Description

M.D.C. is a homebuilder. Our firm had been large holders of the homebuilders from 1999 until the past several months, when we sold a large percentage of our holdings. Why then do we recommend purchase of M.D.C.? Here is the method behind our madness!

In 1999, our thesis for purchasing the homebuilders was that their earnings would grow rapidly (20% or more in a normal market environment) as the larger builders gained market share in a highly fragmented market from disadvantaged smaller builders. Close to 15% of the earnings growth would come from increased sales and prices and the remainder from margin gains due to efficiencies of scale, leverage over fixed costs, and the benefits from know-how that are enjoyed when a highly fragmented cottage industry transitions itself into an industry with more modern and efficient manufacturing and management techniques. This thesis has been working – and the large builders, by any measure, have gained market share and have become more efficient. Our analogy for this consolidation is Wal-Mart – which due to cost and other advantages was able to take market share and grow rapidly at the expense of disadvantaged local merchants

In late 2003, however, the demand for and price of homes in many parts of the country started to accelerate above trend-line – and this acceleration continued through 2004 and most of 2005. Unfortunately, most of the large builders responded to this acceleration by aggressively increasing their holdings of undeveloped land – making many of the purchases at relatively high prices. It is logical that, at some point, and maybe now, the demand for new homes will return to a more level. When I confronted the homebuilders on their plan of action once the market returns to normal, almost all responded that they will sharply reduce their land purchases and use a large percentage of their free cash flow to repurchases shares – and, in fact, many have started to do this. The risk is that, as many homebuilders slow down their purchases, the value of land will decline, leaving many builders to work through large inventories of relatively high cost land. This intermediate term risk is why we sold most of our shares in the homebuilders, even though we believe that the shares are substantially undervalued over the longer-term based on the homebuilders earnings power in a normal market.

M.D.C. is an exception to the rule because the company controls a relatively small land position – only about a 2½ years supply, of which about 55% is owned and 45% is under option. Thus, M.D.C. will work through its exiting owned land position quite quickly – in less than two years because the owned land is sold first (much of the option land is still in the permitting and development stage). Thus, importantly, M.D.C. has all of the upside potential of a typical larger homebuilder (we believe it has more potential) without the risks of a material impairment and without the burden of having to work through large quantities of relatively high cost land.

Looking ahead, we will analyze the near-term fundamentals under various scenarios. The first scenario is that the homebuilding market does not materially slow – a scenario that we believe is quite unlikely. M.D.C. earned $10.99 per share in 2005. If the industry does not slow, we project that company’s earnings will grow at a 15+% rate – to over $12.50 per share this year and to over $14.00 per share next year. The company’s book value, which was $43.74 on December 31, would increase to in excess of $68 by the end of 2007 (after dividends at an $1.00 annual rate). For a homebuilder, M.D.C. has a particularly strong balance sheet – with the net debt-to-cap ratio only 28%. Given these projections and strengths, it is clear that, if the homebuilding industry does not slow, the risk-to-reward ratio of owning M.D.C.’s shares for the next year or so is compelling.

Let us look at another scenario: that the industry returns to normal conditions. We believe that the single-family housing starts have been running about 15% above normal – and we project that, if 2007 is a normal year, M.D.C. would sell about 15,000 homes – flat with the 15,307 homes closed in 2005 (remember – the large homebuilders are continuing to gain market share). We also estimate that prices in M.D.C.’s geography currently are averaging about 8% above normal – with prices 20%+ above normal in some markets, but below normal in other markets (including Texas and parts of Colorado). Prices historically increase about 4-5% per year, with 3% of the increase due to inflation and the remainder due the tendency of homes to have increased size and content (and this trend that has continued unabated). Thus we would estimate that average selling prices in 2007 would be about flat with 2005 at about $314,000. Regarding margins, last year M.D.C. was burdened with high cost inflation for land and high prices for labor, lumber, cement, and wallboard. It is logical that, if demand weakens materially, labor and lumber costs will ease – and cement and wallboard prices could come under pressure also (although land cost will rise for a year or two as the company works through its existing inventory). Another consideration is that the company has been spending for future growth. For example, it currently is incurring start-up losses in Philadelphia, Tampa, Chicago, and the Delaware Valley. Management says that, if the industry slows, it can and will bring down start-up and other fixed costs. On balance, our best estimate is that, under the conditions described above, M.D.C.’s pre-tax homebuilding margins would slip from 16.2% last year to about 13%. I note that in the 2001-2003 period, when demand, prices, and margins were “normal”, the company’s pre-tax margins averaged above 11%. It is reasonable to conclude that, given efficiencies of scale and other efficiencies, M.D.C.’s normalized margins could improve by 200 basis points in five years (we believe that this is a conservative estimate).

Based on the above estimates we can project that 2007 revenues given a normal housing market would be $4.71 billion and that pre-tax homebuilding earnings (which are after interest expense) would be about $610 million. After a projected $25 million of earnings form the mortgage subsidiary and after a 37.5% tax rate, net earnings would be just under $400 million, or about $8.70 per share on 46 million shares. I note if the company earns $11.50 this year (the company is projecting an up year in spite of the recent slow down) and $8.70 in 2007, the book value at the end of 2007 would be about $62, or close to the present price of the shares.

Therefore, we conclude that M.D.C. is a bargain that is (1) growing rapidly as the homebuilding industry continues to consolidate; (2) selling at only 7.5X our projection of “normalized” 2007 EPS; (3) selling at about what its book value will be two years form now; (4) blessed with a very strong balance sheet; and (5) blessed with almost none of the problems facing corporate America, including competition from emerging countries (you cannot build a home in China and ship it to the U.S. in a container) or legacy costs (the industry subcontracts the construction of its homes and therefore hires relatively few workers). We believe that M.D.C. is better than an average company. Over a 30-year period the U.S. stock market has sold at an average of about 15X earnings. Thus, we believe that M.D.C. is worth more than 15X its normalized earnings. But, to be conservative, at only 12.5X our 2007 estimate of normalized the earnings, the shares would be worth about $109 next year, or 52% above the present price – and the shares are protected by the company’s book value, strong balance sheet, and quality of its management.

There is one other important consideration: M.D.C.’s current sales are relatively heavily weighted towards markets that have been “hot”. However, this has been taken into consideration in the above projections and, furthermore, is a long term positive. Many of M.D.C. markets have been “hot” because they are growing rapidly and are land (permitted land) constrained. True, this is a negative as these markets weaken, but over the longer term it is a major advantage to be selling homes in markets where the population is growing rapidly and where it is difficult to obtain building permits.

M.D.C. was founded by Larry Mizel (M.D.C. stands for Mizel Development Company), who remains the controlling shareholder. Competitors say that the company is particularly well managed. In spite of the fact that the company does not benefit from large profits on its land holdings, M.D.C.’s margins are among the highest in the industry – which attests to the quality of the company’s management and strategies.

Importantly, M.D.C.’s shares in recent weeks have materially lagged its competitors. Weak orders may be one reason – but another is that two of the company’s largest shareholders (Barclays and Marsico) have been selling their positions and have been putting pressure on the market. Given our above analysis, we believe that his selling pressure has created an unusual opportunity.

As an aside, two former CEOs of large homebuilders each told me that Centex and Lennar also have relatively conservative and well positioned land positions – and that each is relatively well positioned for a return to normalcy, although not as well positioned as M.D.C.

note - I will be out of the country for about a week and therefore will not be able to respond to questions until later next week

Catalyst

M.D.C. shares have been depressed by selling by two of the company's largest holders. This selling pressure, which has to end once the two holders have sold all their shares, has created an unusual opportunity. Furthermore, the company's small land base is a major advantage as the housing market returns to normalcy -- and this advantage, at some point, should be recognized by the market.