Is MDC Holdings one of the better NYSE stocks?

Value Investing Case Study 23-1. I first covered MDC Holdings for Seeking Alpha* in Nov 2021 based on the financial results till Sep 2021. This post provides some of the background analysis for the article.

When I wrote the Seeking Alpha* article, MDC Holdings Inc (MDC or the Group) was trading at USD 50.21 per share (as of 25 Nov 2021). I had concluded then that there was no margin of safety. The market was pricing MDC as if it was in a growth industry rather than in a cyclical one.

My view of MDC can be summarized as:

MDC Holdings' current good performance was because Housing Starts had been on an uptrend over the past 11 years. But this is a cyclical industry with no uptrend in the long-term average Housing Starts.

MDC growth matched that of the industry, i.e., it only just maintained its market share. Growth came from growth in physical units and increased in the average house price.

MDC performance will mean revert and any growth will only be due to the increase in house price. But historically house price increased at about US long-term GDP rate.

That analysis was based on comparing MDC performance with the US Housing Starts. I did not go into the financial and other operating performance of the Group. As such I did not form any opinion on the fundamental position of MDC. This article is an attempt to fill the gap.

Based on the company analysis, I would conclude that MDC is not one of the better NYSE stocks. The stock is not only overvalued, but it is not a fundamentally strong Group.

Should you go and short it? Well, read my Disclaimer.

Financially not so sound

Is there anything special about its expertise?

Is the Current Performance Outstanding?

Will Housing Starts overshoot the long-term average?

Management performance is below average

Did not create shareholders’ value

No margin of safety

Pulling it all together

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Financially not so sound

As of the end of Sep 2021, the Group had a Total Capital Employed (TCE) of USD 4.3 billion. Shareholder’s fund accounted for 57 % of the TCE with the 43 % balance from debt (including leases).

About 80% of the TCE was deployed for the operations with the balance tied up mainly in cash. The Group’s cash position looks a bit high as its Cash to Firm Value is 17 % compared to the homebuilding industry average of 11 % (Source: Damodaran Jan 2021). Note that the Firm Value = Market Value of Equity + Book Value of Debt & Leases.

Table 1: Capital Structure

MDI debt level looks high based on a number of metrics.

It has a book Debt to TCE ratio of 43 % compared to the US homebuilding industry average of 36 % (Industry source: Damodaran Jan 2021).

Its Debt to Market value of Equity of 56 % is above the homebuilding industry level of 33 % (Source: Damodaran Jan 2021).

Chart 1: Sources and Uses of Funds

Another troubling feature is that from 2010 to 2020, the cumulative Cash Flow from Operations was negative USD 618 million. During this period MDC incurred the following:

USD 133 million for CAPEX.

USD 532 million for Dividends.

As you can see, the total of USD 665 million exceeded the Cash Flow from Operations. To make up for the short fall, MDC had to sell off a substantial part of its Other Investments (mainly securities).

The main reason for the negative Cash Flow from Operations was the negative change in Net Working Capital. From 2010 to 2020:

MDC generated USD 1.75 billion Cash Flow from Operations before changes in Net Working Capital.

The Net Working Capital requirements was USD 2.37 billion.

The changes in Net Working Capital were to fund its revenue growth. MDC had a reinvestment rate that is not sustainable.

Reinvestment can be defined as = CAPEX + Changes in Net Working Capital - Depreciation. The reinvestment rate is the reinvestment as a proportion of net income.

In the case of MDC, the Reinvestment incurred from 2010 to 2020 = USD 125 million + USD 2,365 million - USD 105 million = USD 2,385 million.

During this period, MDI generated USD 1,469 million of PAT. You can see that the Reinvestment exceeded the PAT generated. MDI had thus to fund the growth by selling off the Other Investments. This Other Investment is nil today

I would project that to fund its growth in the future, MDC would have to increase its borrowings or cut dividends. Either option does not look favourable.

Will it be able to generate positive Cash Flow from Operations? It could if there was no growth or if the revenue declines. But this is not a good business position to be in.

Is there anything special about its expertise?

MDC reports it business under two segments - homebuilding and financial services. MDC described them as follows:

“Our homebuilding subsidiaries build and sell primarily single-family detached homes that are designed and built to meet local customer preferences...Our homebuilding subsidiaries build a variety of home styles in each of their markets, targeting primarily first-time and first-time move-up homebuyers.”

"Our financial services operations include subsidiaries that provide mortgage financing, place title insurance and homeowner insurance for our homebuyers, and provide general liability insurance for our subsidiaries and most of our subcontractors.”

Chart 2: Revenue by Segment

But as can be seen from the segment performance charts, the majority of the revenue and earnings came from homebuilding. The financial services focus on inhouse sales and can be considered a vertical integration strategy.

Chart 3: PBT by Segment

Notwithstanding management description of its business, I would look at MDC as a homebuilder. Any projections about its prospects should be tied to the housing sector. The financial services segment should not be seen as an independent business.

The Homebuilding segment is the largest contributor in terms of revenue, operating income, and Total Assets. However, in terms of return, the Financial Services segment did better. Refer to Table 2.

Table 2: Segment Performance

Case Notes

The US property companies have a different development model that those in Malaysia. The difference is in not just the types of properties they developed but also the scope of the development.

For example, the US homebuilders focus on residential developments. They have different players for the shopping malls and corporate offices. In Malaysia, it is very common for a property company to be involved in all types of properties. For example, i-Bhd develops residential units, corporate offices and even owns a shopping mall.

Secondly, in Malaysia it is very common for a property developer to be involved in all stages of the process. This is from the land acquisition stage to the handover over of the physical buildings.

In the US, land development and property development are commonly by different companies. The land developer takes raw land, obtains the necessary permits, and puts in the necessary infrastructure. The homebuilders tend to acquire land that have been approved for development. In many instances, the homebuilders try to get options on the land.

This was actually an eye-opener for me. It thus requires a different frame of mind when analysing US homebuilders compared to Malaysian property developers.

As you can see, fundamental analysis requires you to dig in the various aspects of the business. If you are not familiar with them but yet want to invest based on fundamentals, one way is to rely on third party advisers. There are several financial advisers who provide such analyses.

Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

Is the Current Performance Outstanding?

For the 9 months ended Sep 2021, the Group achieved USD 3.7 billion of revenue with USD 411 million net income. For the same period last year, the Group achieved revenue of USD 2.6 billion with USD 220 million net income.

The improvement in the net income was due mainly to the following:

Both the Homebuilding and Financial Services segments contributed to the increase.

The main drivers of the increase in homebuilding income were the increase in home sale revenues and an increase in the operating margin.

The increase in financial services income was due to the overall increase in the volume of its homebuilding operations. Additionally, USD 8 million of net losses on equity securities were recognized in the prior year period.

The current YTD performance is in line with the long-term trend in the business as can be seen from the Performance Index below.

Chart 4: Performance Index

Revenue has improved since 2010 growing at a CAGR of 15.1 %. At the same time, gross profitability has improved from 10 % in 2010 to 22 % in 2020.

Net income turned around from losses in 2010 and 2011 to profits from 2012 onwards. There was a one-off spike in 2013 due to a USD 188 million reversal of the valuation allowance against its deferred tax assets.

In my Seeking Alpha article, I had shown that the revenue growth was due to the growth in the US Housing Starts.

There was a 0.95 correlation between MDC's revenue and the Housing Starts.

The number of units delivered by MDC better tracked the Housing Starts index when compared to that for MDC's revenue.

MDC's revenue grew faster than the Housing Starts because there was also an increase in the average unit selling price. From 2010 to 2020, MDC average unit selling price increased at a 5.0% CAGR.

Chart 5: Revenue Index

My view was that the Housing Starts will mean revert and when this happens, the revenue of MDC will also mean revert. Along this line, the earnings of MDC over the past 11 years had grown due to the revenue growth. Over the long run, as revenue mean revert so will the earnings. In other words, although the charts point to a continuous uptrend, it will eventually peak and then decline.

An analysis of the assets employed showed that the growth in revenue was contributed by both a growth in the Asset Turnover and Total Assets. I had earlier pointed out that net Working Capital grew substantially and this accounted for the majority of the asset growth.

This will mean that as the revenue mean revert, I expect the Net Working Capital to also come down. In other words, Total Assets will also decrease. I would then expect the Cash Flow from Operations to turn positive.

Chart 6: Drivers of Growth

Will Housing Starts overshoot the long-term average?

Chart 7: Housing Starts. Source: Trading Economics

There are two key macro trends driving the demand for houses in the US.

Housing Starts. As can be seen from Chart 7, this is cyclical with the long-term average at about 1.5 million units per year.

US housing deficit. There is currently a national housing shortage with estimates varying from one million homes to 5 million homes. Refer to the Seeking Alpha article “Lennar: Strong Secular Tailwinds Propel This Stock”

Looking at both of these, I would conclude that it the Housing Starts would overshoot the long-term average in the current cycle.

To get a picture of how it will overshoot, I used the following model:

The Housing Starts will reach the long-term average of 1.5 million units in 2021.

The growth will continue at CAGR of 8.9 %. This was the CAGR from 2010 to 2020.

The Housing Starts will then peak and decline with the same profile as during the uptrend.

I looked at 2 scenarios. The first is that the total excess is about 1 million units - Conservative Scenario. The second is when the total excess is about 5 million units - Optimistic Scenario. The excess for each year is the number of Housing Starts greater than 1.5 million units

The chart below shows the Housing Starts projections under the 2 scenarios.

Chart 8: Housing Starts Projection

If you take the Conservative scenario with the deficit of 1 million, it will peak around 2024.

If you take the Optimistic scenario with the deficit of 5 million, it will peak around 2027.

I do not expect there would be any changes to the long-term average given that it is 6-decades Housing Starts average.

Management performance is below average

You could be forgiven for thinking that management must have done a fantastic job to grow revenue and earnings over the past 11 years. I do not agree that it was an excellent performance.

This was because the growth was due to the tailwind provided by the growth in the Housing Starts. In my Seeking Alpha article, I had shown that MDC growth matched that of the industry, i.e. it only just maintained its market share.

When you compare MDC performance with those of its peers, MDC did not stand out. For the peer comparison, I selected that top 5 homebuilders based on their 2020 revenue. I looked at 3 metrics - revenue growth, ROA and cash generation.

Table 3: Peer Comparison

In terms of revenue growth from 2010 to 2020, MDC ranked No 4 among the panel.

In terms of average ROA from 2010 to 2020, MDC ranked No 5 among the panel.

I used Cash Flow from Operations as a % of Revenue. MDC was the only one with a negative result.

Chart 9: Peer Revenue Index

Chart 10: Peer ROA

Did not create shareholders’ value

I looked at 3 metrics to assess shareholders’ value creation. Shareholders’ value would be created if the returns was greater than the respective cost of funds based on the following:

Comparing the average returns from 2010 to 2020 with the WACC. For this analysis, I looked at the average EBIT/TCE for each of the year and assumed a constant tax rate of 26 % to derive the average EBIT(1-t)/TCE.

Comparing CAGR in SHF assuming no dividend was paid with the cost of equity.

Comparing the total gain achieved by a shareholder who bought 1 share at the start of 2010 and held onto it till end of 2020 with the cost of equity. Unlike the other two metrics that looked at the business returns, this one focus on the share market returns.

The results of the comparison are shown in the following table. There is not clear evidence of shareholders’ value creation.

The business returns were less than the respective cost of funds.

The stock market return was comparable to the cost of equity

Table 4: Shareholders' Value Creation

Note

(a) As per Table 5

Table 5: Shareholders' Gain

No margin of safety

In my Seeking Alpha* article, I had valued MDC based on an EPV of USD 34 per share based on the long-term Housing Starts at 1.43 million units per year.

If I assumed the long-term Housing Starts at 1.5 million units per year, the EPV would be USD 36 per share. This scenario assumed that the Housing Starts is cyclical. Thus, any value above the long-term average would be balanced by the values below the long-term average.

What if we assumed a different scenario for the downtrend given the current demand and shortfall. Assumed that after overshooting the long-term average, it falls and remain at the long-term average. We then have the picture as per the Chart 8.

The value of MDC is then the EPV plus the value of the earnings during the excess stage. Excess here is defined as the amount greater than 1.5 million.

I then valued the excess earnings based on the following assumptions:

Excess earnings or EBIT(1-t) = Gross Profit X (1-tax rate). I assumed that the there is no additional SGA incurred to generate the excess revenue.

Gross profit margin is based on the past 5 years average.

There is no additional reinvestment as the excess growth phase is balanced by the excess declining phase.

The Free Cash Flow to the Firm = EBIT(1-t).

The excess Free Cash Flow the Firm was then discounted back to 2020 based on the WACC.

Based on the Optimistic scenario, the excess value = USD 7 per share. The revised value of MDC = EPV + excess value = USD 36 per share + USD 7 per share = USD 43 per share.

This is still below the current market price of USD 53.28 (as of 6 Jan 2022). In other words, there is still no margin of safety

Pulling it all together

A company analysis of MDC showed that:

It 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 2020. 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 2020 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.

Based on the above, I would conclude that MDC is not strong fundamentally. At the same time, a valuation based on the Optimistic scenario showed there is no margin of safety. As such MDC is not one of the better NYSE stocks to invest in.

The current market price of MDC only makes sense if you believe that its business is not cyclical. But this would be challenging 6 decades of cyclical Housing Starts.

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