M.D.C. (MDC) 10-Q2022 Q1 Quarterly report

The Unaudited Consolidated Financial Statements of M.D.C. Holdings, Inc. ("MDC," “the Company," “we,” “us,” or “our,” which refers to M.D.C. Holdings, Inc. and its subsidiaries) have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"). Accordingly, they do not include all information and footnotes required by U.S. generally accepted accounting principles (“GAAP”) for complete financial statements. These statements reflect all normal and recurring adjustments which, in the opinion of management, are necessary to present fairly the financial position, results of operations and cash flows of MDC at March 31, 2022 and for all periods presented. These statements should be read in conjunction with MDC’s Consolidated Financial Statements and Notes thereto included in MDC’s Annual Report on Form 10-K for the year ended December 31, 2021.

Where necessary, reclassifications have been made to our prior period financial information to conform to the current year presentation.

An operating segment is defined as a component of an enterprise for which discrete financial information is available and is reviewed regularly by the Chief Operating Decision Maker (“CODM”), or decision-making group, to evaluate performance and make operating decisions. We have identified our CODM as two key executives—the Executive Chairman and the Chief Executive Officer (“CEO”).

We have identified each homebuilding division as an operating segment. Our homebuilding operating segments have been aggregated into the reportable segments noted below because they are similar in the following regards: (1) economic characteristics; (2) housing products; (3) class of homebuyer; (4) regulatory environments; and (5) methods used to construct and sell homes. Our homebuilding reportable segments are as follows

Our financial services business consists of the operations of the following operating segments: (1) HomeAmerican Mortgage Corporation (“HomeAmerican”); (2) Allegiant Insurance Company, Inc., A Risk Retention Group (“Allegiant”); (3) StarAmerican Insurance Ltd. (“StarAmerican”); (4) American Home Insurance Agency, Inc.; and (5) American Home Title and Escrow Company. Due to its contributions to consolidated pretax income, we consider HomeAmerican to be a reportable segment (“mortgage operations”). The remaining operating segments have been aggregated into 1 reportable segment (“other”) because they do not individually exceed 10 percent of: (1) consolidated revenue; (2) the greater of (a) the combined reported profit of all operating segments that did not report a loss or (b) the positive value of the combined reported loss of all operating segments that reported losses; or (3) consolidated assets.

Corporate is a non-operating segment that develops and implements strategic initiatives and supports our operating divisions by centralizing key administrative functions such as finance, treasury, information technology, insurance, risk management, litigation and human resources. Corporate also provides the necessary administrative functions to support MDC as a publicly traded company. A portion of the expenses incurred by Corporate are allocated to the homebuilding operating segments based on their respective percentages of assets, and to a lesser degree, a portion of Corporate expenses are allocated to the financial services segments. A majority of Corporate’s personnel and resources are primarily dedicated to activities relating to the homebuilding segments, and, therefore, the balance of any unallocated Corporate expenses is included in the homebuilding operations section of our consolidated statements of operations and comprehensive income.

Diluted EPS for the three months ended March 31, 2022 and 2021 excluded options to purchase 15,000 and zero shares of common stock, respectively, because the effect of their inclusion would be anti-dilutive.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments as of March 31, 2022 and December 31, 2021.

Gains on sales of mortgage loans, net, are included as a component of revenues in the financial services section of our consolidated statements of operations and comprehensive income. For the three months ended March 31, 2022, we recorded net gains on the sales of mortgage loans of $2.1 million, compared to $23.5 million for the same period in the prior year.

Our inventories are primarily associated with communities where we intend to construct and sell homes, including models and unsold homes. Costs capitalized to land and land under development primarily include: (1) land costs; (2) land development costs; (3) entitlement costs; (4) capitalized interest; (5) engineering fees; and (6) title insurance, real property taxes and closing costs directly related to the purchase of the land parcel. Components of housing completed or under construction primarily include: (1) land costs transferred from land and land under development; (2) direct construction costs associated with a house; (3) real property taxes, engineering fees, permits and other fees; (4) capitalized interest; and (5) indirect construction costs, which include field construction management salaries and benefits, utilities and other construction related costs. Land costs are transferred from land and land under development to housing completed or under construction at the point in time that construction of a home on an owned lot begins.

In accordance with ASC Topic 360, Property, Plant, and Equipment (“ASC 360”), homebuilding inventories, excluding those classified as held for sale, are carried at cost unless events and circumstances indicate that the carrying value of the underlying subdivision may not be recoverable.  We evaluate inventories for impairment at each quarter end on a subdivision level basis as each such subdivision represents the lowest level of identifiable cash flows. In making this determination, we review, among other things, the following for each subdivision:

If events or circumstances indicate that the carrying value of our inventory may not be recoverable, assets are reviewed for impairment by comparing the undiscounted estimated future cash flows from an individual subdivision (including capitalized interest) to its carrying value. If the undiscounted future cash flows are less than the subdivision’s carrying value, the carrying value of the subdivision is written down to its then estimated fair value. We generally determine the estimated fair value of each subdivision by determining the present value of the estimated future cash flows at discount rates, which are Level 3 inputs, that are commensurate with the risk of the subdivision under evaluation. The evaluation for the recoverability of the carrying value of the assets for each individual subdivision can be impacted significantly by our estimates of future home sale revenues, home construction costs, and development costs per home, all of which are Level 3 inputs.

If land is classified as held for sale, we measure it in accordance with ASC 360 at the lower of the carrying value or fair value less estimated costs to sell. In determining fair value, we primarily rely upon the most recent negotiated price, which is a Level 2 input. If a negotiated price is not available, we will consider several factors including, but not limited to, current market conditions, recent comparable sales transactions and market analysis studies, which are considered Level 3 inputs. If the fair value less estimated costs to sell is lower than the current carrying value, the land is impaired down to its estimated fair value less costs to sell.

We lease certain property, land and equipment, the majority of which comprise property related leases to provide office space where we operate our business. Leases with an initial term of 12 months or less are not recorded on the balance sheet. We recognize lease expense for these leases on a straight-line basis over the lease term.

The property related lease for the Company’s headquarters in Denver, Colorado is ten years in length with an expiration date of October 31, 2026 and contains a ten year option to extend the term of the lease through 2036. This option has been excluded from our calculation of the right-of-use asset and lease liability as it is not currently considered reasonably certain that the option will be exercised.

Operating lease expense is included as a component of selling, general and administrative expenses in the homebuilding and expenses in the financial services sections of our consolidated statements of operations and comprehensive income, respectively. Components of operating lease expense were as follows:

Supplemental cash flow information related to leases was as follows:

The following table sets forth the components of homebuilding prepaids and other assets:

Our warranty accrual is included in accrued and other liabilities in the homebuilding section of our consolidated balance sheets and adjustments to our warranty accrual are recorded as an increase or reduction to home cost of sales in the homebuilding section of our consolidated statements of operations and comprehensive income.

The establishment of reserves for estimated losses associated with insurance policies issued by Allegiant and re-insurance agreements issued by StarAmerican are based on actuarial studies that include known facts and interpretations of circumstances, including our experience with similar cases and historical trends involving claim payment patterns, pending levels of unpaid claims, product mix or concentration, claim severity, frequency patterns depending on the business conducted, and changing regulatory and legal environments. It is possible that changes in the insurance payment experience used in estimating our ultimate insurance losses could have a material impact on our insurance reserves.

The establishment of reserves for estimated losses to be incurred by our homebuilding subsidiaries associated with: (1) the self-insured retention (“SIR”) portion of construction defect claims that are expected to be covered under insurance policies with Allegiant and (2) the entire cost of any construction defect claims that are not expected to be covered by insurance policies with Allegiant, are based on actuarial studies that include known facts similar to those for our insurance reserves. It is possible that changes in the payment experience used in estimating our ultimate losses for construction defect claims could have a material impact on our reserves.

In the ordinary course of business, we make payments from our insurance and construction defect claim reserves to settle litigation claims arising from our homebuilding activities. These payments are irregular in both their timing and their magnitude. As a result, the cash payments, net of recoveries shown for the three months ended March 31, 2022 and 2021 are not necessarily indicative of what future cash payments will be for subsequent periods.

The carrying values of our senior notes as of March 31, 2022 and December 31, 2021, net of any unamortized debt issuance costs or discount, were as follows:

Our senior notes are not secured and, while the senior note indentures contain some restrictions on secured debt and other transactions, they do not contain financial covenants. Our senior notes are fully and unconditionally guaranteed on an unsecured basis, jointly and severally, by most of our homebuilding segment subsidiaries.

In January 2021, we completed an offering of $350.0 million of 2.500% senior notes due January 2031 at 100% of par. In August 2021, the Company issued $350.0 million of 3.966% senior notes due August 2061 at 100% of par. We used the net proceeds for general corporate purposes, which included the retirement of our 5.500% senior notes discussed further below, which were scheduled to mature in January 2024.

In September 2021, we accelerated the retirement of $123.6 million of our 5.500% senior notes scheduled to mature in January 2024 through a cash tender offer. The retirement resulted in a loss of $12.2 million, which included the write-off of debt issuance costs and transaction fees. In December 2021, we accelerated the retirement of the remaining $126.4 million of our 5.500% senior notes pursuant to their optional redemption provisions. This retirement resulted in a loss of $11.4 million, which included the write-off of debt issuance costs and transaction fees.

The following table sets forth share-based award expense activity for the three months ended March 31, 2022 and 2021, which is included as a component of selling, general and administrative expenses and expenses in the homebuilding and financial services sections of our consolidated statements of operations and comprehensive income, respectively:

Additional detail on the performance share units ("PSUs") expense is included below:

We have made no material guarantees with respect to third-party obligations.

The derivative instruments we utilize in the normal course of business are interest rate lock commitments and forward sales of mortgage-backed securities, both of which typically are short-term in nature. Forward sales of mortgage-backed securities are utilized to hedge changes in fair value of our interest rate lock commitments as well as mortgage loans held-for-sale not under commitments to sell. For forward sales of mortgage-backed securities, as well as interest rate lock commitments that are still outstanding at the end of a reporting period, we record the changes in fair value of the derivatives in revenues in the financial services section of our consolidated statements of operations and comprehensive income with an offset to other assets or accounts payable and accrued liabilities in the financial services section of our consolidated balance sheets, depending on the nature of the change.

At March 31, 2022, we had interest rate lock commitments with an aggregate principal balance of $521.1 million. Additionally, we had $66.2 million of mortgage loans held-for-sale at March 31, 2022 that had not yet been committed to a mortgage purchaser. In order to hedge the changes in fair value of our interest rate lock commitments and mortgage loans held-for-sale that had not yet been committed to a mortgage purchaser, we had forward sales of securities totaling $378.5 million at March 31, 2022.

For the three months ended March 31, 2022 and 2021, we recorded net gains on derivatives of $3.6 million and $9.0 million, respectively, in revenues in the financial services section of our consolidated statements of operations and comprehensive income.

The Revolving Credit Facility provides for a transition from the eurocurrency rate to a benchmark replacement upon the occurrence of certain events.

The Revolving Credit Facility is fully and unconditionally guaranteed, jointly and severally, by most of our homebuilding segment subsidiaries. The facility contains various representations, warranties and covenants that we believe are customary for agreements of this type. The financial covenants include a consolidated tangible net worth test and a leverage test, along with a consolidated tangible net worth covenant, all as defined in the Revolving Credit Facility. A failure to satisfy the foregoing tests does not constitute an event of default, but can trigger a “term-out” of the facility. A breach of the consolidated tangible net worth covenant (but not the consolidated tangible net worth test) or a violation of anti-corruption or sanctions laws would result in an event of default.

The Revolving Credit Facility is subject to acceleration upon certain specified events of default, including breach of the consolidated tangible net worth covenant, a violation of anti-corruption or sanctions laws, failure to make timely payments, breaches of certain representations or covenants, failure to pay other material indebtedness, or another person becoming beneficial owner of 50% or more of our outstanding common stock. We believe we were in compliance with the representations, warranties and covenants included in the Revolving Credit Facility as of March 31, 2022.

We incur costs associated with unused commitment fees pursuant to the terms of the Revolving Credit Facility. At March 31, 2022 and December 31, 2021, there were $51.7 million and $40.1 million, respectively, in letters of credit outstanding, which reduced the amounts available to be borrowed under the Revolving Credit Facility. At March 31, 2022 and December 31, 2021, we had $10.0 million and $10.0 million, respectively, outstanding under the Revolving Credit Facility. As of March 31, 2022, availability under the Revolving Credit Facility was approximately $1.14 billion.

The Mortgage Repurchase Facility contains various representations, warranties and affirmative and negative covenants that we believe are customary for agreements of this type. The negative covenants include, among others, (i) a minimum Adjusted Tangible Net Worth requirement, (ii) a maximum Adjusted Tangible Net Worth ratio, (iii) a minimum adjusted net income requirement, and (iv) a minimum Liquidity requirement. The foregoing capitalized terms are defined in the Mortgage Repurchase Facility. We believe HomeAmerican was in compliance with the representations, warranties and covenants included in the Mortgage Repurchase Facility as of March 31, 2022.

The Company has a sublease agreement with CVentures, Inc. Larry A. Mizel, the Executive Chairman of the Company, is the President of CVentures, Inc. The sublease is for office space that CVentures, Inc. has continuously leased from the Company as disclosed in the Form 8-K filed July 27, 2005 and the Form 8-K filed March 28, 2006. The current sublease term commenced November 1, 2016 and will continue through October 31, 2026. The sublease agreement is for approximately 5,437 rentable square feet at a base rent that increases over the term from $26.50 to $31.67 per rentable square foot per year. The sublease rent is an allocation of the rent under the master lease agreement based on the sublease square footage.

Our senior notes are fully and unconditionally guaranteed on an unsecured basis, jointly and severally, by the following subsidiaries (collectively, the "Guarantor Subsidiaries"), which are 100%-owned subsidiaries of the Company:

The senior note indentures do not provide for a suspension of the guarantees. Other than for the senior notes due 2061, the senior note indentures, provide that any Guarantor may be released from its guarantee so long as (1) no default or event of default exists or would result from release of such guarantee, (2) the Guarantor being released has consolidated net worth of less than 5% of the Company’s consolidated net worth as of the end of the most recent fiscal quarter, (3) the Guarantors released from their guarantees in any year-end period comprise in the aggregate less than 10% (or 15% if and to the extent necessary to permit the cure of a default) of the Company’s consolidated net worth as of the end of the most recent fiscal quarter, (4) such release would not have a material adverse effect on the homebuilding business of the Company and its subsidiaries and (5) the Guarantor is released from its guarantee(s) under all Specified Indebtedness (other than by reason of payment under its guarantee of Specified Indebtedness). The indenture for the senior notes due 2061 provides that, if a Guarantor is released under its guarantees of our credit facilities or other publicly traded debt securities, the Guarantor will also be released under its guarantee of the senior notes due 2061. Upon delivery of an officers’ certificate and an opinion of counsel stating that all conditions precedent provided for in the indenture relating to such transactions have been complied with and the release is authorized, the guarantee will be automatically and unconditionally released. “Specified Indebtedness” means indebtedness under the senior notes, the Company’s Indenture dated as of December 3, 2002, the Revolving Credit Facility, and any refinancing, extension, renewal or replacement of any of the foregoing.

As the combined assets, liabilities and results of operations of M.D.C. Holdings, Inc. and the Guarantor Subsidiaries (the “Obligor Group”) are not materially different from those in the homebuilding section of our consolidated balance sheets and consolidated statements of operations and comprehensive income, separate summarized financial information of the Obligor Group has not been included. As of March 31, 2022 and December 31, 2021, amounts due to non-guarantor subsidiaries from the Obligor Group totaled $58.9 million and $60.2 million, respectively.

On April 21, 2022, our subsidiary, Richmand American Homes of Tennessee, Inc., entered into an asset purchase agreement ("Purchase Agreement") to acquire substantially all of the homebuilding assets of The Jones Company of Tennessee, L.L.C. (“Seller”) for a purchase price of $117.3 million, subject to the adjustments outlined below, which is expected to be paid entirely in cash. The Seller is a leading homebuilder in the Nashville, Tennessee area, and this acquisition provides us with the opportunity to quickly scale our operations and increase our footprint in one of our newest markets.

For the three months ended March 31, 2022, our net income was $148.4 million, or $2.02 per diluted share, a 34% increase compared to net income of $110.7 million, or $1.51 per diluted share, for the same period in the prior year. Our homebuilding business was the driver of these year-over-year improvements, as pretax income from our homebuilding operations increased $75.0 million, or 66%, compared to the same period in the prior year. This was slightly offset by a decrease in pretax income from our financial services operation of $17.4 million, or 57%, compared to the period ended March 31, 2021. The increase in homebuilding pretax income was the result of a 19% increase in home sale revenues and a 430 basis point increase in our operating margin. The increase in operating margin is the result of our improved pricing resulting in an increase to gross margin of 380 basis points as well as an improvement of 60 basis points in our selling, general and administrative expenses as a percentage of home sale revenues. The decrease in financial services pretax income was primarily due to our mortgage operations, which benefited from increased profitability per loan originated during the period ended March 31, 2021. As competition in the primary mortgage market has increased, we have seen these profit levels return to more historical levels during the period ended March 31, 2022.

The dollar value of our net new home orders increased 12% from the prior year period, due to a 14% increase in the average selling price of net new orders, slightly offset by a 2% decrease in the number of net new orders. The decrease in the number of net new orders was due to an decrease in the monthly sales absorption rate in order to keep our backlog at a manageable level given the increase in cycle times discussed above. The increase in the average selling price was the result of continued price increases implemented in nearly all of our communities.

For the three months ended March 31, 2022, we recorded homebuilding pretax income of $188.5 million, an increase of 66% from $113.5 million for the same period in the prior year. The increase was due to a 19% increase in home sale revenues, a 380 basis point increase in our gross margin from home sales and a 60 basis point decrease in our selling, general and administrative expenses as a percentage of revenue.

Our West segment experienced a $53.3 million year-over-year increase in pretax income, due to a 15% increase in home sales revenue and an improved gross margin. Our Mountain segment experienced a $4.6 million increase in pretax income from the prior year, as a result of a 3% increase in home sales revenue and an improved gross margin. Our East segment experienced a $23.6 million increase in pretax income from the prior year, due primarily to a 97% increase in home sales revenue as well as an improved gross margin. Each of our homebuilding segments also benefited from decreased selling, general and administrative expenses as a percentage of revenue driven by improved operating leverage. Our Corporate segment experienced a $6.6 million decrease in pretax income, due primarily to increases in stock-based compensation expense, bonus expense and salary related expenses due to higher average headcount and increased salaries.

Total homebuilding assets increased 4% from December 31, 2021 to March 31, 2022. Homebuilding assets increased in each of our operating segments largely due to a greater number of homes completed or under construction as of period-end.

For the quarter ended March 31, 2022, the number of new homes delivered in each of our segments was negatively impacted by an increase in construction cycle times. This increase was primarily the result of extended permitting times, supply chain disruptions and labor shortages as a result of the pandemic as well as the increased demand for new homes.

West Segment Commentary

East Segment Commentary

Our gross margin from home sales for the three months ended March 31, 2022, increased 380 basis points year-over-year from 21.9% to 25.7%. Gross margin from home sales increased across each of our segments on both build-to-order and speculative home deliveries driven by continued price increases implemented across nearly all of our communities. This increase was partially offset by an increase in building costs year-over-year, a $0.7 million inventory impairment and a $2.4 million warranty accrual adjustment recognized during the three months ended March 31, 2022.