Our Inflation Nation Update & New Home Development Stock

November 15, 2021

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Our Inflation Nation Update & New Home Development Stock

Courtesy of Tobin Smith, Transformity Research

In our 2022 Inflation Nation Update last week, I stated that:
1) There are really two inflation rates in America–one for homeowners for 3-5 years or more and then everyone else
2) With not 5.4% but now 6.2% REAL inflation rates (from last Friday's October Inflation report) it now means your money has to earn at least 6.2% a year (via yield or appreciation), otherwise YOUR INVESTMENT PORTFOLIO IS UNDERWATER. Your reduced buying power means a declining lifestyle.

With a 6.2% inflation print comes a new reality for the stock market in 2022. A 6%+ CPI inflation rate is here for most of 2022 year-over-year and the Federal Reserve is backed into a corner when it comes to the American economy aka "Inflation Nation".

The Fed is Behind the Inflation Curve NOW & Policy Mistakes Have Been Made

As I reported in the 2022 Transformity Research 2020 Playbook last week, "By far the greatest risk to the stock market is if a majority of institutional investors see conclusive evidence that the Fed is "behind the inflation curve" and it will be obvious that YoY inflation rates will be with us at least through 2022 and into 2023–aka we in the Western World have NON-Transitory/"sticky" price and wage inflation."

Both the stock and bond market understand there is a significant risk the Fed is behind the inflation curve and sooner than expected is going to have to SLAM the brakes on $120 billion in monthly bond purchases and given ZERO percent Fed fund rates:

1) The Fed has proven it has NO proven macroeconomic model to accurately analyze how a diversified Western economy recovers from a global pandemic (nor does any other Reserve bank for that matter).

2) The Fed's goal of 2%-ish inflation goal was never hit for the last 40 years due to the disinflationary forces of higher labor productivity and eCommerce/outsourced supply chains plus the Walmart & Amazon price of goods deflation effect that produced LOWER input and finished products pricing + a $2 trillion energy fracking investment made by America's public and private E&P industry at what turned out to be a $trillion negative economic return but kept energy prices and OPEC+ honest.

Key Point: ALL of the Disinflationary Powers of the last 20 years have now been REVERSED starting with energy:

First, we have the transformation of the energy E&P industry from "Frack Baby Frack" to "Cash Baby Cash" thus US energy and export prices are now "higher for longer"
Plus OPEC++, in the face of a massive expansion of EV and ETruck market share 2022-2030, is now ALL ABOUT getting the highest prices they can get for their oil and natural gas for as long as they can (that do not accelerate the significant energy demand destruction that is coming from the electric battery transportation revolution
It's now a reasonable assumption that IF the majority of CEOs on earnings calls are right and Global Supply Chains remain broken past 2022 and
5%+ of US and Europe under 65 aged labor force has disappeared or is demanding VERY STICKY substantially higher hourly/salary/benefits (the stickiest cost/price inflators of all—see 1971-1982)
Along with ALL blue-collar/hourly wage earners + truck drivers + eCommerce delivery+ food service etc demanding and getting double-digit wage and benefit raises (which never go away)

We must now conclude that input price/labor/energy/supply chain delivery logistics & wage costs are NOT TRANSITORY but are EMBEDDED in the U.S. and global economy –and we are not hearing from the Fed that this new embedded inflation narrative is the most likely scenario in 2022.

Moreover, as a result of the global shared pandemic life experiences, we have to conclude that a global GENERATIONAL cultural shift in people's wage and work condition expectations has arrived. I think it is a fair assumption that this cultural change IS NOT in the "Fed Inflation Model" because of the lag in how the model is operated.

ADD IN 20-35% higher home prices YOY 2020 to 2021 that are NOT included in CPI calculations–which brings REAL 2021-2022 cost-of-living inflation above 10%–and it would almost take a miracle to see lower than 5% YOY price inflation from now to the last quarter of 2022 at the earliest.

Key Point: The odds of a Fed monetary policy mistake that will result in "Behind the Curve Emergency Rate Hikes" is virtually certain AFTER the first six months of 2022. The Fed Fund futures are pricing in Fed Fund rate hikes at the July and December meetings–and if 10% ish real inflation stays with us for the next 4-6 months, we should expect more dramatic earlier + bigger Fed "brake slamming."

What to do with our investments?

We need to put on our "how do we profit FROM inflation" and our "what happens to secular tech growth sector with 10-year risk-free rates rising 1-2%" hats. Our Ultra Income energy portfolio works well in inflation. Part of the answer to how do we profit from inflation is adding sectors and companies that benefit from price inflation—which brings us to our new Ultra Growth + Ultra Income investments in Harbor Custom Development, Inc.

Harbor Custom Development, Inc. (NASDAQ:HCDI) is a small home builder that is growing aggressively in the hottest US urban adjacent regions to meet the changing demand for suburban housing demand for the new hybrid work transformation of which we have talked extensively.

Key Point: Housing demand and home prices have increased dramatically in key urban adjacent areas in the United States as the need to commute to jobs has been reduced. HCDI is literally selling out EVER PROJECT they finish.

Increasing inflation and low-interest rates have also contributed to the red-hot housing market in these areas. HCDI is developing land and homes that are seriously affordable for knowledge-based professional families who seek the higher quality of life/less expensive way of life that comes from moving from America's ultra-expensive urban regions (Southern CA/SF/Greater SF Bay Area/Silicon Valley/Seattle/Greater NYC/Boston/Chicago/Connecticut) to urban adjacent suburbs and a 4-bedroom/Chef Kitchen/Family Room home with an actual grass and tree swing backyard AND (because America pays for its public schools mostly from property taxes) higher quality public schools that means they don't have to spend $30-$50k a year per kid for private schools.

This headline in the Wall Street Journal this morning sorta says it all:

The Company: Residential real estate developer Harbor Custom Development, Inc (HDCI)

Investment Ideas:

HCDIP Preferred Stock Under $16.25 or better with a $25 target with @13% annual yield paid monthly and five $5 warrants redeemable into HDCI stock (with $9.75 discount to HCDIP $25 par value) at @$2.70 (with HDCI stock trading at $2.10 right now!),
HCDIW 5 Year $5 Convertible Warrants < .35 with a $2.50 target in the next 24-36 months with HCDI stock re-rated to reflect normal 1x sales residential home builder valuations.
HCDI Common Shares < $2.30 with an $8 target in the next 24-36 months with HCDI stock re-rated to reflect normal 1x sales residential home builder valuations.

Core Investment Thesis: The move from expensive urban cities to a new 4-bedroom home and 3 bedroom condos in key urban adjacent suburbia for the hybrid work anywhere family is accelerating and a long term generational shift just getting started.

We all know people that have made the “Get Me OUT of SF/Bay Area/LA/Orange County CA/Seattle/Chicago/Greater NYC/Upstate NY/Boston/Connecticut etc move already. According to industry sales reports, IF there are homes to be bought (especially NEW HOMES), there are millions of American urban area homeowners cashing out and moving to the 50%-75% more housing affordable Burbs.

In the most desirable urban area suburbs, EVERY new home built and ready for sale is being sold —to newcomers mostly. Sadly in these new hot suburbs (like Phoenix Metro where we live or say Boise, Idaho) the average income native cannot afford most of these new homes (unless they move WAY out of the Metro area).

But for the middle to upper-middle-class professional/knowledge worker families uprooting for a hybrid commute free way of life, they are coming with $millions of after-tax profits from selling their urban area home/townhome/condo/co-op and they want to be living large—4 bedrooms, chef kitchen, family room and a BACKYARD (and since schools in America are paid for by property taxes, great well-funded schools in general).

Key Point: On its current sales and projected sales growth path, HDCI’s preferred and common shares are massively undervalued by 300-500%.

In fact, if you look at where HDCI is developing housing tracts and building new homes for knowledge-working Millennials and Gen-Xers (Great Seattle, Austin Texas, Sacramento, Florida), they are in the very right spots at the very right time with the right product at the right price. For instance, Austin Texas metro area just reported the highest median price increase EVER for single-family homes in Q3 ending September at a staggering 33.5%.

Greater Seattle reports a 27% median price increase—Sacramento 26% price increase and the Florida area HCDI is building communities 23% media price increases.

But it's NOT JUST families buying these homes–they are competing with the NEW American Single Family Homebuyers–America's $trillion Build-to-Rent Landlords.

The $trillion build-to-rent home demand is exploding at the same time as Hybrid Work Transformation

My old pals at real estate investment consultants Green Street Advisors (I used to share an office with them in Irvine, CA back in the day) just put out research that “with historically high housing prices, steep down payments and nearly perfect credit scores required for low rate mortgages, more and more families are not able to compete for buying new homes and are forced to rent their homes when they are shut out of home sales.

“The cost for housing alternatives for single-family renters has exploded” they just announced in their latest research. Eh, sorry but anyone who rents a single-family home knows that reality all too well.

In fact, Green Street reports that the $trillion homes-to-rent players are many times buying out ALL the well-located suburban new homes ahead of suburbs seeking families from developers.

Key Point: Now HCDI has THREE bidders EVERYTHING They Build–$billion home-to-rent giants, $trillion private equity players and the new cashed out urban home sellers looking for commute free (or 30 minute limited hybrid work commutes) and better schools for their kids (and if they don't have to pay $45k+ per kid for private schools they lower their cost of living by $100k a year! )

TR’s HCDI Investment Thesis: For all the reasons above, our data say that HDCI common stock is massively undervalued. Steve Hilton, my Scottdale neighbor and CEO of the amazingly well-run homebuilder Meritage Homes (MTG) says that in 2022, a well-run full-cycle home developer (raw lots to finished homes) in the right suburban areas are valued today at 1X annual their sales (e.g., MTG will do @$4.3 billion in sales in 2021 and their market cap is about $4.3 billion at only a 6 p/e).

With HCDI management guiding to over $128 million in 2022 revenues (and just a $32 million market cap on $80 million in 2021 estimated sales), HDC is without a doubt MASSIVELY undervalued based on $128 million is 2022 revenues, to say the least. If you just extrapolate their 3-year sales growth rate, HCDI easily gets to $200 million in lot/home sales simply with the projects they ALREADY have stacked up and in-house.

Key point: At 1X $200M sales in 2023, HCDI is a $200 million value public company, not $35 million, ok?

The No Brainer Preferred and Warrant Math

Short Version: If you buy just the preferred HCDIP, you are getting nearly a 13% yield paid monthly and 5 warrants per HCDIP share that are convertible at a SIGNIFICANT discount to their $5 face value over a 5-year period. Why? Because the warrant conversion price is discounted by the price $10 discount on the $25 preferred stock. (Note: most people who don’t deal in preferred stock with warrants don’t know how the below $25 par usually works).

Quick math: What is the attached warrant conversion price on a $25 preferred stock valued at only $15.10?

Apply that discount to the $5 warrants and those warrants exercise at @$2.70 (the HCDI stock trades around $2.20)

And again: HCDI is presently just a $31M market residential cap real estate developer growing 56% in revenues this year with a similar forecast for 2022. CEO and founder Sterling Griffin recently provided guidance that we will generate approximately $80 million in revenues in 2021, which would equate to a 59% increase over 2020. He also projected revenues for 2022 will follow a similar growth trajectory with an estimated up to $128 million in sales or a 60% annual increase.

Key Point: HCDI is a Lightening Fast Growing residential real estate developer in ALL the right close-in ex-urb locations in the United States (and British Columbia with the hottest real estate market in the world).

HCDIP is a par $25 cumulative preferred convertible issue trading at only 61 cents on the dollar.
HCDI turned profitable in Q2 and just pre-announced an expected Q3 profit of about $3.6 million.
HCDIP is fully covered at par by HCDI net assets.
HCDI should benefit from high inflation, soaring housing prices and changing commuter patterns due to Covid-19 (which is likely to NEVER GO AWAY).

The Short Term Catalysts: HCDI is Finally Ready to Do Some Serious Investor Relations Work to Tell Their Amazing Growth and Valuation Story

Harbor President and CEO, Sterling Griffin recently stated, “We are extremely pleased with our third-quarter results which represent a significant step forward for the Company. We will provide additional financial details for the quarter and a preview of our 2022 business objectives during our earnings conference call.”
Harbor will host a conference call and webcast on Monday, November 15, 2021, at 9 a.m. PT (12 p.m. ET) to elaborate on the third-quarter results and the Company’s outlook.

Note: The public may access the conference call through a live audio webcast available at https://investors.harborcustomhomes.com/events. Those who would like to submit written questions in advance, please email: IR@harborcustomdev.com. The conference call will be available by telephone at 1-877-407-0789 (for international callers, dial 1-201-689-8562), and refer to “Harbor” or conference ID: 13723841. A replay of the conference call will be available for two weeks at 1-844-512-2921 (for international callers, dial 1-412-317-6671) using the replay PIN: 13723841.

Simply stated–HCDI now has a real story to to tell Wall Street: They are selling out EVERYTHING they can entitle and develop. For example:

Harbor Custom Development to sell 144 entitled lots to Lennar for $10.4M

Harbor Custom Development (HCDI +0.2%) entered into a sales contract with Lennar Northwest, subsidiary of the Lennar (LEN -1.3%), for $10.4M on 144 entitled lots in Olympic Ridge located in Belfair, Washington.
The company has further announced that it has separately contracted with Lennar to develop the Olympic Ridge lots for an additional $10.88M bringing the combined contracted value to $21.2M.
"We are excited to continue our relationship with Lennar at the Olympic Ridge subdivision and look forward to delivering them the 144 lots in 2022.

Harbor has active or recently sold-out residential communities in Gig Harbor, Bremerton, Silverdale, Bainbridge Island, Belfair, Allyn, Port Orchard, and Blaine in the state of Washington.

In addition, Harbor has acquired land and will begin constructing homes in three new markets. In the Sacramento metro market, Harbor will be constructing homes in completed subdivisions in both Rocklin and Auburn, California.

In the Austin metro market, Harbor has acquired developed lot inventory in Dripping Springs, Driftwood, and Horseshoe Bay, Texas. The Company has recently acquired a property in Punta Gorda, Florida, and plans to begin construction of oceanfront condominiums there in 2022.

Harbor Custom Development to sell 24 developed lots in Washington for $4.8M
Nov. 11, 2021 8:53 AM ETHarbor Custom Development, Inc. (HCDI)By: Jignesh Mehta, SA News Editor

Harbor Custom Development (NASDAQ:HCDI) entered a contract with MainVue WA for the sale of 24 developed, view lots in the Horizon at Semiahmoo community in Blaine, WA.
The closing is scheduled for late December 2021.

HDCI's business strategy is simple: acquire raw land and develop the property for the construction and sale of residential lots, home communities, or condominium properties within a 30- to 60-minute commute to major metropolitan employment corridors of the Puget Sound region of Western Washington, with further expansion underway into similar markets in California, Austin Texas, and Florida.

With $8,438,800 in heavy equipment, the HDCI infrastructure development division efficiently constructs a diverse range of residential communities and improved lots in a cost-effective manner. We utilize heavy equipment to develop raw land and through this process create residential subdivisions and multi-family communities. The equipment is primarily used for land clearing, site development, public and private road improvements, and installation of wet utilities such as sewer, water, and storm sewer lines, in addition to the construction of dry utility lines for power, gas, telephone, and cable service providers.

They own or control 25 communities in Washington, Texas, and California containing an aggregate of 1,322 lots and 263.5 acres in various stages of development.

The company has all the debt financing it needs. (See Harbor Custom Development, Inc. (HCDI)HCDI By: Khyathi Dalal, SA News Editor, Harbor Custom Development entered into term sheets with U.S. Capital Global for credit facilities totaling $158.4M for providing construction financing on three Western Washington condominium projects and one in Southwest Florida.)

"We are delighted to enter into a relationship with U.S. Capital Global which has the ability to provide us construction financing on a national scale. U.S. Capital Global fills a key role by offering a one stop shop for our land development and vertical construction financing needs," President and CEO Sterling Griffin commented.

So why did the Series A shares drop from $25 to $15 and stock from $6 IPO to $2.10? I have seen this many times with this bucket shop broker-dealer underwriter Think Equity out of NYC. They promise a company like HCDI that "We will raise you a whole bunch of permanent capital so you can build as many communities as you can find and you have the cash to pull the trigger ahead of the big guys."

First off, the geniuses at Think Equity

IPO’d HCDI in August 2020 at $6 — are you kidding me?
Then they did a secondary stock offering at $3 on January 15, 2021—who does a down round 6 months AFTER an IPO?

Harbor Custom drops 13% after pricing stock offering

Harbor Custom Development (NASDAQ:HCDI) has priced public offering of 8M common shares at $3.00/share, for gross proceeds of $24M.
Underwriters' over-allotment is an additional 1.2M shares.
ThinkEquity is acting as the sole book-running manager.
The closing date was January 15

Also, management chose to do a second Series A Preferred round at $15 in September with warrants that all converted would add about 10 million shares to their 13 million common shares aka dilution

Harbor Custom Development (NASDAQ: HCDI) trades 12.3% down premarket after pricing its underwritten public offering of 2.4M shares of its 8.0% Series A Cumulative Convertible Preferred Stock and 12M warrants to each purchase one share.
Each share of Series A Preferred Stock will be accompanied by five warrants; each share of Series A Preferred Stock and accompanying five Warrants is offered at a price of $15.
The conversion price of $4.50/share or 5.556 shares; warrants are exercisable immediately, have an exercise price of $2.97/share, and expire five years from the issuance date.
Offer is expected to close on Oct.7; warrants will commence trading on Nasdaq on Oct.5 under the symbol, "HCDIZ".

All in, they made a mistake to go public with Think Equity. That said, at 1X $200 million in sales by 2023, the shares are undervalued and with warrant conversion, they will have an additional $30 million or some in cash so that they never have to raise equity money again. In addition, recently, the HCDI Board approved a 17% stock buyback program which should put a decent bid under the shares for an extended period.

At this insanely cheap valuation, I like buying the HCDIP preferred, the HCDIW warrants, and/or some HDCI common and holding for the next 24-36 months as the American Hybrid Work economy isn't going anywhere and there are millions of urban real estate owning families moving to the great American Suburbs.