Description

Overview & General Thesis

Melcor is a diversified real estate development company founded by the Melton family back in 1923.  The Melton family maintains control of the company today.  The bulk of Melcor’s history has been in the province of Alberta.  Over the years they have diversified into select US markets, however the bulk of raw land, development and investment properties continue to be Alberta based.  

Melcor went public in 1968 with dividends being paid since 1969.  Public history is readily available from 1992 to present.  Over that 30 year history:

•  ROE has averaged 11.6%. 

• No year has incurred negative earnings, although 2020 was barely positive at +1.1%.  

• Book value and dividends per share have grown at CAGR’s of ~9.2% and ~11.2% respectively. 

However, the past 7 years (since 2014/15) have been very difficult with an average ROE of only 4.5%.  The dividend payout has just now recovered to that of 2015.  For the 23 year period leading up to 2014/15, the returns are much better:

• ROE averaged 13.7%, 

• Book value and dividends per share grew at CAGR’s of more than 11% and 15% respectively.  

These recent tough ~7 years are consistent with Alberta’s downturn over this period.  The recent despair in Alberta has been so bad that GDP per capita is just now recovering to near pre-GFC levels (2006-2008).  GDP per capita is still well under the level seen in 2014.  

With these last 7 difficult years, it’s not surprising MRD trades at 37% of adjusted book value and offers a present 5% dividend yield.  But there are signs Alberta’s economy is recovering with past headwinds possibly shifting to tailwinds.  House building is robust, inter-provincial immigration trends are up, O&G companies are profitable (albeit cautious) and the provincial government is running surpluses again. And the economy is becoming better diversified with less reliance on O&G.

If these trends are sustainable, MRD could represent a deeply discounted bargain opportunity at the present price.  I view it as a long term above average compound opportunity with a nice growing dividend stream.  There is a shorter term possibility of getting bought out closer to the underlying value of the business.  

MRD (parent company) vs MR.UN (REIT)

The other way to play this one is via the REIT.  The REIT currently has a higher yield (8.3%) but my preference is MRD:  

• The REIT seems set up to provide value to MRD.  The REIT has first refusal of commercial properties developed by MRD.  In purchasing these properties there is risk of share dilution for the REIT.  

• Based on current stock price the REIT’s AFFO yield is ~13% based on YE 2021 results but has dropped down to ~11% based on Q3’s declining trend.   MRD’s AFFO yield based on 2021 YE was ~21%, however the TTM AFFO is up slightly and since April/22 have completely filled their 5% NCIB. MRD’s AFFO is more volatile, but not included in AFFO are the fair value adjustments on investment properties - these can be quite sizable and cash based when a sale transfer is made (to the REIT or elsewhere). 

• MRD is the one insiders have been buying (aggressively at times).

• MRD is more diverse and less caprate sensitive.

• MRD owns 55.4% of the REIT, so indirectly one share of MRD buys over half a share of the REIT anyway. 

However, they both trade at similar multiples to book value, MR.UN does appear quite undervalued also.  It’s worth pointing out there is a unique way of accounting for the REIT on MRD’s balance sheet.  If MR.UN increases in price, book value decreases for MRD accordingly (and vice-versa).  My understanding is the cost accounting method takes into account what it would cost the parent (MRD) to buy back the other 44.6% of the REIT it does not own.  I adjust the current book value of MRD from $35.55 to $31.80 which accounts for the REIT at it’s full book value. 

Alberta Economy

If the Alberta economy is not on the verge of recovery, much of this thesis could be off base.  Historically, Alberta’s economy is aligned with a strong O&G market. However, in the mid 1990’s Alberta’s recovery began despite O&G prices continuing their downward decline only to bottom out 4-5 years afterward.  It seems likely this time around Alberta will need to innovate and diversify (there is already evidence of this occurring).  Yes, there is likelihood of expenditures on carbon capture and the like - but it’s doubtful the overall O&G expenditures make up for the oil sands investments present in the last cycle.  Oil companies are being cautious with their capital spending, so this recovery could look different than others.

It is quite interesting to compare the previous period of stagnant GDP per Capita growth to the more recent experience. 

The chart below begins where the one above ends (note the chart above is in 1998$, the one below is in 2012$).  Recent history follows a very similar trend.  GDP per capita makes one last gasp before continuing the sideways slide. In the example above it took ~12 years until full recovery.  In the present situation below it’s going on ~15 years. 

Melcor’s Financial History

Melcor is very well managed.  The spreadsheets below contain various key ratios for Melcor’s performance over the years.  The past 7 years have been the worst, yet revenue in 2021 slightly edged out the previous record set in 2014.  And the annual dividend is back to the previous high set in 2015. I am optimistic the worst is behind them.  

Melcor’s public financial record begins around the start of the previous recovery in the early 1990’s (from a similar period of economic despair in Alberta).  As a note of reference, Melcor’s share count has fluctuated between ~30-33 million shares - having fully filled their recent 5% NCIB it’s back to around the middle of that range.  

Melcor - ROE history

Melcor - Dividend Growth

Melcor - Book Value Growth

Melcor Revenue, Gross & EBIT Margins

Segments

The Alberta housing market has been very robust.  Year-to-date, they have sold 676 single-family lots compared to 408 last year.  The Harmony community in Denver is the largest land development project in their US region. Sales in this area are often sold in bulk and thus result in lumpy sales - no lots have been sold in the US year to date.

The housing market falls within the Community Development segment which owns ~10,000 acres of raw land broken down into the following (includes surrounding areas): 28% Edmonton, 22% Calgary, 18% Red Deer, 7% Lethbridge, 6% Regina, 5% BC (mainly Kelowna), 10% Denver & 3% Phoenix. 

The Property Development segment’s activity seems to be down due to the uncertainty associated with changing trends from the pandemic, the pandemic itself; a cautious business mood from this, rising interest rates, possible recession, etc.

These cautious business moods also seem to have the Investment Property division waiting things out and turning over property at a slower pace. Rising interest rates/inflation are causing a lot of uncertainty as it pertains to caprates.  An increase in caprates by 50 basis points decreases the carrying value of investment properties by $69.5 million. That’s the equivalent of ~$2.25/share in MRD’s book value but assumes no inflation passed along and also needs to back out the REIT’s portion. 

The REIT’s overall occupancy last reported is ~88%.  Breakdown is as follows: Retail ~97%, Office ~79%, Industrial @ 100%.  Again the REIT is carried on the balance sheet as a liability for the portion MRD doesn’t own.

Below is some info on each segment. 

Community Development

Community Development acquires raw land and plans residential communities, commercial and industrial developments.  The process often takes years from the land acquisition to the first home or commercial building being built. 

Property Development

Property Development plans and builds industrial, retail and suburban office spaces.  Includes moving process through municipal approval process, pre-leasing and project managing development and construction.  

Investment Properties

Investment Properties is the property and asset manager for Melcor’s current 4.75 million sq ft in commercial real estate and 593 residential rental units including the REIT.  

REIT

Melcor has a 55.4% control interest in the REIT.  They manage, administer and operate the REIT and it’s properties under an asset management & property agreement via the Investment Properties team.

Recreational Properties

Melcor owns and operates 3 championship golf courses built in the midst of Melcor communities. A fourth golf course is jointly owned and operated by a joint venture partner. 

Breakdown, etc

Departure of previous CEO (announced August 2021)

Not sure of the real reason for the departure of Melcor’s previous CEO Darin Rayburn.  The stated reason was he was going to retire, but he has since joined the firm KV Capital through a newly created division that will support real estate development and provide equity backing.  The reason for leaving (retirement) didn’t sound right - he is still quite young.  Chairman and previous CEO Tim Melton has taken back the reins.  The company is in very capable hands, but Tim is up there in age - it leads one to wonder if the real reason for this change is a desire from the Melton family to sell.

Headwinds

There is the opposite potential of interest rates trending upwards rather than the decline experienced in the historical data above.  Could this make their business less profitable going forward?  We have witnessed first hand the recent quick rise in interest rates as it correlates to the inflation spike.  So if interest rates are on the rise, it’s cause would be inflation. If persistent, inflation should tend to be beneficial as they monetize raw land and property purchased/developed years prior. Just as an example, of the 10,000 acres of raw land they own, the lots they sell each year only eat into a small sliver of that.  Perhaps this should be listed under possible tailwinds? 

The uncertainty surrounding work from home and how that impacts their office development and investment portion of the business.  I think we are already seeing evidence of this trend having it’s limits.  A recovering Alberta economy should fill in vacant office space (and that being developed) in due course.  If the trend is persistent, they can perhaps pivot toward more retail/industrial development.  Failing that, they can right-size the division accordingly.  It might be a headwind but has its limits as far as shareholder returns go over the long term at least.  

Tailwinds

Melcor Specifically

• Affordability and a Robust housing market. 

• Large property asset from which to develop upon provincial recovery.  A good chunk of FFO can be returned to shareholders. Recent share buyback under the NCIB equated to about the same return of free cash flow as the dividend.

Economically (IE Provincial Economy) 

• 7 lean years leading to a more efficient economic base.

• Immigration trends. Both internationally and inter-provincial.

• Diversification underway.

• Transmountain Pipeline expansion is expected to be in commercial service by the end of this year.  Will add 590,000 barrels per day of capacity.  Will reduce bottlenecks, increase efficiency and decrease WCS and WTI spread.

• Weak Canadian dollar.  It could strengthen some but too much would hurt the eastern economy - forces at play should keep in balance.  75 cents per USD right now but even a mid-80’s level is still quite profitable for many O&G firms especially if/when the WCS spread tightens.

• Underinvestment in fossil fuel exploration and development.  O&G spending expected to increase but at a more cautious pace.

• While O&G capital expenditures may be down, royalties for the province have been going up, resulting in fiscal surplus. Trend could continue allowing dollars for further diversification/innovation, paying down debt, etc.

• A few select slides from recent Business Council of Alberta presentation follow.

Valuation

Book Value

Below is a chart showing the yearly high/low multiples of price to book value. Volatility is very apparent over the 30 year history.  The average over that time works out to 0.64 to 1.05 times book value.  In 2010/11 the switch to IFRS accounting had a fairly large increase in retained earnings - so this and the establishment of the REIT in 2013 should be considered in making present comparisons.

Book value at Q3/22 was $35.55 per share, but as mentioned previously I adjust this downward to ~$31.80 which more realistically accounts for the 45% public owned portion of the REIT. 

Dividend Yield

The chart below is dividend yield history with the high and low mark per each year.  There has been a lot of (stock price) variability in the dividend yield also.  The present yield of 5.1% is higher than the average yearly range of between 2.6% and 4.2%.  It should be noted that in 2013 the company paid a special dividend of $0.50 that is not taken into account in this range or in the chart below.  

FFO 

FFO in 2021 was ~$81 million.  It’s improved slightly and on a TTM basis sitting at ~$84 million. Based on the current share count that’s about $2.68/share compared to the current stock price of $11.80.  Over the last 12 months they have distributed back at least 45% of that amount in dividends and share buybacks.

Below is the last 10 years of FFO history. 

Conclusion

Melcor has a very long history of success. The last 7 years distort what was achieved the previous 23.  Alberta seems very much on the verge of economic recovery, Melcor stands to benefit as past history demonstrates..  

Melcor’s business model and competitive advantage involves owning raw land bought in previous years with the foresight to purchase land best suited for eventual development of desirable communities. The development and investment property segments have a similar mindset - as a result the downfall over the past 7 years didn’t hit them as hard as others.  

MRD presents a very nice bargain with strong likelihood of a steady increasing dividend stream - provided it doesn’t get bought out first. 

Catalyst

Alberta economic recovery 

Increasing Dividends and possibly more buybacks

Increasing FFO, EPS

Buyout of the company