The report on Melcor Developments is updated and rated (higher) Buy at $11.36.
Admittedly, this has been a poor investment since it peaked at over $26 back in 2014. It then fell as much lower oil prices caused a recession in Alberta and then after a long slide it really cratered with the pandemic. During that time the dividend was cut in several stages but the stock price finally staged a nice a nice recovery to over $18 in early 2022 as oil prices soared and the Alberta economy was very strong and as the dividend was increased. But then it slipped back to the $10 to $12 range.
Trading at just 31% of book value, I believe the company is clearly under-valued.
Fundamentally, Melcor appears to be a relatively low return business. Its investment property rental buildings including its REIT are fundamentally lower return but also lower risk investments. With an occupancy level of about 88% and which does include substantial older office buildings that portion of the company should justify a price to book value ratio closer to but probably not above 1.0.
The land development business appears to be problematic by tying up investment for far too many years. The gross margins on sale at about 39% do not appear to be high enough to generate an adequate ROE considering the years the investment was tied up before sale. And it may be that Melcor is sitting on way too much vacant land. It’s very hard to know what price to book value is reasonable here but 31% certainly seems WAY too low.
Melcor’s share price seems to suffer from the fact that no bank analysts follow the company. This may be because it is too thinly traded. It may also reflect the fact that there are essentially no other publicly traded land development companies in Canada. And Melcor is a mix of a property developer and a REIT while the market prefers pure plays. Overall, there is an extreme lack of interest in this company. The fact that the Melton family owns over 50% of the shares also seems to preclude any takeover possibility, despite the depressed share price.
In 2022 the ROE based on funds from operation remained far too low at 4.7%. But there are some very positive aspects to consider including:
- The dividend decrease that were made in 2016 – 2020 have been restored with 5 increases since 2021 and the yield is now 5.6%.
- 5% of the shares were repurchased in 2022 at low prices and this shows confidence.
- An office building Kelowna was recently sold for $19.5 million. This was $4.3 million higher than the book carrying value of the building even though buildings are carried at estimated modeled market value.
- In late 2022 they sold 117 residential units in Phoenix for $35 million. They had purchased these units around 2013 for $12 million. What was particularly surprising was that it appears that the this was a huge gain over the book value of these residential units even though they were theoretically already marked to market. A fair value gain of $23 was made on the sale and it appears that almost all of this was booked in 2022 indicating the residential units were significantly undervalued on the books. An additional $11 million in fair value gains was booked on other U.S. residential units that remain unsold.
- Here we have two major asset sales at well above carrying value and yet overall the shares trade at 31% of book value and counting debt plus equity the assets trade at 58% of book value.
- Melcor’s conservative approach to financing with limited use of short term debt is now paying off as much of the debt is locked in at lower than current market interest rates.
- In 2022. there was a substantial improvement in the occupancy level of the non-REIT investment properties. From 76% to 89% in Canada and from 75% to 83% in the US.
- The book value per share rose 11% in 2022.
- Melcor will continue to operate conservatively but appears to be optimistic about 2023.
There are some headwinds for 2023 including higher interest rates which could limit housing starts. But the Alberta economy is strong and Melcor appears set for a better year in 2023 as they expect to sell their inventory of U.S. lots this year along with possibly additional land sales there.