Deerfield Capital Corp. Q3 2008 Earnings Call Transcript

Deerfield Capital Corp. (DFR)

Q3 2008 Earnings Call Transcript

November 11, 2008, 11:00 am ET

Executives

Cathy Price – IR, Financial Relations Board

Jonathan Trutter – CEO

Frank Straub – CFO

Presentation

Operator

Good day, and welcome to the Deerfield Capital Corporation third quarter 2008 earnings conference call. Please be aware that today’s conference is being recorded. At this time, I would like to turn the conference over to Cathy Price of the Financial Relations Board. Please proceed.

Cathy Price

Thank you, operator. Good morning, and welcome to Deerfield Capital Corporation’s third quarter 2008 conference call. The earnings press release was distributed on Monday, November 10, after the market closed. In the release, the company has reconciled all non-GAAP financial measures to the most directly comparable GAAP measure in accordance with Regulation G requirements. If you did not receive a copy, these documents are available on the company’s Web site at www.deerfieldcapital.com, under Press Releases. Additionally, we are hosting a live webcast of today’s call, which you can access under the header Investor Relations. Following the slide call an audio webcast will be available for one month on the company’s Web site at www.deerfieldcapital.com under the same header.

Management will provide an overview of the quarter and year, and then we’ll open the call to your questions. Before we begin, management would like me to you inform me that certain statements made during the conference call which, are not historical may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Although Deerfield Capital Corporation believes the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that its expectations will be attained. Factors and risks that could cause actual results to differ materially from those expressed or implied by forward-looking statements are detailed in today’s press release, and from time to time in the company’s filings with the SEC. The company does not undertake a duty to update any forward-looking statements.

Additionally, we wanted to remind participants that the information contained in this call is current only as of the date of this call, November 11, 2008. And the company assumes no obligation to update any statements, including forward-looking statements made during this call. Listeners to any replay should understand that the passage of time by itself will diminish the quality of these statements.

I would now like to introduce you to Jonathan Trutter, Chief Executive Officer of Deerfield Capital Corp, and turn the call over to him for his opening remarks. Jonathan, please go ahead.

Jonathan Trutter

Thank you. I would like to welcome you to today’s call, and thank you for your participation. Joining me today from the company are Frank Straub, our CFO; Aaron Peck, Managing Director and Senior Portfolio Manager of DFR; and, other members of DFR’s management team. We appreciate you joining us today.

As you all know, the third quarter of 2008 was a period of market deterioration of global financial markets resulting in a historical coordinated international response. During the quarter, among other significant events, Fannie Mae and Freddie Mac were both placed in federal conservatorship, Lehman Brothers filed for bankruptcy, and the financial health of several large financial institutions was threatened. Despite numerous actions by the US Treasury Department and the Federal Reserve Bank and their international counterparts, equity in credit market experienced considerable stress. Fifteen com [ph] markets were marked by significant illiquidity, spread-widening and price volatility.

Our third quarter results reflected the conditions of these broader financial markets. Despite positive core earnings, DFR took significant non-cash charges during the quarter. DFR posted the loss of $156.9 million, which included $110 million of non-cash impairment charges related to goodwill and intangible assets associated with the asset management subsidiary, Deerfield Capital Management. This quarterly loss also included impairment charges on loans and declining prices for securities and loan considered help for sale.

Core earnings, which eliminated certain non-cash charges and income tax expense from GAAP earnings, were positive $7.9 million for the quarter.

The economic turmoil also impacted the assets under management or AUM and our investment management segment. Our government arbitrage trading fund, which represented assets under management of $331 million as of October 1st, exhibited poor year-to-date performance through October resulting in a notice of significant redemption by investors. All the positions in this fund have been liquidated to cash. And the fund is expected to be closed by November 30th, 2008.

In response to the challenging economic environment, we implemented cost savings initiative intended to more properly align our core structure with our projective revenue streams. Similar actions are being taken across our entire industry. Our cost savings initiative involves reducing our headcount by 25 people or approximately 27% of our total workforce, and decreasing compensation expenses in other areas. The compensation payable to those 25 employees accounts for approximately 37% of the company’s annual compensation expense. These reductions were largely related to our government arbitrage trading business and the associated back office infrastructure.

On an annual basis, this initiative is expected to save approximately $10 million of annual compensation and benefit expense, and an excess of $1 million of other general operating expense. We believe these actions will make our asset management business cash flow positive in 2009 without the presumption of any new successful business initiatives.

Despite the material adjustment to our cost structure, our goal has been insured that Deerfield remains fully staffed in the core areas of our ongoing business lines. We believe we have maintained the staffing continuity to not only manage existing portfolios, but also to grow in our core areas of expertise.

Our cash position remains stable. As of September 30th, we have cash, cash equivalents, encumbered liquid securities, and net equity in financed liquid securities of approximately $78 million. This includes cash, cash equivalents, and encumbered liquid securities of approximately $50 million. While the financial markets remain volatile during the quarter, our cash position, contractual investment management revenues, and smaller portfolio footings have allowed us to maintain a stable financial position with core earnings generation.

In our principal investment segment, we believe our investment portfolio continue to be prudently levered, with pay downs on our residential mortgage backed securities or RMBS, holdings being used to build cash. Our RMBS portfolio has been reduced since the end of the second quarter, declining 6.7%.

As mentioned in earlier calls, the accumulation of cash will be used in the longer term for strategic investments in new managed accounts. In addition, we have continued to reduce our alternative asset holding through pay downs and selected asset sales in order to enhance liquidity and reduce risk.

In our corporate leverage loan and commercial real estate portfolio, our assets declined in the third quarter by approximately 3.1% to $379.1 million.

Termination of REIT status, as we announced on our October 2nd, DFR terminated its REIT status retroactive to January 1st, 2008, and converted to a C-corporation. This conversion results in the potential creation of future tax savings, which we estimate to total $85 million to $95 million, including projected cash savings of $8 million to $12 million for 2008. These tax savings create an extremely valuable off balance sheet asset for DFR.

Share repurchase and retention of UBS. In August of this year, we announced that our Board of Directors have authorized the repurchase of up to $1 million of our common stock. The amount of this repurchase was led by the terms of our series A and B notes. To date, we repurchased, and subsequently retired, 220,000 shares of our common stock in private transactions at an average fully adjusted price of $4.40 per share.

In the quarter’s prior call, we also discussed the formation of the special committee of our Board, the Strategic Relations committee, to explore opportunities to enhance shareholder value. This committee retains UBS Investment Bank to assist in this process. While we have no update at this time as to the timing and structural probability of the new Strategic transaction, UBS and the Strategic Relations committee continue to actively pursue opportunities to enhance shareholder value.

We have previously mentioned that we are targeting near term growth through two primary initiatives, one, acquiring CDO management contracts from managers that are looking to exit the CDO management business; and two, adding AUM to the creation of new investment products. In our CDO contract acquisition strategy, we have continued to reevaluate opportunities to acquire management contracts on terms that we have believed to be economically viable. In our new investment product strategy, we’re exploring new product concepts and continue to have conversations with interested potential investors who recognize the attractive investment opportunities available in the current asset pricing environment.

Now, I would like to turn the call over to our CFO, Frank Straub, for more a more detailed discussion of the third quarter financial results. Frank?

Frank Straub

Thank you, Jonathan. The company reported a GAAP net loss for the quarter of $156.9 million or $22.81 per split adjusted share, and core earnings of positive $7.9 million or $1.14 per share. Core earnings is a non-GAAP measure that the company uses to evaluate its financial results. Please see our latest quarterly earnings release or 10-Q for reconciliation of core earnings to our GAAP net loss. Core earnings eliminate the impact of this.

The most significant items impacting our GAAP results and adding back for purposes of core earnings for the quarter were the following, goodwill impairment of $78.2 million; intangible asset impairment of $32.1 million; provision for loan losses of $15.5 million; and, other net losses on loans and securities, primarily unrealized, totaling $31.8 million.

In accordance with accounting standards, the significant decline in our overall market value during the quarter required an interim analysis of our goodwill for possible impairment as of September 30th, 2008. This analysis resulted in our recognizing full impairment of the remaining goodwill balance of $78.2 million. This decision was a result of the combined effects of several factors. These inputs included lower market multiples for our publicly traded tier group; continued decline in our overall equity market value; and, to a lesser extent, reduced estimated cash flows from our investment management segment, compared to cash flows at the date of acquisition as a result of lower assets under management.

The intangible asset impairment charges of $32.1 million, primarily relates to the intangible asset associated with the government arbitrage investment fund we currently manage. This intangible asset became fully impaired during the quarter as the funds exhibited poor performance and received significant notices of redemption. As Jonathan previously mentioned, this fund has been liquidated to cash, and only closed by November 30th, 2008.

The provision for loan loss was primarily related to one borrower, a medical education company, which is being significantly impacted by unfavorable changes in this industry’s regulatory environment. Other net losses consisted of unrealized losses in our RMBS portfolio and Market Square CLO loans held for sale portfolio.

From a balance sheet perspective, our book value on a GAAP basis was $9.50 per share at quarter-end, and $12.23 on an economic basis. Economic book value adds back unrealized losses in excess of the equity at risk associated with the Market Square CLO, which we are required to consolidate under GAAP.

However, as Market Square CLO is a bankruptcy remote entity, if these largely unrealized losses were realized, it would be born by certain Market Square debt holders, rather than DFR. Similarly, if the equity Market Square was sold at quarter-end and the subsidiary was deconsolidated, we would expect the company’s pro forma GAAP book value to be $12.23 per share or significantly higher, depending on the sale price of that equity.

The termination of the company’s REIT status, retroactive to January 1st, 2008, provided us with potential future cash savings estimated to be between $85 million and $95 million, or $12.74 to $14.24 per share. The economics of these savings are available to us, even though we are unable to recognize an unbalance sheet asset as of September 30th, 2008 due to the ongoing disruption and uncertainty in the credit markets. Additionally, converting to a C-corporation provides more flexibility for future capital investments, and was a step in shifting our business model toward the investment management segment.

Although we continue to climb in overall global markets and the weakness in the US economy continue to put pressure on our business, we have taken the following steps to help improve our future earnings and liquidity. We decided to implement the cost savings initiative with the expectation of not only improving operating results, but also increasing our overall future cash position. This initiative was necessary to properly align our cost structure with projected revenue strains in order to ensure that our overall business operations remain cash flow positive going forward.

To be clear, none of the expected annual savings of approximately $11 million associated with this cost savings initiative has been added back to core earnings, which I described earlier. This $11 million of cost savings represent expected future cash savings.

Finally, we also worked the representatives of the holders of our approximately $123 million of trust preferred debt securities, and to obtain a waiver of our net worth covenant to April 1st of 2010. While we recognize the difficult environment in which we are operating, we continue to stay focused on managing our existing business, and believe that our recent actions will better position us from our overall cash and operating perspective. We are also hopeful that we can introduce new funds and investments that capitalize on our investment management expertise and the many market opportunities this market dislocation has presented.

And now, I would like to turn the call back over to Jonathan.

Jonathan Trutter

Thank you, Frank. We thank all of you on the phone for your participation in this call today. And I’d like to open it for questions at this time.

Question-and-Answer Session

Operator

Thank you. The question-and-answer session will be conducted electronically. (Operator instructions) And we will pause for just a moment to give everyone an opportunity to signal for questions.

And it appears there are no questions at this time, Mr. Trutter. I will go ahead and turn the call back over to you.

Jonathan Trutter

Great. Again, I thank everyone for their participation in this call. And we look forward to addressing this difficult market environment with future good news. Thank you very much.

Operator

Ladies and gentlemen, this does conclude today’s presentation. We thank you for your participation. You may now disconnect.

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