Description

                Melcor Developments Ltd. (“MRD” CN) has been consistently undervalued for much of the last five years, trading at levels comparable to those seen during the worst parts of the Great Recession. Despite the lack of interest in the stock, this is a high-quality business, with high returns on equity over long periods of time, and with a gigantic margin of safety in the form of tangible real estate assets. There was a high-quality write-up on MRD posted in 2016, so see that write-up for a basic understanding of the business and its various segments. In brief, the company is composed of five segments. The Community Development segment acquires raw land for future use. The Property Development segment develops the buildings on owned land. The Investment Properties segment manages and leases properties held directly by the company or by the controlled REIT. The REIT segment is a controlled publicly traded REIT. The Recreational Properties segment owns and operates golf courses. 12.5% of total assets are held in the United States, primarily in the Phoenix and Denver markets. The rest is held in Canada, primarily near Calgary and Edmonton. The Canadian assets are near major oil producing regions, so the real estate markets in those regions are heavily tied to the price of oil. For a more detailed look at the segments, particularly a good analysis of how the controlled REIT factors into the consolidated financials, see the previous write-up.

This is a company that has not lost money for over 20 years. The assumptions required to justify the current valuation don’t pass the smell test, and the stock will recover in the next several years as either a) the company takes steps to realize value, b) earnings improve as a result of an improving macro environment in the company’s core regions, or c) the market comes to appreciate the size of the value gap. This writeup will focus on five elements indicating the stock is a steal.

                First, the value of the real estate presents a large margin of safety for the conservative investor. Barring a nuclear attack centered on Calgary, there is almost no way this stock loses money over the long-term. With a market cap of approximately $480 million, the company has a book equity value of over $1 billion. Assets are primarily composed of 1) cash ($32mm), 2) agreements receivable ($109mm), 3) land inventory ($765mm), and 4) investment properties ($983mm). Cash is cash. Agreements receivable are essentially accounts receivable, but are typically collateralized by real estate developments (and hence safer than typical A/R). Land inventory is valued at the lower of cost or realizable value and includes capitalized development expenses. It seems fair to assume (as investors do for every other company that holds land on its books for very long periods of time) that the actual value of the raw land ($383mm) is probably a very conservative estimate of fair value given Canadian real estate has appreciated over the long-term. Furthermore, given the company has not lost money in over 20 years (as far back as records go), insofar as the land inventory is incorporated in the COGS determining margins, there is a long track record to suggest that the land inventory isn’t materially overstated. In fact, the company will probably realize a profit margin above the value of the inventory. Finally, the investment properties are marked to fair value annually (at least), usually by independent appraisers. The weighted average assumed cap rate for investment properties is 6.6%. For each rise in the assumed cap rate of 50 bps the value of the investment properties declines by roughly $50mm. So, to justify the current valuation, assuming the other assets approximate fair value, you need to assign a roughly 12% cap rate (i.e. roughly what the worst mall assets trade for) to a bunch of high quality office, retail, industrial and residential properties. To justify a significantly lower stock price you must materially raise the cap rate from there! The assets in play here easily cover the value of the liabilities and leave a gigantic margin of safety for the enterprising investor.

                Second, if you are looking for more proof that the assets here have a value closer to the estimated value than the market value, we can examine asset sales over the last several years. Note that the highest cap rate assumed for any investment property is 8.75%. So, upon sale, the only way a property could conceivably sell for a worse cap rate would be if the company recognized a material loss upon the sale. Also remember that even in this worst-case scenario, where all assets are valued at the low end of management estimate for their worst assets, an 8.75% cap rate would justify a ~60% appreciation in the stock price. Over the last 3.5 years, at a horrible time for the real estate market in their primary markets, the company has disposed of nearly $150mm in investment properties and realized a small gain on asset sales in each year while doing so. Obviously, the private market is valuing these assets the same way the management team is!

                Third, if you are looking for MORE proof that the company is not using insane assumptions to justify its 6.5% cap rate for investment properties, consider the cost of debt for the properties at issue. At year end 2017 select investment properties under development secured over $40mm in debt at an average interest rate of approximately 3.6%. Completed investment properties and golf courses with a carrying value of roughly $710mm secured debt of $445mm at a weighted average interest rate of 3.4%. So, to get to the 12% cap rate implied by the current stock price at that debt / equity ratio we need to assume a cost of equity of over 26%. Does it make sense that a conservative, consistently profitable real estate company with a gigantic pool of assets has a cost of equity comparable to Theranos in 2018? Clearly the debt markets are at odds with the equity markets over the value of these assets.

                Fourth, moving away from the idea that the company is worth more dead than alive, this is perhaps the most consistently profitable small cap company in the North American market. The company has never lost money on an annual basis since accessible records exist in 1996. Consider how amazing that is for a real estate company whose primary markets have been in major bear country for the last several years. Although ROE the last couple years has been poor, over the last decade (or two or three), ROE has averaged well over 10%. Moreover, in the LTM period ROE has begun to rise again and is poised to go above 10% with just one or two more good quarters. Note that in the first half of 2018 MRD generated $16.3mm in net income vs. a loss of $5.1mm last year. Things are obviously getting better for the company as the oil market improves in their primary markets. If they can return to a 10% ROE the stock will be trading at 4.8x earnings. As it is, you are buying an ultra-consistent earnings machine with massive asset coverage for 7.6x LTM adj. P/E.

                Finally, it would be an understatement to say that board incentives are aligned with investors. With one family owning over 50% of the company and holding key positions on both the board of directors and within management, clearly the power players at the company have a huge incentive to see the stock rise over the long term. If management appeared to be incompetent, or if the company had a long history of value destructive actions, then having a captive shareholder would obviously be a negative. But instead this is a team that has consistently created value over its tenor and appears poised to do so as the real estate market improves in their primary markets. This is precisely the type of situation that has worked so well for Buffett over time – find a team that has a long track record of success, wait for shares to get cheap, then buy a stake alongside people who are incentivized to maximize economic value.

                I would guess that the bears here might actually not disagree with many of these points. Instead they would point to the clearly overvalued Canadian real estate market and say that the company will face an extremely tough market over the next several years if the bubble collapses. Several responses. First, if you are a long-short guy, go find an overvalued short with a ton of leverage and use a cheap position like this to offset it. Second, if the underlying assets here are worth a lot right now given prevailing market conditions, then shouldn’t this be worth far more in the here and now? If a company sitting on a billion dollars of gold were selling for $500mm, it wouldn’t be rational just because you think gold is overvalued. Third, the company is exposed to idiosyncratic markets that are not representative of the bubbles in Vancouver and Toronto. The real estate markets have been poor around most of their properties, so there is less risk they have been impacted by the bubble at play in other markets. With oil moving back to $70, the local economies there should continue to build on positive momentum they have seen in the last year. The bear macro case instead must be based on $30 oil and another depression in oil dependent regions. But remember, that JUST happened and MRD was profitable throughout! Fourth, if none of those get you comfortable, don’t buy it. Calling the entire Canadian real estate market should be in the “too hard” basket for any self-aware investor. I’m not trying to do that, I’m just trying to point out a clearly oversold company with an intrinsic value far ahead of market value.

                MRD has been systematically undervalued for several years. I don’t see a specific catalyst approaching aside from earnings continuing to improve and investors becoming more aware of the situation. Any corporate actions to unlock value would be gravy. With a gigantic margin of safety and the opportunity for huge upside in the event they return to a consistent 10% ROE, this is one of the better deals in North America.

Catalyst

- Company takes steps to realize value

- Earnings improve as a result of improving macro environment in their core markets

- Market comes to appreciate the size of teh value gap