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Harbor Custom Development, Inc. (NASDAQ:HCDI) has made significant progress since my first article on the company on 11/1/2021. Q4 earnings were outstanding and management has guided for continued EBITDA growth in 2022. Credit risk for HCDIP has decreased due to the company’s continued profitability, stronger balance sheet and new bank credit line. Despite this progress, Harbor Custom Development, Inc. 8% CONV PFD SR A (NASDAQ:HCDIP) has traded slightly lower. At a recent price of $15.22, HCDIP yields 13.1% and trades at a 39% discount to par.
What is HCDIP?
HCDIP is a par $25 cumulative preferred convertible issue with an 8% coupon. Dividends are paid monthly, and HCDIP now yields 13.1% at a recent price of $15.22. HCDIP is a perpetual issue, which means that the company is not required to call it. The company has the option to call HCDIP at par starting on 6/9/2024. HCDIP is convertible into 5.5556 shares of HCDI with a strike price of $4.50. The company may force conversion of HCDIP in the unlikely event that HCDI (currently trading at about $2.19) trades above $7.65.
See prospectus for additional details. Average daily trading volume is around 18K shares. HCDIP dividends are qualified for tax purposes. HCDIP holders will NOT receive a k-1. Use limit orders and patience when trading. A total of 4.02 million shares of HCDIP are now outstanding including the first and second offerings.
1. Continued profitability
HCDI reported blowout profits in Q4 2021. Q4 consolidated net sales of $26.3 million only increased moderately from $24.3 million in the prior year. However, higher profit margins from land sales drove greatly improved earnings:
“Net income of $5.6 million, or $0.26 basic earnings per share (EPS), compared to a net loss of $(1.9) million, or $(0.34) loss per share”
This was the second consecutive strong quarter for HCDI. Q3 2021 earnings were also excellent:
“Net income of $3.7 million, or $0.21 basic earnings per share (EPS), compared to a net loss of ($0.4) million, or ($0.10) EPS”
HCDI earnings for the 2nd half of 2021 totaled 47 cents per share. Despite that remarkable achievement, HCDI still trades at just $2.17 per share and HCDIP still trades at only 61% of par value.
2. Stronger liquidity
Liquidity is always an important consideration for high yield investors. Preferred stock investors want a company with plenty of cash on hand to pay the preferred stock dividend obligation. As noted in the Q4 earnings report, unrestricted cash increased to $25.6 million as compared to $2.4 million in Q4 2020 and $4.8 million in Q3 2021.
3. Cost of capital has declined
Real estate development is a capital-intensive business. Obtaining bank financing on favorable terms is critical. This is especially true for a small startup company such as HCDI which had been heavily dependent on “hard money loans” with very high fees and interest costs. As noted in the 10K report (see page 29) significant progress has been made with the new BankUnited credit line:
“On March 7, 2022, we entered into a senior secured revolving credit facility with BankUnited for $25.0 million. The unpaid principal bears interest at a fluctuating rate of interest per annum equal to the daily simple secured overnight financing rate (SOFR) plus the applicable margin of 4.75%.”
4. Estimated 2022 preferred dividend coverage of 1.5X
HCDI had very strong Q4 2021 earnings with adjusted EBITDA of 8.3 million as compared to $1.4 million for Q4 2020. Management has guided for 2022 adjusted EBITDA of $20 million (34% growth from 2021). The blowout Q4 earnings results included a big gain from high margin land sales. Results are expected to moderate somewhat going forward.
The annual preferred dividend obligation on 4 million shares of HCDIP is $8 million. HCDI reported total Q4 debt of $55.1 million, however I believe that debt will tend to increase somewhat in 2022 as various construction projects progress. I’ll assume an average 2022 debt level of $65 million with an average interest rate of about 8%. Many construction loans reflect higher rates, but the new BankUnited credit line has a lower rate of only SOFR + 4.75%. SOFR is currently 0.27%.
Using the above assumptions: EBITDA / (Interest + Preferred Stock Dividend Obligation) = $20 million / ($8 million + $5.2 million) = 1.5X
5. Full asset coverage of HCDIP
As of 12/31/2021 HCDI had total stockholder’s equity of $100 million (See page 15 of Q4 Earnings Presentation). Preferred stock is senior to common stock. Therefore, the $100 million par value of HCDIP is fully covered by assets.
6. Real estate is an inflation hedge
Inflation is now running at an estimated rate of 7.9%. As of 12/31/2021 HCDI had real estate assets of $122 million. Home prices skyrocketed almost 19% in 2021. Slower home price increases are predicted for 2022, but prices are still increasing. Real estate assets are a great inflation hedge.
7. Satellite community housing markets remain attractive
HCDI’s real estate is strategically located in growing satellite communities that are a 20 – 60 minute commute from urban job centers. Even though the Covid pandemic is ending, the trend of working more remotely appears to be permanent. HCDI’s real estate holdings are ideally suited for these lifestyle changes and likely to appreciate in value faster than real estate located in urban centers.
8. Rental housing shortage
There is a shortage of rental housing in the U.S. and HCDI has shifted its business model accordingly. CEO Sterling Griffin explains this shift in strategy in response to question 3 on the Q4 earnings conference call:
“Over the past year, we have seen apartment rents escalate to historically high levels, while capitalization rates for multifamily projects in the suburbs have correspondingly decreased substantially. This financial combination has caused a rapid escalation of apartment values and created a great opportunity for HCDI in the markets that we serve. We believe a substantial percentage of our income will be driven by revenues from the sale of apartments for the next several years.”
9. HCDIP may be of value as a convertible issue
HCDIP is convertible at the holder’s option into 5.5556 shares of HCDI. The HCDI common traded as high as $3.02 on 12/10/2021, but has since declined in price to $2.19. The price fell despite the company repurchasing $5 million of stock in Q4.
HCDIP could benefit from even a moderate rally in HCDI. For example, suppose that HCDI rallied back to $3 where it traded in December. The conversion value of HCDIP would then be: 5.5556 X $3 = $16.67. If HCDI stock eventually rose to $3.50 then the conversion value of HCDIP would be $19.44. Note that HCDIP should always trade above its conversion value. HCDIP pays a dividend and HCDI does not.
10. Reasonable valuation at 6X EBITDA
HCDI has provided guidance for 2022 Adjusted EBITDA of approximately $20 million. The company now has a combined market capitalization of $29 million for HCDI and $61 million for HCDIP. Therefore, the total enterprise value in millions of dollars as of Q4 is about:
29 common+ 61 preferred + 55 debt – 26 cash = 119 enterprise value
With an enterprise value of about $119 million based on the current market prices of HCDI / HCDIP, the company is trading for about 6X EBITDA. While 6X EBITDA is not dirt cheap, this is a very reasonable valuation for a profitable company that is growing rapidly.
What are the major risks?
See pages 1 -6 of the 10K annual report for a detailed discussion of risks. I have briefly highlighted a few of the major risks here. HCDI is a small company with an equity market capitalization of only about $30 million. HCDI has a short history as a public company and management has undertaken an aggressive growth strategy. There have been some recent management changes over the last year including an Independent Director, the Chief Financial Officer and the Vice President. This type of management change can be a red flag.
The housing market is especially vulnerable to increases in interest rates or an economic downturn. The Fed has recently raised interest rates and signaled that more rate increases are ahead. Some economists believe that recession risk has increased due to the Ukraine war, higher energy prices and increasing interest rates. HCDI has made some important strategic changes to deal with these risks. Liquidity has been strengthened (see items #2 and #3) and more moderate growth (see item #4) has been projected for 2022. HCDI has also shifted their focus (see item #8) from selling single family houses to building rental units. The shortage of rental units is likely to persist even if an economic downturn and / or higher interest rates reduce the demand to purchase homes.
See page 52 of the 10K Annual Report for details on related party transactions. While related party transactions are not unusual for a small startup company such as HCDI, they can create conflicts of interest with shareholders. HCDI has a history of past construction loans and land purchases from insiders. The company uses a quarry owned by the CEO to dispose of waste materials.
Conclusions
HCDI has made significant progress since I last covered the company five months ago. While HCDIP remains a high-risk issue, credit risk has been substantially reduced due to continued profitability, increased liquidity and lower borrowing costs. Recession fears and rising interest rates have kept HCDIP from rallying. However, investors may be over-estimating these risks. HCDI is now focused on building rental housing. The rental housing market is more recession resistant than new home sales.
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