Melcor Developments Ltd. Stock Report

Melcor Developments Ltd.

 

Melcor’s revenue per share (red line) has displayed substantial volatility. Earnings per share have been quite volatile but always positive on an annual basis. The company is quite cyclical and exhibits periods where its revenues and profits fall.  Adjusted earnings were up strongly in 2013 but were flat in 2014 and declined in 2015 and more so in 2016 but recovered somewhat in 2017. Book value per share grew at a rapid rate assisted by mark-to-market accounting for the investment buildings adopted at the since the end of 2009 but has been flat since 2015. In the past few years book value per share is relatively flat due to lower net income and also currency losses and the effect of the dividend. Also a modest increase in the value of the Melcor REIT since the end of 2015 becomes a liability due public unit holders and that pushed book value down.

MELCOR DEVELOPMENTS LTD. (MRD, Toronto)
RESEARCH SUMMARY  
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  Author(s) hold shares
Based on financials from: Dec ’17 Y.E.
Last updated: 14-Mar-18
Share Price At Date of Last Update:  $                             14.00
Currency: Canadian $
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Strong Buy rated at $14.00
SUMMARY AND RATING:  This cell of the report summarizes information from the cells below. The graph of adjusted earnings per share demonstrates excellent past growth but with a rather precipitous drop in 2008 and 2009 followed by a very strong recovery after 2009 but then flatness in 2014 and a significant decline in 2015 and a further significant decline in 2016 and then some recovery in 2017 (which ended quite strongly). Book value per share has grown at an average of 12.8% annually in the period shown but this was boosted by mark-to-market accounting of its rental buildings. With quite cyclical or volatile earnings, the earning-related and other value ratios are somewhat unreliable but would currently suggest a Strong Buy rating based particularly on the price to book ratio of 47% and the fact that the assets are likely worth more than book value or at least not much less than book value. Residential building lot sales were 40% higher in 2017 versus 2016 after several years of declines. The long-term outlook is for continued growth in adjusted earnings although there will be cyclic declines as well and there is uncertainty regarding the Alberta economy at this time. GAAP earnings will decline if interest rates rise due to the lower values on investment properties that would result or if the properties decline in value due to other reasons including vacancies. Management seems to be high quality and trustworthy although we have concerns about the clarity of disclosures and management seems unconcerned about the low share price.  The insider trading signal is neutral. It’s not entirely clear that they have any lasting competitive advantage although they have strong market knowledge and abilities in a field that is probably not that easy to enter for new competitors. There is risk associated with higher interest rates.  In some recent quarters there was some market value losses on some buildings and this could be a sign of more to come.  Also some further risk from bad debts.  Overall we rate this a Strong Buy at this time based on the very large discount to book value combined with the fact that land and building prices have apparently held up quite well despite the Alberta recession. The trading liquidity is very thin which can make the price more volatile. Investors should place limit orders (buy at a specific price) rather than buy at the market orders. The stock is not without risk, however, we believe that the low price and the solid assets mitigates much of the risk. In our opinion, this is a company that has good (but certainly not spectacular) economics, a good long-term outlook, good management and that is available at a very attractive price. The stock could be purchased for the 3.7% dividend yield and the potential for the share price to move closer to book value and to grow over time provides an expectation of a capital gain. However this scenario could fail to be realized if the recession in Alberta fails to continue its recent recovery and instead deepens.
DESCRIPTION OF BUSINESS: Updated March 2018 based on 2017 figures. The contributions of its various segments to revenue and earnings varies from year top year. In 2017, just over half  of the business was as a residential (with some commercial) land developer (57% of revenue and 55% of segment earnings). Also develops, retail and industrial buildings for transfer to its rental division (4% of revenue and 16% of segment earnings – the contribution of this segment can vary greatly year to year) .  Rents out office, retail and industrial buildings including some in a 56% owned REIT structure (36% of revenue and  43% of segment earnings which however is before deducting the share of the REIT owned by others). Also Owns and operates three golf courses and has an interest in a fourth. (3% of revenue and less than 1% of profits). Operates mostly in or near the major cities of Alberta. Has some U.S. residential developments (Phoenix and Denver) and rental property (9% of revenue and 10% of assets, included in the segments above). The rental investment property portfolio totals about 62 buildings or properties and 3.92 million square feet (of which 37 properties or 2.71 million square feet are in the REIT which is 47% owned by the public unit holders and 53% by Melcor). Tenants include Canadian Tire, Canadian Western Bank, Home Depot, Rexall Drugs, Rona, Royal Bank, Save-on Foods, Sobeys, Scotia Bank, Shoppers Drug Mart, Sport Chek, Staples, TD Canada Trust, Tim Hortons, Walmart and many others. Buildings include 609 residential apartment units  and several parking lots. The total assets are $1991 million. Melcor is not employee intensive as it contracts out the physical work of developing properties. Excluding golf course workers there are 118 staff members or just one staff member per $16 million in assets (2016 figures). 10% of the assets are in the U.S. and the great majority of the Canadian assets are in Alberta.
ECONOMICS OF THE BUSINESS: The largest business is residential land development. In this business they buy raw land typically on the edges of typically fast growing cities, mostly in Alberta. In this business capital spending, unlike the case for most companies, goes directly into the product that is sold, so that capital is recycled. Developing the land into residential building lots requires obtaining permits and installing infrastructure such as roads and utilities (which is done through contractors). Also there is substantial surveying and grading (which also is done by contractors). This business involves investing for a number of years before any lots can be sold (if ever). There is a competition. The business can be highly cyclical and unpredictable. However gross margins on lot sales have been relatively  good and were 37% in 2017 and 34% in  2016 (having declined from 45% in 2014).Another portion of the business is to manage the construction (by contractors) of commercial, retail and industrial rental buildings. The economics have been such that Melcor has been able to make good profits on this business. The third major area of business is renting out the commercial and retail space. This portion of the business has also generated good returns including increases in the market value of the rental properties as interest rates have declined – but more recently building values were declining. Overall it appears that Melcor’s businesses have reasonably good economics over time but earnings do decline substantially during slower periods.
RISKS: The primary risk is the state of the Alberta economy and the demand for new housing and for commercial space. Another risk is the risk of a large hike in interest rates. Some risk of bad debts from builders.  See annual report for additional risks. Also, this public company has a majority controlling owner. In most cases this will benefit outside shareholders as compared to non-ownership type management. But there is a risk that the controlling shareholder will use his position to award large bonuses and stock option grants to himself and the family and not act strictly in the best interest of outsiders. To date, this has probably not occurred although the family spoke out against the NDP government in 2015, warning people not to vote NDP, and this activism associated with the corporation seems counter to the interests of shareholders. The executive chair continued to criticize government policies in in his Spring 2017 letter. The family may have little interest in the share price since they apparently have no intention of selling. This family control feature can tend to hold the share price down somewhat (perhaps significantly) since it seems to preclude any possibility of a take-over bid.
INSIDER TRADING / INSIDER HOLDING: Checking from September 1, 2017 to March 14, 2018. There was very little activity. A younger controlling family member sold 1680 shares in September at $15.30 and failed to report this for four months. A senior family member bought 1000 shares on December 29 at $15.22. A number of insiders bought small amounts of shares through a regular purchase plan (which we believe is something new for this company). A retired executive disposed of some shares through gifting. Overall the insider trading signal is neutral.  Insiders hold substantial  stock which is a positive indicator. A number of them hold significant amounts, such as $1 million, while a couple hold huge amounts well into the $ millions.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand (marginal pass as the accounting is complex and the business very cyclical), has favorable long-term economics due to cost advantages or superior brand power (marginal pass – possibly has some existing cheaper land inventory, operating knowledge and strong market knowledge), apparently able and trustworthy management (pass given strong track record), a sensible price – below its intrinsic value (pass – low P/E and apparently selling well below market value of assets), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (marginal pass) little chance of permanent loss of the investors capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass)
MOST RECENT EARNINGS AND SALES TREND:  The graph shows a strong growth trend in revenues and adjusted earnings per share from 2008 (which was a low point) to 2013 and then flatter in 2014 and with a sharp decline in 2015 and a further sharp drop in 2016 and then some recovery in 2017. Earnings tend to be very cyclical and lumpy and therefore a trend is difficult to interpret. Overall, the recent trend has been quite negative but with some recovery in 2017. 2017 ended on a strong note.
INDUSTRY SPECIFIC STATISTICS:  We look at lot sales but the numbers may not be comparable due to a higher prevalence of joint ventures. Residential building lot sales in Q4 2017 were up 40%. Residential building lots sold in Q3 2017 were up 58% while prices were about unchanged.  Residential building lots sold in Q2 2017 were up 13% while prices were down 2.6% but remained above the 2016 average. Residential building lots in Q1 2017 were up a surprising 172% while prices were down 25% but remained above the 2016 average.  Residential building lot sales in 2017 were up 47% versus 2016 while the average selling price was down 6%. Residential building lot sales in 2016 were down 30% versus 2015 while the average selling price was up 3%. Residential building lot sales in 2015 were down 15% versus 2014 and the average price was down 16% .  Lot prices  in 2017 averaged $134,700 versus $142,800 in 2016 and $139,000 in 2015 and$166,400 in 2014 and $143,000 in 2013 and $139,00 in 2012 and  $143,000 in 2011 and $147,000 in 2010.   Year end lot inventory is targeted at one year’s of sales.
Earnings Growth Scenario and Justifiable P/E: The P/E was recently about 9 times adjusted earnings. With a 3.7% dividend yield it would take only modest growth to justify this P/E.
VALUE RATIOS: Analysed at a price of $15.37. The Price to book value ratio appears very attractive at 0.47. However note that the shares have a history of trading somewhat (though not this much) under book value. Earnings and ROE value ratios should be considered less reliable due to the cyclical nature of the business. Under IFRS accounting, investment properties have been marked to market value but land (other than under rental buildings) remains valued at the lower of cost (including costs of improvements and capitalised interest) and market. The dividend yield is attractive at 3.7% and dividends amounts to only 34% of the trailing adjusted earnings.  The interim adjusted P/E appears quite attractive at 9.0 but is not that meaningful due to the cyclic nature of earnings and the fact that we do not count any market value gains from property development. Earnings will vary significantly with the real estate market in Alberta.  Adjusted return on equity is similarly volatile and appears very low at 5.3% but this is lowered by the marking to market of the investment properties (which has boosted the equity while we have not counted it in adjusted) and is therefore understated (probably quite significantly understated). Our calculation of intrinsic value based on our view of adjusted earnings is $12/07 assuming no growth and $19.37 assuming 5% growth and then a sale after five years at a P/E of 12. Overall the value ratios (in isolation) indicate a Strong Buy rating on the basis of buying dollar bills (the book value) for about 47 cents.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: MRD, Toronto
Currency: Canadian $
Contact: ir@melcor.ca
Web-site: www.melcor.ca
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $258.0
Latest four quarters annual earnings $ millions: $38.5
P/E ratio based on latest four quarters earnings: 12.1
Latest four quarters annual earnings, adjusted, $ millions: $51.7
BASIS OR SOURCE OF ADJUSTED EARNINGS: Starting with 2010 we have removed the after tax gains on market value of buildings that the company then started reporting under International Financial Accounting Standards.  In most historic years before that no adjustments were made, but note that earnings are cyclical and heavily dependent on economic activity. There have been some unusual gains on asset sales but we have generally not adjusted for these due to the overall cyclical nature of the company and the difficulty of obtaining a normalized view of earnings. We have adjusted for changes in the market value of liability to the minority REIT unit holders, these value changes flowed through earnings and we backed that out. In 2015 we added back an unusual deferred income tax expense.
Quality of Earnings Measurement and Persistence: Lower measurement quality and lower persistence quality. Earnings result from sales of developed residential building and some commercial lots at a profit, value added in developing rental buildings, rental income, and  from the mark to market gains (or losses) on investment properties and occasional sale of rental property (though we adjust for the market value gains or losses). Builders often have  about 1 year to pay for the lots interest-free and there is some risk of bad debt although that receivable is secured by the lots sold. Earnings are quite cyclic so they are not very predictable.  However we removed the mark to market gains for adjusted earnings and so adjusted earnings are of reasonably good measurement quality but remain cyclically volatile. Our adjusted earnings are conservative in not including market value gains created by developing rental buildings.
P/E ratio based on latest four quarters earnings, adjusted 9.0
Latest fiscal year annual earnings: $38.5
P/E ratio based on latest fiscal year earnings: 12.1
Fiscal earnings adjusted: $53.3
P/E ratio for fiscal earnings adjusted: 8.8
Latest four quarters profit as percent of sales 20.0%
Dividend Yield: 3.7%
Price / Sales Ratio 1.81
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         0.47
Balance Sheet:  (Last updated Q1 ’17). Assets are comprised as follows: 51% of the assets are investment properties which are marked to market (and a further 3% are mostly tenant incentives). 36% of the assets are represented by the land inventory (which would be land cost plus subsequent costs of developing the land and plus capitalized interest – this is not marked to market). 6% of assets is largely a large and somewhat longer term receivable from builders who apparently pay for lots only after one year and in some cases longer. No interest applies until one year passes and then 4.7%  interest applies. 3% of assets is cash and Accounts receivable is 1%.  Property and equipment accounts for less than 1% of assets which illustrates the fact that this is a company that manages land development by contracting out that work. On the liability side of the balance sheet, 52% of the assets are supported by common equity, 32% by debt, 5% by a provision for land development costs, 5% by the minority interest of the REIT (the publicly traded share of the REIT) 4% by deferred income taxes and 2% by accounts payable. 90% of the common equity is retained earnings which proves that it has a history of making profits especially considering that substantial additional earnings were dividended out over the years. There is no purchased goodwill. Deferred income taxes owing  can be considered a softer liability in that it may continue to grow and be deferred for years (even as deferred taxes are paid, new deferred taxes may take their place in which case there is no net cash paid out on deferred taxes). Overall, this is a very strong balance sheet with hard and valuable assets financed with relatively modest debt.
Quality of Net Assets and Book Value Measurement: Very high, although real estate assets are subject to significant market value fluctuation. See our comments about the balance sheet. As of March 14, 2018, the shares traded at just 47% of diluted book value. Investment properties have been marked up to market value. The land inventory remains at the lower of cost (including development costs and capitalized interest) or market and it seems likely that land market values are somewhat above book value, but the actual ratio is unknown and subject to change. There is also value in the going concern aspect of the business beyond its asset value. Overall the quality of the assets and the book value measurement is high.
Number of Diluted common shares in millions:                                  33.5
Controlling Shareholder: (Updated November 2017) T.C Melton, the chairman of the company, together with his family, control about 54% of the shares. A former CEO and current board member owns another 4% and other directors/officers total about 1%. It appears that about 40% of the shares are available to trade however there are some other large holders as well..
Market Equity Capitalization (Value) $ millions: $469.0
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 50.7%
Interest-bearing debt as a percentage of common equity 65%
Current assets / current liabilities: not available
Liquidity and capital structure: Good liquidity, the company does use debt to finance their investment properties and (to a very limited degree) raw and developed land but the debt is probably not excessive and was recently 66% of the equity amount which is relatively low leverage although in part this is based on the equity that was pushed higher by marking rental buildings to market. And with the equity trading at 47% of book value, debt is higher than the market value of equity.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 5.2%
Latest fiscal year adjusted (if applicable) net income return on average equity: 5.3%
Adjusted (if applicable) latest four quarters return on market capitalization: 11.0%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share -1.7%
Volatility of sales growth per share:  Good long term growth with significant volatility.
5 Years compounded growth in earnings/share -18.6%
5 years compounded growth in adjusted earnings per share -0.5%
Volatility of earnings growth:  Highly volatile
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Not recently
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 3.5%
More conservative estimate of compounded growth in earnings per share over the forecast period: 0.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 5.0%
GROWTH OUTLOOK:  In the long term it seems likely to continue to grow at least modestly. In the shorter term they are vulnerable to a decline in the market for new houses (And therefore the home building lots that they sell). And they are vulnerable to lower rental rates and vacancies in the commercial property portfolio. This is particularly a concern in 2017 with the lower oil prices compared to peak years and its heavy concentration in Alberta, although as of November 2017 oil prices have recovered somewhat and the Alberta economy is recovering. Also with buildings marked to market they are vulnerable to GAAP losses there. The company has continued to invest in new land holdings and this illustrates confidence in the future. Entering 2018, the company reported that lot sales had recovered to normal levels and that most “promotions” had been removed. The company appears to be optimistic about the future.
LONG TERM PREDICTABILITY: While earnings are highly unpredictable in the short term, it seems safe to assume the company will continue to grow over the decades.
Estimated present value per share:  This company is quite cyclical is therefore more difficult to value based on earnings. But we calculate a value of $12.07 assuming (perhaps quite pessimistically) that there is no growth and the P/E remains at 9.0. Or $19.32 with growth at 5% annually and a sale at a P/E of 12 after five years.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition.  The development industry probably has limited barriers to entry – although scale, financing and industry knowledge may provide some barrier  (marginal pass). There are no known issues with powerful suppliers although governments may play a restricting role and they may be dependent on key contractors though we have no information on this (pass). No issues with excessive dependence on powerful customers (pass although there may be some vulnerability to a few key home builders), No viable substitute products (pass), Probably at least some tendency to compete excessively on the basis of price (marginal pass). Overall this industry appears to be only neutral in attractiveness.
COMPETITIVE ADVANTAGE: Established presence in the market place and knowledge. Relationships with contractors who build its buildings and do the physical development of land. Has an existing inventory of land which overall was probably purchased on average at prices somewhat below the current market value, although we may be wrong on that as market values may have decreased.
COMPETITIVE POSITION: Unfortunately, we have no information as to how they stack up against their competitors in the business.
RECENT EVENTS: In 2017 sold a parking lot in Edmonton for $2.99 million which was apparently carrying value despite that these properties are marked to market and resulted in booking a gain in market value on the remaining 6 parking lots. Also in 2017 sold an industrial rental building with the sale price exceeding the carrying value. As of Q3, Melcor has also become a home builder in Kelowna. Home building will likely remain a very small part of its operations in order not to compete with its home builder customers. A new CEO was appointed from within effective April 15, 2017. Interestingly, the two Melton brothers on the Board will no longer have executive positions. We view this as positive since having an executive chair could limit the power of the CEO and lead to confusion about who is in charge. Increased the dividend by 8% for 2017. But reduced the dividend by 20% starting Q1, 2016. In some recent quarters there was market value losses on some of their rental buildings which could be an indication of more to come.  They reduced administrative expenses noticeably in 2015, and further in 2016,  in response to the softer economy. The company continues to add to its land positions and to develop property.
ACCOUNTING AND DISCLOSURE ISSUES: With the stock trading well  below book value it is important to understand the assets and their accounting value. The capitalized interest included in its raw land costs would be a useful figure but does not appear to be disclosed. The accumulated mark-to market gains would be useful but are not disclosed. The age of all its buildings would be useful but is not disclosed. The share count and diluted share count are not disclosed clearly each quarter but should be. Under IFRS the value of its investment properties have been written up to market but the development land inventory remains stated at cost and the market value of the land does not appear to be disclosed. The past writing up of the buildings to market value pushes up book value and pushes down the ROE. The value of the minority unit holders in the REIT is considered a liability and changes in the unit value lead to gains and losses in the income statement which is confusing and we have adjusted for that. There is not much explanation of the nature of operating lease incentives or straight line rent adjustments. They do not provide much detail on their use of contractors to build buildings or develop land although the fact that they use contractors for the actual work is disclosed in the Annual Information Filing. The company provides FFO as something of an alternative to net income but this is not a figure that we would see as a substitute for net income. Overall it appears that “the market” has a difficult time understanding the accounting and economics of the company and that the disclosure could certainly be improved.
COMMON SHARE STRUCTURE USED: Normal, 1 vote per share
MANAGEMENT QUALITY: A new CEO was appointed from within the company effective April 15, 2017. Management appears to be high quality with a long record of profitability. We do have some concerns that the disclosure could be greatly improved.  The CEOs historically have been promoted from within which is a sign of good management. We were disappointed that shares were not repurchased, except to extremely minor extents in 2015 and 2016 after the company announced that it had permission to do so and appeared to strongly signal that they intended to do so. Overall, management seems unconcerned about the fact that the share price is so far below book and presumably the true value.
Capital Allocation Skills: Based on accounting results, management appears to have made good choices in investing its capital and in its financing. It retains most of its earnings which has proved to be advantageous in the long term. On occasion it has bought back shares at good prices. It appears to have missed an opportunity in 2015 and 2016 and 2017  to buy back shares at very attractive prices.  It appears to have made reasonably good returns on its capital investments although that is hard to judge due to the cyclical nature of profits. The creation of the REIT in 2013 appears to have been a prudent move. However the stock market for the past few years seems to disagree that the capital investments were wise given that it is valuing the equity at only about half of book value.
EXECUTIVE COMPENSATION: Salaries are probably reasonable. Bonuses and options for the executive chairman and the executive vice chair seem on the generous side but perhaps not enough to be much concerned about. We understand that the chair and vice chair positions are no longer considered executive positions in 2017 and this should lower compensation there.  Pay for the other executives does not seem too high.  Executive pay was reduced in 2014 and further reduced in 2015 and yet further reduced in 2016 for some executives.
BOARD OF DIRECTORS: Updated from 2017 circular) A strong small board. Key members own large stock holdings which aligns their interests with that of outside shareholders. It is disappointing however that 3 of the nine Board members hold very few shares.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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