With a scarcity of distressed sectors in the stock market nowadays, Fools might want to consider shares of homebuilder MDC (NYSE:MDC). But wait! Homebuilders? Anyone with half a brain knows that all homebuilders will be dead money for at least a couple of years. Luckily, I have an entire brain, so I think Motley Fool Hidden Gems selection MDC might be a great place to park some idle cash.
A simple homebuilding model
After reading every public homebuilder's 2006 annual report, I concluded that large homebuilders such as DR Horton (NYSE:DHI), Centex (NYSE:CTX), and Pulte (NYSE:PHM) have some advantages in scale, and homebuilders like Toll (NYSE:TOL) and KB Home (NYSE:KBH) have some advantages with their brands. But at the end of the day, capital allocation skills played the biggest role in determining returns.
Homebuilders are kind of like hedge fund managers, but instead of buying and selling stocks and bonds, they buy and sell land. While they may sell the occasional house, homebuilders generally subcontract out the actual construction.
Land dominates a homebuilder's balance sheet. At the end of 2006, for example, DR Horton had about $7 billion worth of land, including parcels under development and options on its books. That compares to roughly $6.5 billion worth of current shareholder equity and a current $6.7 billion market cap. Clearly, DR Horton's ability to turn that land into cold, hard cash is crucial to its overall performance.
When it comes to managing land, MDC is one of a handful of homebuilders with a great financial position and a sufficiently strong balance sheet to capitalize on housing's down cycle. As of the latest quarter, MDC had $630 million in cash and $1.3 billion in land and land under development, compared to its $2 billion in shareholder equity and a $2.4 billion market cap.
When less is more
During a slumping housing market, it pays to own less land than your competitors, since that land costs money to keep. Companies must pay off the debt they used to finance the purchases of their land, and the property taxes that come with it, even as the market value of that land continues to fall. Homebuilders overleveraged with land may be forced to sell property at a loss just to get it off their books and pay off debt.
According to a Centex investor presentation, MDC enjoys the industry's lowest amount of land on the books. (That figure is determined by dividing total owned and optioned land lots by trailing-12-month closings.) By this measure, MDC had slightly more than two years' supply of land. Its next-closest competitor, Ryland (NYSE:RYL), had slightly more than four years' land supply. When you ignore optioned lots and measure owned lots alone, MDC still has the third-lowest land supply among its peers. Its financial flexibility allows the company to sell its land and houses in a more orderly manner, and to capitalize on others' misfortune by buying land at fire-sale prices.
In its latest analyst conference, MDC stated a clear interest in buying land. Its rivals aren't yet desperate enough to sell at MDC's low asking prices. But if the slump continues, the company might be able to snap up a bunch of land on the cheap.
Place your bets
For this reason, I believe MDC might be a very Foolish place to invest. The company currently trades at a $2.2 billion market cap, only a slight premium to its solid $2 billion book value. Its extremely conservative nature virtually guarantees that it will survive the downturn, and its financial flexibility may help it to buy very cheap land, yet be first out of the gate when the housing cycle turns. I consider these shares a nearly free call option on the housing cycle.
If things go poorly, MDC's great balance sheet, conservative management, and low price-to-book value could help limit your losses. And if they go well, you could win big if MDC can pick up cheap land, fattening its margins when the housing market recovers. Assuming you're a gambling Fool, this sounds like a good bet to me.
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MDC Holdings is a Motley Fool Hidden Gems recommendation. If you're interested in small-cap companies with great potential, take a free 30-day trial of our market-crushing investing newsletter.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool's disclosure policy has huge tracts of land.
