Mirvac's shaky foundations

There's always a temptation for investors to look for shortcuts. Sifting through pages of management jargon and accounting standards can be quite painful at times. Who wouldn't want more time for fun?

One easy way to cut corners is to base buy and sell decisions on whether simple ratios are above or below an arbitrary number. So easy, in fact, that many investment books have been sold about how variations on this approach can earn you millions.

When it comes to listed property trusts like Mirvac, the ratio you'll hear most about is the company's net tangible assets per share (NTA). If a property trust's price is below its NTA then apparently it's time to fill your boots.

If only it was that easy.

NTA 101

The NTA ratio is popular for companies like Mirvac as their asset base is largely made up of real assets. If there are any intangibles, the amount is usually negligible. Most of their assets are also periodically revalued to approximate market value, or what you would get if you sold them into a fair market, instead of being kept at historical cost.

Since the release of its interim result, Mirvac's share price has traded at a slight premium to its net tangible assets per share of $1.83.

If you follow the shortcut approach, the current price of Mirvac could easily appear a buying opportunity.

However, taking short cuts will often leave you cut short; and, in this case, a deeper look into the company's development history leaves us wary of accepting its figures at face value.

Development woes

Mirvac's largest division is its residential development segment. This division builds and sells apartments and masterplanned communities – typically in Sydney, Melbourne, Brisbane and Perth. Although it regularly generates 60-70% of the company's revenue, its history of profitability has been quite volatile (see Table 1).

It's interesting to note that during a period many believe encompassed one of Australia's greatest property booms, total revenue and operating profit for its development division has been so unsettled.

In 2015, revenue and earnings before interest and tax (EBIT) for the division was actually less than in 2006. This is despite total inventory – the value of its lots and properties under development but not sold – increasing by more than 21% in the ten years to 2015.

Despite the boom, it appears that generating consistent profit has been extremely difficult.

Inflection Point

Which must be a concern as those boom times now appear to be over.

Mirvac is required to carry inventory on its balance sheet at the lower of cost and net realisable value. If the carrying amount on the balance sheet is above net realisable value than an impairment or write-off must occur.

In February 2013, Mirvac had to write off $273m from the value of its Queensland and Western Australian development properties. A major reason was weaker than expected residential sales and a deteriorating property market.

In the commentary accompanying its 2016 interim result, management put forward its view that the residential property market had passed an ‘inflection point'. The company thinks demand from foreign buyers will weaken and that sales volume and price growth will start to decline. Any such deterioration in the property market could easily lead to further writedowns, as they did in 2013.

What's the development business worth?

Since the company's 2013 strategic review, where management decided to focus only on those businesses where it believed the company had a competitive advantage [always a smart choice — Ed], the profitability of the development business has stabilised.

Not since 2006-07 has the company generated two consecutive periods where the operating margin of its development business was in positive double figures.

However, considering the company's own views on the future of the residential property market and its chequered history of profitability, assuming the bad times are over could be dangerous.

A frequent approach we use to adjust for this involves replacing the inventory book values with an estimate of the value of the development business ‘through-the-cycle'. As Mirvac also has a funds management division, we have performed the same process to bring its management fee income onto the balance sheet. Finally, we've assumed changes to the valuation of its investment property portfolio based on different capitalisation rates (see Table 2).

Even in our most optimistic scenario, Mirvac's share price is at a decent premium to our adjusted NTA figure and is almost 18% higher than our base case valuation.

Whilst our assumptions could easily be proven too conservative in today's low interest rate environment, in light of Mirvac's history of impairments we feel more comfortable with this approach than using the figures supplied to us in the balance sheet.

Mirvac's share price has fallen 4% since Mirvac and Stockland's understated risk (Avoid — $1.96). Until we see its development segment generating more consistent profits we continue to recommend members AVOID.