M.D.C. Holdings Stock: Near-Term Concerns May Weigh On Performance

Description

I think M.D.C. Holdings (NYSE:MDC) is entering the very early stage of an up-cycle, which I believe investors seem to think of as well given the share price reaction. However, I have my concerns on the near-term performance of MDC, especially given a weak order guide, declining gross margins, uncertain interest rate environment, and yet-to-be confirmed demand trends. On this backdrop, valuation has already increased to price in an up-cycle movement, which I think an investment today carries much more risk than pre-earnings. In my opinion, if this were to be a true up-cycle, there would be opportunities to make money out of it, there is no need to take additional risk to get exposure today. As such, my recommendation would be to wait out a couple of quarters, at least until we see a more stabilize demand trend.

4Q22 Review

Several key points emerged during the earnings call. To begin, at the mid-point, MDC expects a decline in closings of 31% y/y and a decline in gross margins to 18.5% for 1Q23. With regards to demand trends, demand patterns improved in January as a result of MDC’s increased market aggression following the completion of its higher-margin backlog. In addition, the majority of the company’s 4Q gross orders (74%) were spec, as such MDC plans to keep expanding its spec construction to better meet the needs of modern buyers.

On the pricing side of things, discounts for 4Q orders rose by about 4ppts q/q to around 12%, while order ASPs fell by about 6% q/q and 1% y/y on a gross order basis. If we extrapolate these results literally into FY23/24, we could very well see a downward trend in earnings.

Order book

Orders dropped 94% in 4Q22 due to a decrease in absorption, while average community size increased 13%. An important metric to keep an eye on is the 4Q22 cancellation rate, which hit 87%, up from 81% in 3Q22 and 20% in 4Q21. To combat this, MDC has responded by increasing the amount of the deposit it requires from customers interested in purchasing a built-to-order home.

On the bright side, management noted a return to order in January, and this trend is only expected to further improve in 1Q23. This is likely because MDC has become more competitive in the market due to the anticipated Spring selling season. Additionally, as 74% of its 4th quarter orders were for spec construction, management expects to increase their spec constructions to better cater to current buyer preferences.

Impairments

The $93 million recorded in 4Q22 land impairments is the highest quarterly amount recorded since Q4 of 2008, and is a significant increase from the $28 million recorded in 3Q22. Impairments affected ten communities in MDC’s West region and six communities in the Mountain region, most of which were already open for sales with a few that MDC had planned openings in 1Q23. Although I don’t find this particularly concerning at the moment, I do think it’s something we should keep an eye on in the future in case it’s a precursor to a more serious threat.

Guidance

After slightly exceeding the high end of guidance in the fourth quarter with 2,554 closings, management guided closings of 1,500 to 1,600 in the first quarter of fiscal year 23 and ASPs of $550 to $560K in the first quarter. The guided gross margin for 1Q23 is 18% to 19%, a decrease of 230 to 330 bps q/q and 670-770 bps y/y. Moving forward, management expects cost savings on construction thanks to falling lumber prices.

Valuation

I think the market is blind to the fact that MDC’s fundamentals are beginning to stabilize in 2023, as evidenced by the share price. Together with a more stable interest rate environment and investors’ anticipation of a forthcoming new-cycle, I believe the current high MDC multiple will persist (low-to-mid-teens). Indeed, as of the date of this writing, the forward PE has increased to 13x from its initial ~5x level.

Summary

The stock price response indicates that investors think MDC is beginning a positive trend, but I have concerns about its short-term performance due to its poor sales forecast, declining profit margins, unpredictable interest rates, and uncertain demand patterns. I suggest waiting for a few more quarters or until there is a clearer demand trend before investing.