March 19, 2018 and a comment on Melcor

Markets were down on Monday with the S&P 500 falling 1.4% and Toronto down 0.8%.

BHP Billiton was down 2.6% in New York. This and the recent declines partly due to currency fluctuations as the stock has not fallen much in Australia. But it is fair to measure it in U.S. dollars which is what it mostly operates in and reports in. For Canadians the declining Canadian dollar offsets some of the decline in the stock.

CRH Medical continues to slide back from the gains it had recently made. It was down 5.6% today in New York.

AutoCanada bucked the trend and was up 4.6% which was well deserved given its earnings release last week.

I continue to think about the reasons why Melcor Developments is trading at less than half of book value despite the “hard” nature of its assets. Part of the reason is probably that it mixes a REIT in with a property developer. For whatever reasons, investors seem to have very little interest in developers of raw land. There may be other publicly traded companies in Canada that are primarily in the business of developing raw land into residential building lots and serviced commercial land – but I don’t know of any.

Property development is a business that can, by nature, produce VERY “lumpy” results. Imagine if you bought one parcel of land on the edge of a City and sold it 15 years later for a huge gain. You might have 14 years of losses due to interest payments (even if the market value of the land was soaring) and no revenue and then one year of huge profits. In this scenario the annual accounting earnings would bear no relation to the actual annual changes in the value of the land. In Melcor’s case it has a big portfolio of land and it develops the land and so there is certainly some profit from its development operations virtually every year. Nevertheless, its accounting earnings may often bear little resemblance to the true change in its intrinsic value per share each year.

I have been following Melcor closely since the end of 2002. At theĀ  end of 2002 the stock was trading at 96% of book value. At the end of 2000 it had traded at only 62% of book value. In the years since 2002 it briefly traded at over 300% of book value in 2007 when oil prices and optimism were high. As oil prices fell in 2008, the stock fell under 100% of book value. IFRS accounting starting in 2010 inflated book value (which soared 63% that year mostly due to the accounting change). by marking up its rental buildings to market value and the price to book fell (partly for that reason) to an average of 67% in 2012. It briefly recovered past 100% in 2014 but averaged 88% that year. With lower oil prices Melcor’s average price to book ratio fell to 47% in 2016 and averaged relatively similar in 2017. Today the price remains mired at about 47% of book value despite quite a substantial recovery in oil and in the Alberta economy. There was also a noticeable recovery in Melcor’s profits in 2017.

Melcor’s land (other than under its rental buildings) is not marked to market. I would like to think that some of its land is worth more than book value. But some may be worth less than book value if the land was purchased in the more buoyant economy around 2014. Overall, there is no reason to think that Melcor’s assets are worth less than book value.

I think Melcor’s share price will increase in 2018 if its earnings rise substantially or at least noticeably. Melcor has indicated that 2018 is starting off strongly with lot sales having returned to normalized levels. There are still risks given that lot sales could certainly slow and that rental property values would have to be written down if interest rates rise pushing down the market value of commercial rental property.

Overall with a share price of 47% of book value, I think Melcor is at the low end of that range. A rise in profit would push up the book value as well as the trading multiple to book value. Given the higher book value due to IFRS accounting we will almost certainly never see the stock price at anything close to 300% of book again. But something a bit over 100% is certainly not too much to ask for. Melcor’s book value per share has increased almost every year. There can be no guarantee, but I expect that trend to continue.