This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines focus on the housing sector, as one analysts shifts its stance on three big names in homebuilding -- downgrading both PulteGroup (NYSE:PHM) and Ryland Group (NYSE:RYL), but...
Upping MDC Holdings to buy
Before moving on to the bad news, let's start with some good. Investment banker KeyBanc Capital Markets thinks that in view of the broad strength in housing stocks lately, it's time to revisit the sector, take some winnings off the table, and move a bit of that money into stocks with perhaps a bit more potential to keep growing. It's choice today: MDC Holdings (NYSE:MDC).
According to KeyBanc, MDC's numbers are showing improvement, yet the stock continues to trade at a discount relative to its peers in the housing sector. And in a sense, KeyBanc is right about that. Due to weakness among some players in the industry, MDC's numbers are lower than the average in many respects. For example, Yahoo! Finance has the average price-to-sales ratio in this industry at 5.4... but MDC's P/S ratio is only 1.4. The average P/E (hurt by unprofitable players, no doubt), is in the quadruple digits, yet MDC costs "only" 24 times earnings.
It's that "only" that worries me, though, because 24 times earnings isn't something you'd ordinarily call a bargain price -- especially not with MDC's record of having burnt cash (negative free cash flow) for the past three years straight, which suggests MDC's GAAP "earnings" are of pretty poor quality. So while it's true the stock could be the bargain that KeyBanc makes it out to be -- what with the projected earnings growth rate being 50% and all -- I personally remain unconvinced.
Punishing Pulte... unfairly?
Fact is, I'm not even convinced that MDC is selling at the "discount" that KeyBanc says it is. Why not? Well, let's take a look at one of the peers KeyBanc thinks MDC is undervalued-in-comparison-to: PulteGroup.
Priced at 30 times earnings, Pulte sells at a premium to MDC, despite having a similarly pie-in-the-sky rate of projected earnings growth -- 34%. That's probably one reason the analyst downgraded Pulte to hold, while promoting MDC to buy. And yet, if you're a PEG kind of an investor, and agree that any stock with a P/E ratio lower than its growth rate is something to consider buying, it stands to reason that you'd like Pulte shares just as much as MDC shares, inasmuch as both stocks sell for PEG ratios of less than 1.0. Yet KeyBanc does not like Pulte as much as MDC.
The case for preferring Pulte gets even stronger as we turn to the company's cash flow statement. There, in stark contrast to the cash-burn at MDC, we find Pulte churning out an incredible $900 million in positive free cash flow. That's literally three times as much cash profit as Pulte is permitted to report under GAAP accounting profits -- yet every dollar of this cash profit is real, and money in the bank.
Result: I find Pulte a much more compelling buy at 10 times free cash flow and a 34% growth rate, than I do MDC at negative free cash flow, and growing these nonexistent cash "profits" at 50% or more per year.
Rounding on Ryland
As we turn now to the last stock on KeyBanc's list, however, I finally find myself in agreement with the analyst on one point: Ryland's not as good a deal as its peers.
Ryland is burning cash faster than MDC for one thing. It's got a higher P/E ratio (36.5) than either Pulte or MDC for another.
On the one hand, it's growing faster than MDC -- with 55% annualized earnings growth projected. On the other hand... did I mention Ryland's burning cash just like MDC? I did? Okay then -- so that means Ryland's GAAP "earnings" are of just as low quality as MDC's.
Really, the main question that strikes me after reviewing KeyBanc's write-ups today is why it's recommending one cash burner, and panning another. Seems to me, the effort would be better spent focusing on the one company in this industry that's producing truly tremendous cash profits -- PulteGroup -- and determining whether it's going to be able to keep repeating that feat at anything approaching its projected 34% growth rate. If it can, the stock's a pretty obvious buy.
But even if it can't, I think a PulteGroup producing $900 million cash profit, and growing at even as low a rate as 10% or so, would still make for a good investment.
Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.