Melcor Developments is updated and remains rated Strong Buy, now at $14.00.
Certainly, Melcor’s stock price has been disappointing since 2014. Some of the decline was warranted due to the lower oil prices and the weak Alberta economy. But when oil prices recovered somewhat and the Alberta economy recovered and despite Melcor’s earnings rising, the stock price remains similar to levels it traded at in 2015. I have looked closely at the numbers and other factors and I believe the stock is substantially under-valued.
It’s trading at only 47% of book value. And while some of its assets have been “written up” to market value (and are at risk of a write-down as interest rates rise) indications are that the true value of its assets is equal to or greater than book value. For example in 2017 it sold a parking lot and an industrial building for proceeds that exceeded the book value of those assets even those both of those were already carried at estimated market value.
On an earnings basis it trades at 9.0 times my calculation of adjusted earnings. For adjusted earnings I eliminate any gains or losses on fair market value of properties and I eliminate gains or losses caused by changes in the trading value of the Melcor REIT units which due to accounting rules are a liability on Melcor Development’s balance sheet. Overall I believe my view of adjusted earnings is somewhat conservative at this time because it gives no credit for the gains in property values that come from the development process.
So why does the market value these shares at only 47% of book value?
Part of the reason is that it has such low trading liquidity that many market analysts may be reluctant to mention it. For whatever reason it basically gets zero press and attention in the financial news.
Part of the reason may also be the complexity of its accounting. It owns 53% of the Melcor REIT and consolidates 100% of the REITs results and then shows a liability for the 43% minority interest. This creates complexity.
As a property developer, Melcor’s financial statements and results call for a a different interpretation than most companies. All of its undeveloped and partially developed land is better thought of as “inventory” rather than as fixed assets. For most businesses, fixed assets are used to produce products or services. In Melcor’s case these fixed assets get modified and improved and become the product. So we can think of Melcor as having a huge amount of inventory. And that inventory must be carried for quite a few years and its resale value is subject to decline at times (and increases at other times).
Part of the reason for Melcor’s low share price may be fear that its “inventory” will end up being sold at prices that fail to generate reasonable profits. To date, profits on lot sales have fallen somewhat but remain, I believe, reasonably attractive.
What has to happen for Melcor’s share price to rise appreciably?
A higher share price is probably going to require some higher level of investor interest. Possibly a sharp rise in earnings over the next few quarters could be a catalyst. That could happen since the first three quarters of 2017 were relatively low in profit.
Share buy backs are a possible driver of higher share prices but to date the company has been unwilling to buy back shares.
It’s possible that the company will increase the dividend if they continue to feel confident about the outlook for 2018 and beyond.
What could go wrong?
Melcor’s earnings could decline if home building declines substantially in Alberta. There is also the risk of vacancies and of mark-to-market losses on its investment properties due to vacancies and/or higher interest rates.
In the Meantime?
I am going to continue to hold Melcor on the basis that the shares are under-valued and that they are likely to rise over time due to growth and due to investors eventually recognizing the growth. Meanwhile there is also a 3.7% cash dividend yield. I am not holding this for the yield but the yield is helpful. Melcor has very solid assets and it simply seems likely that buying or owning these at 47% of book value of equity is going to work out well eventually.