Previously, I wrote about why MDC Holdings (NYSE:MDC) is one homebuilder that should be bought today if you want exposure to the sector. This thesis was based on the company being undervalued compared to the peer group as well as the safety net offered by the dividend paid, in addition to the conservative strategy the company uses when acquiring land. I would suggest you read that article for some background before actually pulling the trigger on this investment. I have spent additional time since that article, reviewing the consensus Q1 2013 estimates for MDC. The rest of this article will be dedicated to comparing the consensus estimates to what I believe the company will actually deliver for the quarter. The beauty of analyzing plain vanilla homebuilders like MDC is that determining an earnings estimate should be relatively simple. What surprised me when I dug into the details is how far off the consensus estimates are to what I believe the company will actually report. If you are just interested by how much I think MDC will beat earnings, jump to the bottom of the article. For those prudent investors looking to see the analysis, sit back and enjoy the reading below!
Consensus Estimate And Earnings Model
The consensus Q1 2013 estimates for MDC, from Yahoo! Finance are as follows:
Revenue: $310.6M (low of $261.8M and high of $353M)
EPS: $.25 (low of $.08 and high of $.39)
A quick note on these estimates. With many companies you have to worry about adjusted estimates, non-GAAP estimates, etc... With MDC, you will not need a financial analyst to interpret the earnings for you.
The earnings model I am using is the critical component you need to understand in why MDC is likely to crush its earnings estimate. I am going to provide a low-end estimate and a high-end estimate, both of which will blow past the consensus EPS estimates. Below are the components of the model and a quick summary of how they are determined:
Revenue - Modeling revenue for a homebuilder is actually fairly simple. Homebuilders report each quarter what is called "backlog." This represents homes that are under contract, but have not yet closed, and thus have not yet had revenue recognized. From the Q4 2012 supplemental earnings slide provided by MDC we have the following information:
The key item on this slide from the presentation is the backlog conversion. As we know what the backlog for MDC was at the end of Q4 2012, we can use the historical conversion rates to determine the expected Q1 2013 revenue. We will use a low of 51% and a high of 60% as our ranges, which coincides with the last 5 quarters. You should note, that Q1 2012 had a conversion of 59%. Thus, I believe the actual revenue will trend to the higher end of the range.
Again, the company provides us most of the evidence we need to know in order to estimate gross margin %. Through looking at gross margin trends provided in the supplemental Q4 analysis, as well as analyzing the last earnings conference call, we generally can have a good estimate of the gross margin % range. The company reported gross margins of 17% in Q4 2012, excluding a small impairment that should not be recurring. The slide from the previous earnings presentation below shows the trend in gross margins over the last few quarters:
There are a couple of items to note regarding the gross margins shown in the above image. First, use the chart on the left as that is what will impact the income statement. Also, recall that I said Q4 2012 had a 17% gross margin. The reason the chart shows 16.7% is because of the impairment I noted. I fully believe this will not be a recurring event in an environment where sales prices are rising. Also note that, in Q1 2012, gross margins dipped sequentially from Q4 2011. This has to do with how a homebuilder capitalizes overheads into cost of sales. When your revenue is lower you get less leverage from your overhead, and this in turn lowers your gross margin %. This dynamic will still be at play in Q1 2013, but the scale will be smaller because the sequential seasonal revenue decline will be smaller. Management also noted on the last earnings call that they are facing cost headwinds, which would impact gross margins. However, I believe this was a sandbag comment. The reason is because I believe their price increases are outpacing their cost increases right now. They noted on the conference call that prices were up about 2% for homes sold in Q4 2012. This should be more than enough to offset cost increases. For modeling purposes, we will assume a gross margin of 16.5% with the lower revenue assumption and 17.5% with the higher revenue assumption.
Here again, the company essentially can telegraph to us exactly what their administrative, marketing and commission expenses will be. All that has to be done is taking the amounts from Q4 2012, as a percent of total revenue, and apply those percentages to the Q1 2013 revenue assumptions. The slight exception will be the administrative expenses. These will not correlate exactly with fluctuations in revenue as they are more fixed in nature. The slide from the Q4 2012 earnings presentation is below:
The model will assume that the commissions and marketing expenses will be the same percent of revenue as they were in Q4, under both the low and high revenue assumptions. The G&A expenses will be held constant in the high revenue assumptions and will drop by 10% in the low revenue assumption as certain of these expenses would be revenue related. Additionally, stock option and bonus expense would have been higher in Q4 2012, as the stock was up significantly and the final performance numbers would have dictated increasing the bonus accruals.
Financial Services and Interest Income
MDC generates significant profitability from the financial services line item which encapsulates profits from originating and selling mortgages to its home buyers. In estimating this line item in the model, we will assume that the level of profitability functions as a percent of revenue. We will use the same percentage of revenue achieved in Q4 2012 for the high revenue estimate. For the low revenue estimate, we will assume this line item is only 80% as profitable as a percent of revenue when compared to Q4 2012.
MDC is also the only homebuilder generating significant interest income. This was due to the fact that because of their conservative nature, they were not deploying cash as quickly as other builders were over the past few years. That has changed a bit, and the company is now aggressively acquiring land. In light of the cash balance declining somewhat, we will assume in both the high and low revenue models that interest income is only 75% of what it was in Q4 2012.
Income Tax Rate
For GAAP accounting purposes, the company is still in a 3-year cumulative loss position. This is a wonky definition, but essentially it means they should have no income tax expense this quarter. The caveat would be if they get the green-light from a GAAP standpoint, and from their auditors, to reverse their tax asset valuation allowance. Currently, the company has over a $250M tax asset that is fully reserved for. If this were to be reversed, the company would essentially recognize $250M of income in the quarter and then my entire analysis is a moot point. This ultimately would be a positive and provide a headline shock as the reported EPS number would be enormous. I do not think this will happen, but it is worth noting that at some point in time it will.
Earnings Financial Model
As I previously noted, the key starting point to the earnings model is determining the assumed revenue for the Q1 2013. For that, we turn again to the Q4 2012 earnings report, and particularly the section below showing the backlog at the end of the last quarter:
The total revenue in the backlog, of $579M at the end of Q4, will serve as the starting point for the financial model.
Based on all the disclosures above, the model for Q1 2013 earnings compared to the consensus estimates is shown below:
As you can see, on the low side I believe actual earnings could be about 40% higher than consensus estimates. On the high side, I believe actual earnings could be DOUBLE consensus estimates. The high side also would entail a blowout of the revenue estimate.
There is an additional wild card that could make these numbers, both the low and high side, even better. The company acknowledged on the Q4 2012 conference call that they had increased homes under production that were not yet sold. These homes are often referred to as "spec" homes which you can consider short for the term, speculative. There is no buyer when the home construction begins, thus the builder is speculating they can sell the home. The purpose of MDC doing this was to take advantage of what was hoped to be a robust spring selling season in Q1. From what other builders have reported in addition to economic reports, the selling season has been robust. The upside would come because the model above is entirely based on revenue from backlog conversion. If the company converts their backlog as they historically have, in addition to selling and closing their spec homes, the outperformance versus consensus will become even larger.
How To Trade The Earnings Release
The conservative trade would simply be to buy the stock. At this point in time, based on my assumptions presented above, I am strongly considering purchasing call options outright. The stock currently trades at about $32 a share. A month ago, it was over $40 a share, and has pulled back hard the last few days as the market sold off. My conviction is pretty strong that MDC will beat earnings handily. The biggest question mark is whether the market will reward the earnings beat. In this case, considering the stock is undervalued compared to its peers and is also well off its high, I am willing to take that chance. I intend to purchase May call options on the stock to take advantage of what I will believe will be a monster earnings beat on May 2nd. In doing so, I risk losing my entire investment. However, as this will be just a small investment out of my overall portfolio, that is a risk I am willing to take. If the earnings beat as I believe they will and the stock market reacts positively, this could easily turn into at least a 5 bagger for me. As always, do your own due diligence. MDC reports after some of the other homebuilders such as Ryland (NYSE:RYL) and Meritage (NYSE:MTH). If these companies see large spikes after earnings, that would be the green light to move into MDC as long as the stock has not already rocketed up from its current level.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MDC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Most likely will take long position through purchase of May 2013 call options.