Description

Melcor is a deeply undervalued stock, trading at a valuation only briefly seen during the GFC: 0.5x book value and 9.2x (depressed) LTM earnings. It is a high-quality, although cyclical real estate business that has compounded EPS at a 16% CAGR over the past 20 years and has had an average ROE of 15%.  Even after accounting for the depressed current valuation and low trading price, the stock’s total return has been 4,000% (12% CAGR) over the past 33 years. 

Even though it has a $500mm market cap, the stock is underfollowed with low trading liquidity and scant research coverage.  Its price is currently depressed due to poor sentiment and cyclicality, as the majority of its assets are in oil-focused Alberta.  However, I believe the cycle has bottomed.  Nonetheless, Melcor has remained profitable throughout the cyclical lows.  The stock represents a derivative play on the recovery in the price of oil (plus you get paid to wait). 

I propose a long investment in Melcor, with an estimated 20%+ IRR over a 3-5 year timeframe.  Unfortunately, aside from a cyclical recovery, there really are no catalysts.  I believe in the next 3-5 years, we will enter another oil bull market (WTI > $60.00), with Melcor back to a double digit ROE and growing revenue along with improving sentiment.  The stock performance will come from a combination of growth in book value, dividends and reversion to its 10-year average valuation of 1.0 – 1.2x BV (which is warranted for a good business with a mid-teens ROE).

Company Overview

Melcor Developments (TSX: MRD) is real estate development company based in Edmonton, Alberta.  It was founded in 1923 and has been publicly traded since 1968.  In addition to real estate development, MRD is the manager and controlling unitholder of Melcor REIT (TSX: MR-U), in which it vends in stabilized commercial properties and crystallizes value.

Melcor operates five integrated divisions:

1. Community development – acquires raw land for commercial and residential community development (mainly single-family lots).

2. Property development – develops office, retail and industrial properties on land from the Community development division.

3. Investment properties – Manages properties developed through the Property development division. Owns 745k sf of properties in Alberta, Phoenix and Denver.  Manages additional 3.125k sf and earns a management fee from the REIT.

4. REIT – Vends in stabilized properties from the Investment properties division. Owns 38 office, retail and industrial properties comprising 2775k sf GLA.  MRD has a 56.7% interest in the REIT and consolidates its financials.

5. Recreational properties – Owns and operates 4 golf courses as part of the Community development division.

The company’s main operations are in Alberta (Calgary, Edmonton, Lethbridge and Red Deer). It also operates assets in BC, Saskatchewan and the US (Arizona, Colorado and Texas).  Given the majority of its assets are in Alberta, the business’s performance is correlated to the price of oil.

Historical Financial Performance

While the business is cyclical, Melcor has performed well over the cycle and has compounded value over time.  The business is not reliant on capital markets and it has not accessed public markets in recent history. 

Financial results continue to decline in 2016 with YTD revenue has down 13%. While Q4 is the company’s most meaningful quarter, 2016 results are likely to be poor.

Economic Fundamentals

Alberta has been in a recession for two years.  Some consider it a depression.  GDP contracted 3.7% in 2015 and is expected to decline by 2.7% in 2016.

http://business.financialpost.com/news/economy/alberta-in-worst-recession-since-government-began-recording-data-in-the-1980s-as-deficit-balloons-to-10-9-million?__lsa=5bb0-e45b

The current unemployment rate is 8.6%, up from a low of 4.4% in November 2014 when the oil bear market began.  This is the highest unemployment rate since 1994. As seen in the graph below, Alberta housing starts have declined markedly, pressuring Melcor’s Community Development division.  Housing starts are highly correlated to the inverse unemployment rate.

Housing Bubble?

According to Statistics Canada, Calgary had the highest median total family income of all census metropolitan areas in Canada in 2014 at $104,530, followed by Edmonton at $101,470. For Calgary, the median home price is $420,000, the median household income is $104,530 and the home price / income ratio is 4.0.  For Edmonton, the median home price is $384,504, the median household income is $101,470 and the home price / income ratio is 3.8.  These compare to the home price / income ratio of 6.3 for all of Canada and 3.6 for the US.

The valuations of home prices in Alberta are reasonable.  Home prices in Edmonton are still lower than they were in 2007 and home prices in Calgary are slightly higher.  Real returns for home prices in Alberta have been negative over the past 9 years.

Given home prices haven’t declined much (they actually have been quite stable), I believe Melcor’s land has maintained its value.  Given homes don’t seem overvalued, I believe book value is a decent proxy for MRD’s intrinsic value.

Financials

The majority of Melcor’s value resides in its raw land and investment properties.  MRD controls MR-U and it consolidates the REIT in its financials.  If we de-consolidate the balance sheet, we get a better picture of what MRD looks like:

An important accounting change occurred in 2011 when MRD transitioned from GAAP to IFRS.  Previously, under GAAP it accounted for investment properties by recording them at cost and amortizing them over their useful life. Under IFRS, it valued its investment properties at fair value on a quarterly basis (not subject to amortization).  Now that the majority of the investment properties reside in the publicly-traded REIT, we can get a daily mark-to-market valuation of these assets (note the REIT also trades at a sizeable discount to book value).

Given the challenging economic environment, MR-U (the majority of Melcor’s Investment Properties) has performed surprisingly well with YoY AFFO growth of 3%, same-asset NOI growth of 1% and steady occupancy of 93.2%. Office accounts for 57% of GLA, retail 35% and industrial 8%.  I believe results have been strong because MR-U’s office exposure is mostly Edmonton, and therefore the company isn’t exposed to Calgary’s decimated downtown office market, where bankrupt oil companies vacating space has contributed to heavy losses for some real estate companies (see Dream REIT).  Over the next 5 years, roughly 10% of GLA leases are expiring per year.  Tenant industry exposure is <10%.

As seen in the above table, the majority of Melcor’s debt resides in non-recourse mortgages on investment properties.  If an investor didn’t want exposure to Alberta commercial properties, one could short the REIT.  Netting off the REIT, the majority of Melcor’s Investment Property value resides in Arizona and Colorado.  Melcor owns 14.6mm REIT units worth about $130mm (or $3.82 per MRD share, 27% of the current stock price). Given the REIT trades at a smaller discount, Melcor ex-REIT trades at an even more discounted 45% of book value.

Melcor has $700mm of land, representing the lion’s share of the company’s value.  It has over 10,000 acres of raw land with the following geographical segmentation: 

Land for residential development represents 78% with the remainder held for commercial development.  Roughly half of the land value is in raw land, with 19% under development and 30% developed.  Land inventory is recorded at the lower of cost and net realizable value (selling price).  Over the past 8 years, single-family lot sales have grown while margins and gross average revenue per lot has remained relatively stable:  

Valuation

The closest comparable was Calgary-based Brookfield Residential Properties, which was taken private by Brookfield Asset Management in December 2014 for US$4bn, representing 1.9x BV, 12.5x 2015E EPS.  WTI was at $55.84 on the day the acquisition was announced. 

Its closest public comp is Dream Unlimited (TSX: DRM), a western-Canada focused real estate development company.  It currently trades at 1.05x book value.  Given Melcor has superior assets and management compared to Dream, I believe that MRD should trade at a premium to DRM. If one wanted to invest in MRD but maintain market-neutral positioning, one could short DRM.

MRD is currently trading at half of book value, a discount only seen for a brief period during the global financial crisis.  As seen in the graph below, MRD’s multiple is generally correlated with the price of oil.  Its 10-year average price-to-book ratio is 1.1x.

Assuming MRD can earn its 5-year average ROE of 10% (this includes two recession years), book value would grow to $40.00 (after netting off 3% dividend yield).  Assuming the stock would trade to book value in 5 years, the IRR for an investor in the stock today would be ~25% (including dividends). 

Capital Allocation

The founding Melton family owns more than half the shares outstanding.  They established the company 93 years ago, and have been good stewards of capital over recent history.  The company pays a variable quarterly dividend and has a current dividend yield of 3.2%.  In the past it has occasionally paid a special dividend with excess capital.  It usually has a normal course issuer bid outstanding but doesn’t repurchase many shares due to the low liquidity.  As a result, share count has largely remained constant over the past couple of decades. 

Since the GFC, Melcor has implemented numerous strategies to enhance shareholder value:

• It spun-off its stabilized investment properties into a publicly traded REIT.  This created value in three ways: It created a captive vehicle in which it could vend in properties and crystallize value, it created a high-margin (although small) management fee stream and it allowed the market to more clearly value the stock.
• It diversified its asset base geographically to reduce cyclicality: US properties now account for more than 10% of total assets and is increasing.
• It reduced leverage and increased allocation to income producing properties to reduce cyclicality:   Debt / equity went from 1.54x at the end of 2007 to 0.88x currently.

Conclusion

Melcor is a good business with a substantially undervalued stock given its exposure to the troughing oil cycle and the accompanying negative sentiment.  I believe the stock presents an attractive risk-reward for long-term, contrarian investors and the stock price could provide an 20%+ IRR over the next 5 years as the Alberta economy recovers from a two-year recession and Melcor’s multiple re-rates to 1.0 – 1.2x BV.  At the current depressed valuation, the stock provides a significant margin of safety.

Catalyst

n/a