Is This Homebuilder's Hefty Dividend On Solid Ground?

Jun.29.14 | About: M.D.C. Holdings, (MDC)

Summary

It's difficult to avoid backward-looking dividend analysis, but investors must focus on the future.

The Dividend Cushion is a forward-looking measure that assesses a company's dividend on the basis of the firm's cash flow generation and balance sheet health.

Let's examine the industry-leading dividend payer in homebuilding, MDC.

Investors that think homebuilding is a good business need to look no further than the recent housing crisis to get a feel for what could happen when things go wrong. Still, M.D.C. Holdings (NYSE:MDC) has been one of a few builders that has preserved its investment-grade credit rating through the crisis while paying an industry-leading dividend yield. But is the dividend safe? And will it grow in the future?

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Image Source: MDC

Let's start with framing this analysis for readers. Most dividend assessments tend to be backward-looking - meaning, the evaluation rests more on what the company has done in the past: how long it has raised its dividend, for example. Don't misunderstand. We think analyzing historical trends is important, but investors should understand that for a cash-rich, growing company to raise its dividend by a reasonable amount in each of the past 20, 30 or more years isn't much to write home about.

Imagine, for example, giving your grandson $1 for his age on each consecutive birthday. Though you'll effectively be raising his "dividend" each year, the payout isn't necessarily tied to your income stream, nor is it very taxing on your lifestyle (even if he lives to 100 years or older). In a similar manner, a dividend payment is not explicitly tied to a firm's earnings stream, nor is it very taxing on a firm to raise its dividend each year. For one, firms with substantial earnings don't have to pay a dividend, and companies can report declining earnings and still raise their dividend in the same earnings release.

Over the long haul, earnings growth will have to support dividend growth, but in instances where the payout ratio is low, earnings don't necessarily have to expand for the company to raise its dividend for years and years. A company can double its payout ratio by raising its dividend for 50 consecutive years, for example, but the payout ratio at the end of the period could still only be 50% of earnings at the beginning of the 50-year period. Fascinating, no?

With all of this said, it becomes obvious that assessing the future capacity of growth of the dividend is really what matters most for dividend growth investors. After all, dividend growth investors are investing for the next 5, 10, 20 years, not the past 5, 10, 20. And they want their dividends to increase by a material amount. This forward-looking perspective that assesses the potential magnitude of future dividend growth is all the difference in the world. That is why we created a forward-looking assessment of dividend growth through the innovative Valuentum Dividend Cushion methodology.

For those that may not be familiar with our boutique investment research firm, we generate a discounted cash-flow analysis for all firms in our coverage. We use these future forecasts of free cash flow (cash flow from operations less capital expenditures) and expected cash dividend payments, and consider the company's net cash position to evaluate just how much capacity a firm has to keep raising its dividends long into the future.

The Dividend Cushion is a forward-looking ratio (with a numerator and a denominator). It tells investors how many times future free cash flow (cash from operations less capital spending) will cover future dividend payments after considering the net cash on the balance sheet, which is also a key source of dividend strength. It is purely fundamentally-based, and driven from items taken directly off the financial statements.

Let's take a look at MDC's investment highlights and then its dividend report to see how all of the analysis comes together.

MDC's Investment Highlights

• MDC's business consists of two primary operations: homebuilding and financial services. The firm builds and sells primarily single-family detached homes, and its financial services operations provide mortgage financing and title insurance. It has been building new homes under the name 'Richmond American Homes' for 40 years.

• After a half-decade of uneven price retreats, declining interest rates, and a whole lot of litigation, the US housing market appears to finally be on solid footing. A rising tide should life all boats.

• Though we're not particularly fond of MDC's balance sheet, the company is one of only two homebuilders to maintain an investment grade credit rating through the housing downturn. This is quite an accomplishment. Our coverage universe includes well-known firms such as PulteGroup (NYSE:PHM), Lennar (NYSE:LEN), Toll Brothers (NYSE:TOL) and even landowners such as St. Joe (NYSE:JOE), among others. MDC has ~$1.1 billion in liquidity and recently had no problem refinancing debt.

• Management's interest are tied to those of the shareholders. Chairman and CEO Larry Mizel and President and COO David Mandarich have 75 years' combined experience at MDC and together own more than 20% of MDC stock. We like that the executive suite has skin in the game.

MDC's Dividend Report

MDC's dividend yield is nice, offering a ~3.5% annual payout at current price levels. When we say nice at this point in the analysis, we generally mean that the dividend yield is above that of the average S&P 500 firm, and the yield is generally higher than the yields of some of the dividend growth bellwethers across industries.

When we use the terms strong or sustainable, we generally mean that the company's dividend is safe, and the firm has significant available cash-flow capacity to grow the dividend over time. Most dividend growth investors, as you can imagine, are not only looking for nice dividend yields, but also strong dividend payers.

Let's have a look at the table in the bottom right of image below, which reveals our expectations of MDC's future pace of dividend expansion. We publish dividend growth forecasts for all companies in our coverage universe that pay a meaningful dividend. You'll see that, while MDC pays a relatively high dividend yield, its dividend growth prospects aren't great. In fact, if you look closely at the table in the bottom right of the image below, we're not expecting any growth in MDC's dividend at all.

But how can we possibly make such a claim?

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Image Source: Valuentum; Note: The firm pulled 2013 dividends into 2012.

Before talking more about this topic, we need to clarify another important concept. Boards and management teams can do whatever they want with their firm's dividend regardless of the health of the company - whether it makes sense or not. Theoretically, a board can raise a company's dividend until bankruptcy, if debt covenants and reason do not preclude such foolish behavior. Our analytical support for our view of MDC's dividend breaks down into an assessment of the company's dividend safety, dividend growth potential, and risk of capital loss.

The Dividend Cushion ratio, which considers not only the future free cash flows of a company but also the health of its balance sheet, informs both our opinion of the safety of the dividend and its capacity for future growth. The higher the Dividend Cushion score above 1, the more capacity a firm has for future dividend increases.

Dividend Safety / Cushion - VERY POOR / -2.5 (negative 2.5, well below a positive 1)

As we mentioned previously, we assess the safety of a firm's dividend by adding the company's net cash to our forecast of its free cash flows over the next five years. We then divide that sum by the total expected dividends over the next five years. This process results in our Dividend Cushion™ ratio. A Dividend Cushion™ above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flow, while a score below 1 signals trouble may be on the horizon. And by extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall.

Because MDC has a large net debt position (not net cash), the firm scores a -2.5 (negative 2.5) on the Dividend Cushion™, which is VERY POOR. The way to think about the importance of assessing the balance sheet in dividend growth investing is as follows: as a grandparent, you're more able to give your grandson or granddaughter a more expensive gift each year when you have mountains of cash in your savings account than if you had a mountain of debt. When dealing with companies, just replace 'savings account' with 'balance sheet.' In this light, it becomes clear why MDC is not as strong as firms (outside of the homebuilding industry, in particular) that have solid net cash positions. MDC's net debt position is shown below:

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Image Source: MDC

Dividend Growth Potential - VERY POOR

We judge the future potential growth of the dividend by evaluating the capacity for future increases, as measured by the Dividend Cushion™, and management's willingness to consistently raise the dividend, as measured by the firm's dividend track record. As can probably be assumed at this point, MDC registers a VERY POOR rating on our scale.

We assign the actual dividend growth rates to firms on the basis of their qualitative Dividend Growth rating. For example, because MDC has VERY POOR dividend growth potential, we think its dividend growth will be challenged going forward. In nailing down an explicit annual dividend growth forecast, we evaluate the firm's recent dividend growth rate and/or the dividend payout ratio, among other considerations. The scale we use is shown below.

Dividend Growth Potential Scale

Excellent: 8% or higher
Good: 4%-8%
Poor: 2%-4%
Very Poor: 0%-2%

For those interested in dividend growth forecasts of other companies, we have dividend growth forecasts for every company in our 1,000+ firm coverage universe.

Risk of Capital Loss - MEDIUM

Though the dividend certainly can impact a company's share price, we assess the risk of capital loss within the valuation context. If a stock is undervalued (based on our DCF process), we think the risk of failing to recoup one's original capital investment (ex dividends) is relatively LOW. If the stock is fairly valued (it falls within our fair value estimate range), we think the likelihood of losing capital (ex dividends) is MEDIUM. If the stock is trading above our estimate of its intrinsic value, we think the likelihood of losing at least a portion of one's original investment (ex dividends) is HIGH. MDC registers a score of MEDIUM on our scale, which means we think shares are fairly valued.

Wrapping It Up

Whew. You made it through all of this. Congrats!

You may have a few questions. Why did we write an article about a company, which we don't think will experience any dividend growth in coming years? Well, this is what independent research firms do. They comment on and analyze a wide variety of companies for the benefit of the investment community.

Second, you may be wondering why we picked MDC? Well, the firm has an industry-leading dividend among homebuilders, and there may be many dividend growth investors out there holding its stock. Also, it's a great example for readers to get a feeling for the depth of dividend analysis we do, and what separates a poor dividend payer such as MDC from the strong dividend payers, which we include in the Dividend Growth portfolio.

MDC's Valuentum Dividend Cushion ratio exposes the company's balance sheet, which while investment grade, still limits flexibility when it comes to raising the dividend. It's possible that the board can still increase the payout, but we'd prefer the company to pay down its debt to a net cash position before upping the payout in the future. It's just the responsible thing to do.

The following provides the definitions of the terms you may have read in the dividend report (image) above. Thank you for reading!

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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.