MDC Holdings Is A Cigar-Butt Opportunity

Summary

• The homebuilding sector is cyclical without any long-term growth in the physical volume. Any long-term growth is due to price growth.
• MDC is not a growth stock in a cyclical sector. MDC is also not strong fundamentally. So, it can only be a cigar-butt type opportunity.
• There are alternative ways to view the margin of safety. Based on these, I would conclude that there is currently a margin of safety for MDC.

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Investment Thesis

In my Nov 2021 Seeking Alpha article, I had opined that the homebuilding industry is cyclical. I had then valued M.D.C. Holdings Inc. (NYSE:MDC) through this cyclical lens and concluded that there was no margin of safety at the then price of USD 50 per share.

Not everyone agreed with my thesis. I have reviewed the various comments and found that there was no evidence to support them. My original conclusion still stands.

However, there are alternative ways to view the margin of safety. Based on this and given that the price of MDC had declined, there is now an investment opportunity at USD 44 per share.

But MDC is not strong fundamentally. Any investment in MDC is thus a cigar-butt type opportunity.

Recap

In my Nov 2021 article, I had opined that:

• The homebuilding sector is cyclical and over the past 70 years, there was no long-term growth in the average annual Housing Starts.
• I had then valued MDC through this cyclical lens and concluded that there was no margin of safety at the then price of USD 50.

No surprising, not everyone agreed with my analysis. I would categorize them into:

• Those who think that there have been some fundamental changes in the socio-economic makeup so that the historical patterns no longer apply. There are two sub-groups here. There are those who think there is now a cyclical growth pattern. The other sub-group are those that think that that MDC is a growth stock in a cyclical sector.
• Those who think that I have not taken into account MDC operating strengths. For example, one comment is that MDC is best in mitigating the cyclical trends among the homebuilders.
• Those who think that the value of its lots pipeline have not been taken into account.
• Those that think the current momentum will boost the earnings for the next few years so as to provide some margin of safety. The argument is not the cyclical analysis but rather there are other ways to view the margin of safety.

This article is an attempt to provide evidence to either refute or support them.

This is not a cyclical growth sector

For the sector to be a cyclical growth one, we should see the pattern as shown in green in the chart below rather than the one shown in blue.

Chart 1: Cycle Pattern ( Author)

There are several ways to portray the cyclical nature of the property sector. Investopedia listed the following as the top US Housing Market indicators:

• Construction spending.
• Housing Starts.
• Home sales.
• Housing Market Index.
• Housing Price Indices.

Charts 2 to 6 present the actual US picture based on the above indicators. Note that the charts covered different durations. The longest was the Housing Starts which covered about 70 years while the shortest was the Total Construction Spending that covered about 20 years.

Chart 2: Total Construction Spending - Residential (FRED)

Chart 3: US Housing Starts (Trading Economics)

Chart 4: Number of New One Family Homes Sold (FRED)

Chart 5: Housing Market Index (Trading Economics)

US Housing Price Index (FRED)

You can see that only the House Price Index shows any uptrend in the long-term average values. But you should not be surprised by this as this is mainly pricing data. Besides, this covered existing homes and not exactly newly constructed homes.

In the context of homebuilders, I would think that Construction Spending, Housing Starts and the Number of New Family Homes Sold would be the most relevant. For these, there is no cyclical growth pattern.

Are there growth cycles in the housing sector? The chart below shows one. But these are sales of existing homes which included those sold by individuals as well as homebuilders.

Chart 7: Existing Home Sales (Trading Economics)

The evidence does not support the idea that the homebuilder's sector is a cyclical growth one.

I must admit that I am using historical data to illustrate that the sector is not a cyclical growth one. To be fair, those who disputed the no growth cyclical pattern have not offered any data to support the contention that this time it is different from the past. I would have thought that to do so, they would have to use some econometric model.

MDC is not a growth stock

Given the no-growth cyclical nature of the sector, for MDC to be a growth stock, it has to perform better than the sector. In other words, it grew faster than the sector.

I thus compared MDC performance with the sector based on a number of metrics as per Table 1 below. The sector here refers to the performance of the top 10 homebuilders. The top 10 was selected based on their respective 2020 revenue. Refer to the Methodology for details. As can been seen, I would not conclude that MDC performed better than the sector.

Table 1: Growth comparisons (Author)

Notes to Table 1.

a) There was a net loss in 2011 for the sector. I thus derived the growth rate using the method as per Fort Marinus. Refer to Methodology.

b) Cash flow from Ops for the sector and MDC in 2011 was negative.

c) Two of the top 10 companies were established in 2010 and hence I started the analysis from 2011.

d) Sector was based on top 10 homebuilders in 2020 (based on the 2020 revenue) including MDC.

e) Computed as MDC value minus Sector value

At the same time, there were no significant change in MDC's market share in terms of revenue and homes delivered. However, it did improve on the number of homes sold and the number of backlog homes. Refer to Table 2.

Table 2: Market Share Comparison (Author)

Note to Table 2.

a) The market share was based on the total for the top 10 homebuilders in 2020 (based on the 2020 revenue) including MDC.

The conclusion is that at best MDC growth matched that of the sector. Its growth was due to the sector tailwind. When there is no tailwind, or when the sector declines, I would expect MDC performance to decline. I had already shown that there is no long-term cyclical growth (in terms of physical volume) for the sector. Accordingly, MDC is not a growth stock in a cyclical sector.

MDC is not a fundamentally strong company

I had actually carried out a company analysis of MDC in my Jan 2022 blog article "Is MDC Holdings one of the better NYSE stocks?" It was based on the 2010 to Sep 2021 MDC results.

MDC had recently submitted it Form 10k. I had looked the latest data and do not find any evidence to change my Jan 2022 blog conclusion that MDC was not a fundamentally strong company from a long-term investment perspective. My rationales were:

• MDC has a debt level that is higher than the industry. At the same time, it had sold off all its investments in securities to fund its growth.
• It had generated cumulative negative Cash Flow from Operations from 2010 to 2021. This was because the net Working Capital increased in tandem with the growth in revenue.
• It did not have a sustainable reinvestment rate.
• The revenue growth from 2010 to 2021 was because of the tailwind from the growth in Housing Starts. Housing Starts is cyclical.
• MDC just maintained its market share during the past 11 years. MDC revenue would also be cyclical and its long-term average revenue would be pegged to the long-term Housing Starts average.
• MDC performance compared to those of the top 5 homebuilders is at best average. At the same time, it had not been able to create shareholders' value

It is ironical, but I suspect that when MDC stops growing, the cash flow from operations would turn positive. It would then generate more than enough cash for its business needs. Unfortunately, this cash would then be used when it goes through the next growth cycle. It is a feature of its business model.

I differentiate between a fundamentally strong company and a good investment. A good investment is one that enables you to make money. The company could be weak fundamentally in which case it is a cigar-butt type of investment. On the other hand, the company could also be strong in which case you have a Compounder.

I would classify MDC as a cigar-butt investment if there is a sufficient margin of safety. Note that I am looking at MDC through a cyclical lens. I am not suggesting that it is not profitable in the coming one or two years. But for cyclical companies, you should look at the performance over the cycle.

There is no "extra value" from the lot pipeline

As part of the home building process, MDC would acquire lots. These are classified as land under development in the Balance Sheet. The question is whether these are part of the operating assets.

• If they are, the value would have already been accounted for under the DCF valuation.
• If there are excess to the normal business needs, then the excess would be considered as Non-Operating Assets and the value would then be added the DCF value.

As of end Dec 2021, MDC had USD 1.8 billion under land and land under development in its Balance Sheet. This is about 71 % of the common Equity.

The chart below shows the land and land under development as part of the revenue for the year. As you can see, this has declined from its peak in 2011.

Chart 8: Land under dev as % of Revenue (Author)

Although MDC did not provide any breakdown, I estimated the land cost accounted for about 20 % to 30 % of the total cost of sales. If you take this perspective, the current value of the land and land under development does not look excessive. It would appear that what is stated in the Balance Sheet could all be used up within a year at the current pace of revenue. As such I would not consider this as part of the Non-Operating Assets.

The only concern would be if the sector is in a downtrend. Then there is a possibility of either some impairment or excess land. But this is not the case for 2021 or 2022.

Is there another way to look at the margin of safety?

MDC was trading at USD 43.82 as of 25 Feb 2022. In my earlier Seeking Alpha article, I had valued MDC through a cyclical lens as follows:

• Asset Value (updated end 2022) = USD 37 per share.
• EPV = USD 34 per share.
• Conservative Earning Value with growth = USD 39 per share.
• Optimistic Earning Value with growth = USD 64 per share.

To recap, I valued MDC based on the following scenarios.

• Base case Earning Power Value (EPV). This assumed that the long-term Revenue is when the Housing Starts = long term average of 1.43 million.
• Conservative Earning with growth. This assumed that the long-term Revenue is when Housing Start = 1.43 million and the growth is the long-term growth in the House Price index of 4.3 %.
• Optimistic Earning with growth at 4.3 %. This assumed that long-term Revenue is when Housing Starts = 1.5 million. I assumed that there are improvements in the GP margin and SGA margins by using the respective past 2 years average values.

Intrinsic value does not change frequently. Given my long-term basis in the earlier valuation, there is no need to revalue MDC. I am coming from the perspective that I have already factored in the 2021 performance in my earlier valuation.

However, there are alternative ways to look at the margin of safety than merely mechanically comparing price with the intrinsic value.

One way is to look at the gap between the current market price and the intrinsic value. This is about USD 4 per share = (USD 44 - USD 39) based on the Conservative Earnings with growth. MDC profits in 2021 is about USD 8 per share. My valuation was based on MDC average profits over the cycle. If the coming profits is extraordinary, it would be significantly higher than the long-term average profits. In order words, there could be some additional value that could serve as a margin of safety.

Secondly, in the long run in a competitive environment, the Asset Value would be equal to the EPV. A significant part of the assets of real estate companies are in land and properties. As such, the Asset Value is a reliable estimate of intrinsic value. In other words, the USD 37 per share is a conservative floor value.

The Optimistic value is based on 1.5 million units in the long-term average annual Housing Starts. This is not unrealistic. There is thus some margin of safety between the Conservative value with growth based on 1.43 million units and the 1.5 million units of long-term average annual Housing Starts.

Based on the above, I would conclude that there is a sufficient margin of safety based on its current market price of USD 43.82 per share.

Conclusion

My analysis showed that following:

• The sector is cyclical without any long-term growth in the physical volume. Any long-term growth is due to price growth.
• MDC is not a growth stock in a cyclical sector.
• MDC is not strong fundamentally. So, it can only be a cigar-butt type opportunity.
• The value of the lot pipeline has already been taken into account in my valuation.

I looked at 3 alternative ways to view the margin of safety:

• The gap between the current market price and Conservative Earnings with growth is only about half of 2021 EPS.
• The Asset Value provides a floor value.
• From the 1.5 million units for the long term annual average Housing Starts.

Based on these, I would conclude that there is currently a margin of safety for MDC.

However, I see MDC as a cigar-butt investment opportunity. Go in now and when the price exceeds the intrinsic value, get out. I would advise a getting-out price of USD 64 based on the Optimistic Earnings value with growth.

Methodology

To represent the performance of the sector, I took the revenue of the top 10 listed homebuilders based on their 2020 revenue. The financials for these companies were taken from TIKR.com.

In 2020, these top 10 companies sold about 256,459 homes. According to Statista, the new home sales in the US in 2020 was 820,000 houses. This meant that the top 10 companies accounted for about 1/3 of the total US new home sales.

The various housing statistics were compiled from the respective companies Form 10k for the various years. While not all companies use the same terminology, they all distinguish between:

• Sales for the year.
• Homes delivered or closed for the year.
• The backlog of homes at the end of the reporting period.

Note that not all the companies had Dec as the financial year end. For the purpose of these statistics, I took the data for the financial year end to represent the data for the calendar year.

Computing CAGR

The standard CAGR formula will not work if an initial negative value turns positive or vice-versa. Also, if a negative value becomes less negative over time, CAGR will show a negative growth rate. The Fort Marinus article suggests tweaks to the CAGR formula to handle negative values. Refer to "How to handle Percent Change and CAGR for negative numbers."

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.