Wall Street received further proof of life in the housing industry with the release of M.D.C. Holdings' 2Q2009 earnings and conference call on Friday. The company tempered its losses thanks to fewer impairments; posted operational improvements in new orders, cancellations, and margins; and appeared more than ready to dig into its $1.6 billion war chest to ramp up operations. (To access the company’s full earnings results, click here.)
The metric that got most analysts excited was the company’s gross margins. At 18%, the company’s margins outshone those of most of the company’s peers and represented a significant increase in profitability compared to the same period a year ago, when gross margins were at 11.7%. Management said the improvement was a result of both a recent reduction in the company’s warranty reserve and previous impairments, which have totaled more than $1.1 billion since 3Q2006.
With a clear edge on profitability against peers, analysts were anxious to know whether gross margins of that magnitude were sustainable. Both CEO Larry Mizel and CFO Chris Anderson were hesitant to ratchet expectations up that high, but there appeared to be some confidence that margins would likely remain stable if not improve. Here's the reasoning:
1. Benefit from previous impairments. Management believes the company has properly valued the land in its portfolio and made the necessary valuation adjustments. By sufficiently lowering the cost basis of land, the company can build more profitably.
2. Continued rollout of its new product. The company met with some early success in the market with the launch of a new product line that offers smaller, more affordable homes. Although the new product accounted for just 10% of the quarter’s sales, Anderson said, ‘We’re really just getting started.”
3. New spec strategy. Understanding that dirt sales generally yield better margins but accepting that volatility in the market has buyers opting for quick move-in homes, management has taken measures to drastically reduce the number of finished, unsold homes in inventory—the company had 82 finished spec homes on its books at quarter’s end—in favor of bulking up on close-to-finished specs. This means construction on a spec home is halted at the drywall stage until a buyer is found for the home, allowing the buyer to personalize the home with high margin options from the company’s design centers. The end result: the company can maintain sales velocity and inventory turn without sacrificing too much on margin.
4. Opportunities to refill land pipeline at lower cost. Although management has positioned itself as being aggressively on the prowl for lots, deal flow has a trickle at best. CEO Mizel noted that he had seen a sequential uptick in the assets being shopped around by banks and other financial institutions. However, he said bid and ask prices still remained apart. But he cautioned that management was remaining disciplined in its evaluation of potential deals. “You can buy in 10 minutes what you can’t sell in a lifetime,” he cautioned.
About the only thing analysts had to grouse about was the company’s SG&A, which came in at 24.5% of revenues. However, management seemed less concerned with the elevated level than analysts, instead looking at the associated dollars as the cost to keep an infrastructure in place that will be critical to growing the company as housing demand rebounds.
On the cost of sales side of the equation, management highlighted reductions in sales commissions, a 54% reduction in model homes plus lower levels of merchandising, and a 37% decrease in community count. In terms of overhead, management said it believed it had appropriately trimmed headcount; the company had a 36% year-over-year reduction in headcount, bringing the payroll count down to slightly more than 1,000 employees, compared to roughly 4,300 at peak.
“We’re structured to grow as fast as demand grows,” said Mizel. “Remember the ‘Field of Dreams’ movie? We’re dressed and ready to go.”
Sarah Yaussi is editor of BIG BUILDER magazine.