These days, any mention of the housing market in conversation usually elicits a prolonged groan (especially if you live in California or Nevada). Homebuilders nationwide are feeling the pinch of a tight credit market, falling land prices, and mounting inventories. However, while the outlook for real estate is pretty dismal, times like these always make me ask myself: What would Buffett do? The answer? He would start looking for well managed, undervalued companies that he could pay bottom dollar for. While I don’t think now is the time to buy by any means, tenured and cash rich companies like MDC Holdings (NYSE: MDC) may have a place on my watch list moving forward.
Housing Outlook is Unclear
Don’t get me wrong, we could be in for a rough ride in the housing market for some time. In fact, some economists think home prices could fall another 25% over the next 2 years. Even more frightening is research done by Yale professor Robert Shiller, which shows that home prices always revert to the long term mean growth trend of 0.4%. As you can see from the graph below, the market was still well above this trend line at the end of 2007.
Overview
In my opinion, now is the time to start formulating a strategy for the market of tomorrow. As a contrarian, I want to know who has a strong track record, conservative financials, and a solid plan for the future. I am patient, and I have tried to learn that planning ahead is good policy. That’s why I like Denver based MDC Holdings, a fortune 500 company which operates subsidiary Richmond American Homes (a homebuilder operating mainly in the west and mid-atlantic regions) and HomeAmerican Mortgage Corporation (not to be confused with American Home Mortgage).
Opportunity
I know, I know, California and Nevada (two of the areas MDC operates in) are probably the worst places for real estate right now. In fact, MDC’s 2007 earnings took a huge hit due to impairments (basically reductions in the value of land) in those areas. However, what I like is cash, and MDC has plenty of it. In fact, the company had a cool $1 billion dollars in its war chest at the end of 2007 (twice what it had in ‘06). Not bad for a mid cap stock with a market cap of only $2 billion. Further, it has kept a tight reign on costs (expenses were down 36% Y/Y vs. 06) and has one of the lowest lot supplies in the industry. MDC also increased operating cash flow by 63% in 2007 vs. 2006.
Metrics
A quick look at key metrics shows a Price-to-Book of 1.33 vs. the industry average of 5.0. Also, Price to Free Cash Flow is a conservative 3.78 vs. the industry average of 24. However, I’m not excited about the 5 year average ROI of only 5.68. I was certainly hoping for stronger metric there. Of course, earnings have taken a hit due to impairments, so EPS metrics aren’t pretty right now.
Risks
Yep - there are plenty. I listed some above (housing outlook). Also, it’s not a positive sign that both the CEO and COO both recently started selling shares / exercising stock options. That is typically a near term red flag, but the those transactions could also be unrelated or could have been pre-planned.
Summary
The key here is long term. We know housing is in the tank, and will likely remain there for some time. We also know that MDC operates in tough markets that potentially have further to fall. However, because of its cash position and long tenure (the company has been around since 1972) I want to keep an eye on this one. This is not, by any means, a recommendation to buy or sell. However, MDC Holdings may be a name to slip into the vest pocket for review at a later date.
Tags: homebuilders, housing market, mid cap stocks