter that they’ve written about in some of their credit reports on us and again, we will continue to evaluate that. Again, it probably has something in place once – as we continue to move through our capital here, yes.

Unidentified Analyst

Okay, well, that’s the questions I have. So we can wrap it up a slight bit early.

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