Our Melcor Developments report is updated and rated (higher) Buy at $13.70
This has been a frustrating investment. It is extremely thinly traded and has basically no analyst coverage. Partly due to a lack of analyst coverage, it trades at a huge discount to book value (currently a 57% discount). It has a history of usually trading somewhat below book value and has traded substantially below book value for the last five years.
I have given some thought as to why a company would trade below book value.
Valid reasons for a company trading below book value would include that the assets are over-valued on the book, that the company is making too low a return on equity and/or that its outlook is for a poor return on equity.
In Melcor’s case about half of its assets are its income-producing (rental) properties that are marked to market and 38% of its assets are land (19% raw land, 7% land under development, 12% land inventory). Overall, there has been no indication that the book value of its assets exceeds fair market value. Values can decline, but currently the land is likely worth somewhat more than book value.
But Melcor’s return on equity on a GAAP basis has been unacceptably low for the past four years. And on an adjusted basis I calculate the ROE at only 5 to 6% for the past four years. But that is under stated because excludes the regular market value gains it has been making by developing buildings.
One way to measure its return on equity would be to look at its average gain in book value per share over a period of years. Since 2009 its book value is based on IFRS accounting which marks its investment rental buildings to market. This caused a sharp increase in book value per share in 2009. Since then, book value per share has grown at a compounded average of 7.9% per year. That growth includes market value gains on buildings driven by development work on new buildings. And I would add about 2% for average dividends as a percent of book value to that for a total 9.9% ROE – which is arguably an acceptable although not a great return on equity. But that also included some benefit from declining “capitalization rates” used in valuing its rental buildings (from 7.28% average in 2010 to 6.47% in 2018) and cannot be expected to apply in future and could reverse with higher interest rates.
Melcor uses FFO as its preferred measure of income. On an FFO basis, Melcor’s ROE in 2018 was only 5 to 6% for the past two years and that is unacceptably low (unless it is expected to rise). But FFO would give no credit for market value gains even on new building developments and so that would seem to understate the “true” ROE.
Overall, it does appear that Melcor’s ROE may be somewhat too low even over longer periods. That would justify the shares trading somewhat below book value. But other reasons such as the lack of trading liquidity and the inherent volatility of earnings may be responsible for most of the discount.
While Melcor is under-valued on an asset basis, it seems it will continue to require patience. It probably should only be bought by investors who are prepared to hold for the longer term such as five years or more.