For most home building analysts, the big upside to M.D.C. Holdings' second quarter results, released Thursday morning, was that orders were better than Wall Street expected. Orders grew year over year by 5% on a community count growth of 31%. The growth boosted backlog up 28% from the same period in 2010, creating some optimism about the second half of 2011 for the company. But the positive order trend wasn't enough for analysts to overlook habitual balance sheet weaknesses that contributed to a significant widening of the company's loss to $28 million, or ($0.60) per share, from 3.7 million loss during the same quarter last year.
The big drag on profitability during the quarter was that gross margins continued to deteriorate, settling in at 13.1% excluding charges compared with 18.1% a year ago. However, during a related earnings call, management was quick to point out that it was taking some steps to course correct.
First, company management was doing an about-face on its spec strategy, which until now had been held up by management as a safe strategy to protect margin. Under the strategy, construction on new homes would be started but then halted at drywall stage, allowing buyers to both personalize the homes and still close on them quickly while the company preserved the associated margins on options and upgrades.
However, the past three quarters have shown that the strategy yielded poorer than expected margins, as the homes often had to be significantly discounted to move them. Moreover, company executives said the discounting on standing inventory also had a spillover effect on the company's to-be built homes, as dirt-sale buyers pushed for similar pricing. During the quarter, 44% of company sales were spec homes, company executives said.
Also contributing to its speculator inventory was a creeping cancellation rate. The company's can rate surged to 29% during the quarter, from 25% last year.
Vice president of finance and business development Bob Martin said, "It's really just market conditions. Go back to the tax credit, and we ended up with more specs than we should have. But we came off a very good sales period, so there wasn't as much urgency. But as we got further away from the tax credit, that urgency increased."
But Martin said if the company could get margins back up to historical levels, even in today's reduced volume environment, "clearly it would be a huge win for us."
The second thing that management said it would continue to work on to improve margins would be reducing overhead costs. Analysts have hounded the executive team on this point for a number of quarters, as company SG&A levels, as a percentage of revenue, are continually higher than many companies in their peer group.
Despite an absolute dollar decrease from $67.7 million last year to $53.6 million during the quarter, SG&A as a percentage of sales during the quarter headed in the opposite direction, growing to 16.1% from 14%. Management said it cut overhead by roughly 10% during the quarter through the elimination of approximately 100 positions. The move is expected to save the company roughly $9 million annually. But when asked about the possibility of future reduction in forces, Martin answered, "Whether or not it is enough, it's really something the market will tell us."
Similar to other public builders who incurred charges during the quarter, M.D.C. took impairments and option write-offs of $11.2 million, also affecting earnings. Some analysts believed the charges reflected pricing pressures in some areas as well as less than stellar land purchase decisions. But company management didn't seem to be overly concerned over the charges, pointing out that the impairments were associated with just six communities, all purchased in 2010. The company has purchased positions in more than 250 communities since 2009, executives said.
Despite management's confidence in its existing land position, which based on today's sales rates gives them about a three-year runway of lots, executives indicated the company would be throttling back on its appetite for new lots. The move led several analysts to make comparisons with the company's strategy in 2006 and question what executives saw as possible threats to a housing recovery.
Martin said, "In a very uncertain economic environment, we're going to have to be pretty cautious about what land we acquire. There are some serious headwinds, not only here but abroad."