MDC Holdings: Promising Upside Through Subsidiary Company

MDC Holdings (MDC) through its subsidiary Richmond American Homes builds new single family homes in various regions of the country and provides mortgage services as well. We initiate a BUY recommendation as we believe company shares have the potential to appreciate by 50% in the next 12 months. MDC is entering the upscale housing market that, if profitable, could potentially lead the way to further development in this direction. The company could also see a revenue boost and better market share due to implementations of new standard energy features that separates itself from competition.

Catalysts

According to CEO Larry Mizel: "Across the country, we have continued to acquire land in an accelerated pace. During the second quarter, we spent approximately $185 million to acquire nearly 2,800 lots in 69 communities across our markets, 32 of which were new. This level of land acquisition activity reflects our highest level since 2006, driving a 16% increase in our lot supply during the second quarter alone to a total of more than 14,700 lots". With that said, we would like to analyze a specific criteria of recent communities the company is developing. The average price of homes sold in the latest quarter for MDC was $350K. Based on recent lot purchases, we believe the company is moving towards higher income communities with above average home prices that would generate more revenue and improve profit margins.

The first significant investment is the recent purchase of lots in Boca Raton, Florida, where the plan is to develop 64 single family homes. The Oaks at Boca Raton differs from other communities developed by MDC through its exclusivity. It is the company's first appearance in the upscale luxury homes segment that we believe could prove profitable. Based on recent inventory statistics provided by Lang Realty, total home inventory in Boca Raton was 1,681, with 124 sold homes, resulting in a 7.4% absorption rate. The absorption rate for the entire home segment of MDC was 3.2% in the la! test quarter. This makes Boca Raton a good location for home sales, as the company would benefit from an above average absorption rate.

The price for a home within the community starts from $900,000 and could reach close to $2 million. In the last 2 quarters, MDC delivered a total of 131 homes in Florida, generating $33.6 million in revenue with an average price per home of $257,000. The Oaks at Boca Raton could potentially generate around $60 million in revenue, a conservative estimate. The benefits are twofold. First, higher value homes will improve profit margins as current margins from home sales are 18%, according to the latest quarter. Second, the company is diversifying its geographical footprint by entering new markets that adds to its market share.

The company notes that most revenue is expected to come from the West segment, comprising of Arizona, California, Nevada and Washington. MDC has a strong presence in California and most upcoming developments are expected there. Two communities in particular are being developed in areas with higher value homes.

The first is located in Moorpark, California and will feature 71 home lots. The average listing price for the specific area where the community is located was 760,000 as of August and 20% higher year over year. The price range for this community is not available yet, but we believe it will be around the $700K and up range. A conservative estimate places the potential revenue generated around $54 million.

The second community of importance is The Birch Trail at Pavilion Park located in Orange County, California. According to Trulia, the average listing price for Orange County as of September 18th is 979K. The community is located on the border of Orange County and Portola Springs, which has an average listing price of 864K. The price range for the homes offered at The Birch Trail is 750K-830K, well below the averages of the two Irvine neighborhoods between which the community is nestled. We believe the community will be a! ttractive! to potential buyers as it is priced competitively.

MDC is not a newcomer to the Orange County market. The company withdrew during the housing crash as prices sharply dropped. The Case-Shiller Index for the Los Angeles area dropped 44% from its peak in 2006 to its trough in 2010. The national home price index in the same period dropped 33% in the same period. We can see this particular area was more exposed to falling home prices and we understand why the company decided to postpone further developments within the Orange County region. However, from 2010 to present the national index rose by 17%, whereas the LA index rose by 27%, which makes this market better for taking advantage of a housing rebound.

As the Case-Shiller index shows, Los Angeles has historically taken the brunt of home prices. We have come across some interesting data provided by realtor.com that shows the popularity of US housing markets among foreign investors. As it turns out, the number one searched market for real estate by international consumers is Los Angeles, California. US citizens are not the only ones that believe current home prices are a bargain and foreign investors want a part of it. Increasing the pool of customers and investors can only benefit the state of the regional market and ultimately MDC.

The next catalyst we would like to talk about may also function as an economic moat. There is a trend among home builders to offer energy efficient options such as better quality insulation, efficient faucets, and light fixtures. One feature that is gaining popularity is solar energy. Solar panels are mounted on top of the roof of homes and reduce the cost of electricity overall. We like that for certain communities developed in California, MDC is offering solar panel installations standard in all new homes. We believe this is a strong selling point for a potential customer, as such installations could prove costly. Moreover, the buyer will enjoy certain local and state tax incentives. Some if not most of ho! mebuildin! g companies install solar panels in their new homes, but offering this option standard as opposed to the customer having to add it from a list of options could be the key selling point that makes an MDC home stand out among competitors.

Valuations/Fundamentals

Turning to fundamentals, we like the pe and future pe values of 4.99 and 12.52, respectively, could point that MDC is undervalued compared to its current and future earnings. PEG value of 0.1 is very low, which means potential growth is not factored in the current share price. In fact, year to date, the stock is down 18%. Stagnating shares have been an overall market trend year to date among residential home builders mostly due to a negative outlook on the housing market. The fear of a slowdown in the housing recovery looms over investors even though mortgage rates are still low - 4.49% on a 30 year fixed rate mortgage - compared to historical levels.

According to home construction news site Builderonline.com, MDC ranks 11th in terms of total number of home closings for the year 2012. Out of the top 10 competitors, MDC has the lowest PEG value, followed by Ryland Group (RYL) and Meritage Homes (MTH) with 0.23 and 0.6, respectively. The current pe ratio is lowest for the company followed by Ryland Group with 7.4 and Meritage Homes (MHO) with 11. In terms of forward pe, the top ten competitors have values in the 10-14 range. Putting numbers in perspective, relative to its competitors we believe that MDC presents a better value for investors looking to take advantage of the real estate market rebound.

Dividends make up for the lackluster stock performance as the current dividend yield is a solid 3.32%. In terms of financial health, the company maintains adequate debt to equity value of 1. Interest coverage ratio is 28, which means the company has no problem paying its long term debt interest. Current ratio is higher than average at 10.38. The quick ratio which excludes land from current assets is a bit higher than we would lik! e, as we ! look for ideal leverage of assets to liabilities around 2.

DCF Analysis

We expect operating income for the year 2013 to increase to $115 million in light of upcoming community developments. For 2014, we expect income from operations to rise by 25%, followed by 13% for 2015. For the last two years we expect limited appreciation between 3-5%. We assume a 25% tax rate and a 6% residual growth rate. Depreciation will increase as the number of lots owned by the company increases over time. Capital expenditures are projected to double in 2013, followed by 40%-60% appreciation for the following 4 years.

Impediments

Now that we have looked at the potential stock movers, we would like to also look at what could hinder some of the growth of MDC. The inclusion of solar technology as standard in some of the California communities could affect the profit margins. According to an article published by the Lawrence Berkeley National Laboratory, a solar panel installation adds an average value of $17K to the price of a home. It seems that MDC is incorporating the cost of solar system installations. While this initially reduces overall margins, the cost of installation is ultimately subsidized by local government subsidy initiatives for green energy.

Another potential impediment to revenue growth deals with the geographical footprint. As the West represents the bulk of revenue, the historical performance of the California and Nevada markets has been lackluster and if we expect the housing market to curb its growth in the near future, then these regions may underperform based on past performance. Nevertheless, as we have seen MDC is targeting a particular market, developing communities in more stable, higher income regions, where customers are less likely to be affected by slightly higher mortgage rates or have problems qualifying for more stringent lending standards.

Conclusion

The homebuilding segment of MDC shows potential based on the catalysts discussed. We like the shift tow! ards deve! loping high value homes as profit margins are better. In an increasingly environmentally conscious population, offering green technology standard in homes can separate the company's product from other competitors. After taking into account the current share price and valuations, we initiate a BUY recommendation with a $45 price target.

Source: MDC Holdings: Promising Upside Through Subsidiary Company

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any 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. (More...)

Additional disclosure: Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by David Ristau, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.