M.D.C. Holdings: Short-Term Pain, Long-Term Gain (NYSE:MDC)

Ah, I love the smell of a successful investment thesis in the morning.

M.D.C. Holdings (NYSE:MDC) is a homebuilder (via its wholly owned subsidiary Richmond American Homes) with a very strong record of conservative financial management and consistent dividends. The company has paid a dividend for 28 years without cutting or reducing it once. While the dividend hasn’t increased in every year over the last quarter century, a stable dividend is better than a dividend cut, especially in a cyclical industry like homebuilding.

Back in September 2022, I pitched MDC as a shareholder-friendly way to play the long-term trend in Millennials belatedly entering the homeownership game. Since that “Strong Buy” rating, MDC is up over 33%.

Then, in November, I talked in another article about how MDC is “Prepared For A Downturn In The Housing Market” through its strong cash position and long debt maturities (no loans coming due anytime during this decade). Since that article was published, MDC is up 29%.

If only my stock picks worked out this well all the time…

But now that MDC has run up to about $41, is it time to cash in and take one’s chips elsewhere?

I don’t think so. I’m a long-term investor primarily holding MDC for its generous dividend income stream, and I think I’ll get many more good years out of this horse before she retires. Besides, the current price of $41.16 (as of this writing) is still a slight discount to book value per share of $42.60.

If you have more of a trading mentality than me, you might consider taking some gains here as we enter what will no doubt be a tough first half of 2023.

Though the housing market appears to be in for more pain ahead, I think there are some green shoots forming for MDC, including easing input costs.

Let’s dive in for an end-of-year update on this cash-rich homebuilder.

End of 2022 Update

MDC generated $7.67 in EPS for 2022, down only 2% from 2021’s $7.83. That is remarkable considering the fact that the 30-year mortgage rate got up to about 7% late in the third quarter and early in the fourth quarter.

Here are a smattering of key Q4 metrics, taken from the Q4 and full year 2022 earnings release:

• Average selling price of deliveries up 8% to $582,000
• Unit deliveries down 4% to 2,554
• Homebuilding pretax income decreased 51% to $94.5 million from $193.5 million
• Gross margin from home sales decreased 850 basis points to 15.0% from 23.5%
• Net income of $79.8 million, or $1.08 per diluted share, down 51% from $162.7 million or $2.21 per diluted share
• Cancellations as a percentage of beginning backlog increased to 24.6% from 8.7%
• Gross order average selling price down approximately 1% to $551,000

Compared to 2,554 home deliveries in Q4 2022, MDC expects to deliver between 1,500 and 1,600 homes in Q1 2023. This is a pretty steep drop, but it is to be expected given where mortgage rates and home prices are.

It’s also interesting to note that nearly 2/3rds of MDC’s 5,338-home backlog are in MDC’s affordable lines of homes that may appeal most to the first-time homebuyer.

Compared to the average selling price pf $582,000 for new deliveries in Q4, MDC expects an average selling price between $550,000 and $560,000 for home deliveries in Q1 2023.

Executive Chairman and company founder Larry Mizel commented in the Q4 earnings release:

We did experience a rebound in order activity in December thanks to a more aggressive approach to pricing and incentives, an encouraging sign that price elasticity exists in our markets.

Crucially, compared to a gross margin of 15% in Q4, MDC expects a gross margin of 18-19% for Q1. In other words, the hit to MDC’s gross margin from input cost inflation (materials, labor, etc.) probably reached its worst point in the second half of 2022 and is now on the rebound.

Lumber prices have come down significantly, and labor costs are at least not shooting higher like they were up to the middle of 2022.

These input costs were one reason that MDC’s net income halved in Q4. Though home sales revenue increased 3.6% YoY, the cost of homes sold increased 6.7%.

But actually, the bigger reason for the sharp drop in net income was “inventory impairments,” or selling homes in their inventory at lower prices than they originally expected. Excluding this non-cash charge, the gross margin came in a little above 21%.

And, of course, it’s useful to point out that though MDC’s net income and EPS plunged YoY in Q4, the $1.08 in EPS still comfortably covered the $0.50 quarterly dividend at a payout ratio of 46.3%.

Remarkably, in 2022, I estimate that MDC generated around $875 million in free cash flow (~30% of its current market cap), based on $906 million in operating cash flow and around $25-30 million in capital expenditures.

Speaking of spending, management has greatly pulled back on buying or optioning lots for future development. This is a strategic move to remain as capital-light as possible for as long as the housing market remains challenged.

But management do have plenty of dry powder with which to pursue attractive land opportunities if and when those opportunities come.

MDC ended 2022 with cash and marketable securities of $1.28 billion, representing an incredible 42.8% of MDC’s market cap or $17.50 per share.

This enormous cash cushion provides a high degree of safety in the face of economic uncertainty in the year ahead.

Finally, despite the uncertainty, there remains a high level of pent-up demand for homes, especially affordable “starter” homes, from Millennials entering their prime home-buying years as well as Boomers looking to downsize.

Here’s Mizel from the Q4 conference call:

Despite the near term challenges facing our industry, we remain confident in the long term outlook for new home construction. Existing home inventory remains at a historically low level on a national basis, and there continues to be a strong desire for home ownership by a large segment of the population. We believe that comparisons made between this housing correction and the one we experienced during the 2007 and ‘08 financial crisis [are] unwarranted.

Indeed, underwriting standards for mortgages have dramatically improved since the housing bubble era, while the creditworthiness of borrowers has risen, speculative buying has diminished, and home equity has increased.

While some measure of pullback in home prices is warranted given the massive rally over the last two years in combination with higher mortgage rates, a housing market crash like the one seen in the Great Financial Crisis era appears unlikely.

Bottom Line

While MDC’s price to book value is almost back to 1x, the stock price still has another 23.5% upside to its long-term average P/B of 1.195x.

That would seem to suggest that there’s more fuel left in the current rally. But I would still rate MDC as a “Hold” right now because of the conspicuous headwinds the homebuilder faces for at least the first half of 2023.

The market knows the situation will be difficult for MDC in 2023, but no one really knows just how difficult. As such, I believe it is time for investors to exercise a little caution with MDC. Another buying opportunity at a lower price seems plausible in the relatively near future.