Investment action
I recommended a hold rating for M.D.C. Holdings (NYSE:MDC) when I wrote about it the last time, as I thought it was better to wait for a few more quarters to observe if the change in demand trend is sustainable. In hindsight, that recommendation did not play out well, as the stock went ahead and rallied another 22% before losing steam after the 2Q23 earnings. Based on my current outlook and analysis of MDC, I continue to recommend a hold rating. I still think it is better to wait for one more quarter of data to validate that the three key metrics – order, pricing, and gross margin – are moving as expected. This would signify to the market that earnings are indeed undergoing the normalization phase.
Review
To provide a swift overview of the most recent earnings, MDC reported an operating EPS of $1.24 in 2Q23, surpassing expectations of $0.72. The 54% growth in orders during 2Q23 has also partially addressed my concerns regarding demand trends. I am increasingly optimistic about the underlying order growth, especially since management has indicated that order trends in July align with typical seasonal patterns. Throughout the quarter, gross orders remained relatively stable, with April performing the strongest, followed by a slight slowdown in May and a rebound in June. Notably, approximately two-thirds of gross orders were for spec homes (homes started without a contract), consistent with 1Q23 figures, indicating a sustainable demand trend. What’s particularly noteworthy is the substantial decrease in the cancellation rate, dropping from 30% in 1Q23 to 20% in 2Q23, and significantly lower than the 37% rate seen in 2Q22. The current order trends in July, in line with normal seasonality and MDC’s expectations, combined with improved cycle times (a management strategy for shorter build cycles), lead me to anticipate that 3Q23 orders will fall within the range predicted by management, ranging from 1,850 to 2,000.
It’s not just orders that brought positive news; pricing also played a significant role. In 2Q23, the average gross order ASP increased by 2% compared to the previous quarter, thanks to improved pricing trends. MDC raised prices in about 70% of its communities, with an average increase of 2%, while incentives decreased by approximately 150 basis points sequentially, dropping from 8% of the sales price in 1Q23. According to management’s guidance, 3Q23 closing ASPs are anticipated to be around $555K, with gross margins expected to exceed 17%. In my view, both pricing and gross margins are poised for positive growth as speculative units sold and closed should benefit from price hikes and reduced incentives. Looking further ahead, it’s likely that gross margins will continue to rise, considering management’s observation of the potential for further sequential improvement based on recent pricing and incentive trends.
All in all, I believe earnings have begun the process of normalizing over the next 1-2 years, and over the course of 2H23, we should see more critical evidence of this happening. I would especially look out for 3Q23 earnings to verify that all three key metrics – orders, pricing, and gross margin – are moving in the direction I expect.
Valuation
The current situation is certainly appealing, as it seems like MDC is on its way to normalizing earnings while multiples have compressed back to below average (10x forward PE). I see two scenarios playing out here:
- In the bull case, MDC should see valuation pick up back to 10 to 12x forward PE as the earnings outlook becomes clearer with momentum. Using the consensus FY24 consensus EPS estimate and 12x forward PE, this translates to a share price of $69
- In the base case, which is my expectation, I believe the right multiple should be around 10x forward PE-MDC historical through-cycle valuation. The reason I believe a discount is warranted from the bull case is because I believe the prospects of a potentially slowing economy in 2H23 and entering 2024 may suppress such multiple expansions in the coming quarters. At 10x forward PE and using FY24 consensus EPS estimates, this translates to a share price of $57.60 (19% upside).
Risk and final thoughts
Despite the positive trends so far, I am not calling for a rating upgrade yet because of the nature of the MDC industry, which is at the mercy of mortgage rates (impacted by the Fed rate). In recent months and weeks, there have been a series of expectations in terms of interest rates going up or down, and at this point, the clear message is that the Fed is still open to hiking rates. If rates continue to hike much higher, it is definitely going to impact MDC, which will delay the normalization of earnings.
In summary, my recommendation for MDC remains a hold as I await 3Q23 results to validate the start of the earnings normalization phase. While my previous hold recommendation didn’t align with the stock’s subsequent 22% rally before plateauing after the 2Q22 earnings, I continue to advocate caution. I believe it’s prudent to wait for another quarter of data to confirm if the key metrics – order growth, pricing, and gross margins – are moving as anticipated, signaling the start of earnings normalization.
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