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Newcastle Investment Corp. (NYSE:NCT)

Q2 2013 Earnings Call

August 7, 2013 8:30 am ET

Executives

Sarah Watterson - Director, IR

Wes Edens - Chairman

Ken Riis - CEO

Jonathan Brown - CFO

Andrew White - Head, Senior Housing Investment

Analysts

Douglas Harter - Credit Suisse

Bose George - Keefe, Bruyette & Woods

Jason Stewart - Compass Point Research

Matthew Howlett - UBS

Operator

Good morning. My name is Holly and I'll be your conference operator today. At this time, we would like to welcome everyone to the Newcastle Second Quarter 2013 Earnings Call. All lines have been placed on mute to prevent background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions)

I would now like to turn today's conference over to Ms. Sarah Watterson. Please go ahead, Sarah.

Sarah Watterson

Thank you, Holly, and good morning everyone. I would like to welcome you to the Newcastle's second quarter earnings call. Today with me I have Wes Edens, Chairman of the Board; Ken Riis, CEO; Jonathan Brown, CFO; and Andrew White, the Head of our Senior Housing Investment.

Before I turn the call over to Ken, I would like to point out that certain statements made today may be are not statements of fact. These statements describe the company's current beliefs regarding events that by their nature are uncertain and outside of the company's control. Company's actual results may differ materially from the expectations expressed in any forward-looking statements. So do not place undue reliance on any forward-looking statements. I encourage you to read the disclaimers in our earnings release and supplement regarding our forward-looking statements and expected returns to review our most recently filed documents with the SEC.

Thank you and I would actually like to turn the call over to Wes Edens.

Wes Edens

Great. Thanks, Sarah, and welcome everyone.

As Sarah mentioned, we have posted on the web a supplement for our Newcastle that we're going to refer to as we go through that hopefully you will find helpful in terms of keeping track of the call this morning. So let's begin on the overview page, page number two and I will just make a couple of overall comments, I'll turn over to John Brown to go through his financial results.

For the full quarter, GAAP income was $52 million, or $0.20 per diluted share. Core earnings $43 million, or $0.16 million per diluted share. Obviously we spinoff of New Residential smack dab in the middle of the quarter on May 15th. If you look on the right hand side you can see the results for Newcastle specifically. So $0.11 of GAAP income, $0.09 of core earnings, $216 million of uninvested capital at the end of the quarter have we been fully invested that would add another $0.03 we estimate. So those are the financial results, just keep yourself grounded.

Page three, just a snapshot of what our business is today post-spinout. We've a senior housing business, which is an increasingly important one for us; it's a business that we started a little over a year ago inside the company. Andrew White is the next who is going to walk through our activity there, but there has been a lot going on and very, very productive deployment of capital and performance of those investments.

The CDO business, our old legacy business Kenny Riis will talk about here in just a moment but we've had an extremely active last 12 months. The quarter also was active but will give some color on that.

And the business other than that, there is just a handful of debt investments, $400 million invested capital. A small equity investment in Agency ARMS were free at compliance, and then, as I mentioned there is cash that we're showing here of $130 million because there has been some investment activity post-quarter that the Andrew will walk through.

Just the highlights to conclude kind of the introduction of this. The big highlight obviously, was the completion of the New Residential spinoff that we announced back in January, completed on May 15th, NRZ is a standalone company has his earnings call here about an hour but lot of good things going on there.

Senior housing investments is increasingly big, bigger, and bigger, part of our balance sheet in our future. Subsequent to the quarter end, we invested another $86 million. So that total investment is now closing on $200 million of equity but Andrew will through that in a second there is a big pipeline there as well.

Investment activity incremental to that, we did see a number of good opportunities in debt related investments for the quarter. We bought back some of our CDO debt, made a handful other investments, but Ken will talk about that.

Capital raised in June, we raised above $200 million in cash, 40 million shares of common stock that were sold two months ago, and then lastly the CDO IV collapse that was a regular event for a good economic result there as well.

So with that, let me pause and turn it over to Jon Brown to walk through the financial results, Jon.

Jonathan Brown

Hi, everyone. Thanks, Wes. I'm just going to provide a quick recap of the numbers. In the quarter we generated GAAP income of $52 million or $0.20 per diluted share. This included core earnings $43 million or $0.16 per diluted share. We declared and recently paid a common dividend of $0.17 per share or $43 million, which represented 100% of our core earnings.

As mentioned previously, on May 15th, we spun out New Residential in the form of a stock dividend. As a result, our second quarter results included 45 days of New Residential's earnings. Our GAAP income is adjusted to exclude the earnings generated by assets, which were contributed to New Residential would have been $28 million or $0.11 per diluted share, and our core earnings would have been $23 million or $0.09 per diluted share.

As Wes mentioned at the end of the quarter we had $216 million of cash available to invest. If we invested this amount for a full quarter at a 15% return, we expect that our earnings would increase by $0.03 per diluted share. To provide more information on these figures, this morning we posted our Q2 supplemental disclosures on our website, and you'll notice we included detailed asset performance data for each of our primary business lines and the appendices there too. We look forward to updating you on our progress in the coming quarters.

I will now hand the call to Andrew White to discuss our senior living investments.

Andrew White

Thanks Jon. So this morning we share a few comments on the healthcare market generally, and then I'll talk about the operating performance, our existing portfolio, our recent acquisition activity, and our pipeline.

But starting with the market first. On the operating side, we continue to see very strong operating fundamentals across the industry. We're seeing strong occupancy rate growth nationwide and really think this is a function of the continued favorable supply demand imbalance. We've seen a modest uptick in new construction activity recently, but we're still seeing absorption outpace new supply by about 2 to 1 in the markets that we're in.

On the acquisition side, it was a relatively quiet quarter for reacquisition activity and I think the big story there for the healthcare REITs has been the recent rise in interest rates.

Obviously, this has it made it more challenging for the REITs that are focused on the pure net lease business, the pure spread investing business. But we continue to believe that our strategy, which is focusing on investments with meaningful operating upside, is relatively inflated from the rising in rates.

Turning to the operating performance of our existing portfolio. For Q2 our portfolio included 12 properties and $80 million of invested equity. It was a strong quarter for us operationally. We saw 3.9% revenue growth sequentially, which is more than 15% annualized revenue growth, which resulted in leverage yields improving to over 17% from 14.5% in the first quarter, and we continue to expect that leverage yields will stay like in excess of 20%.

As Wes mentioned, following the end of the quarter, we closed on a handful of acquisitions. We closed on three transactions with 17 properties, $263 million of gross asset value, and $86 million of equity invested. We think the targeted returns here are consistent with our existing portfolio, so we expect low teens leverage yield initially and stabilized yields in excess of 20%.

In looking forward, we continue to build our pipeline. Our goal is to invest in incremental $200 million of equity for the balance of the year. The near term pipeline include $60 million worth of transactions in contract as gross asset value. Another $800 million of transactions in the very near term pipeline, which would be about $300 million of potential equity investments, which we won't get all that done, but we think $200 million is a reasonable target for the balance of the year.

All these transactions are non-brokered off-market transactions, but we're one-on-one with the seller. And again we're targeting 12% to 14% leverage yields upfront consistent with our current pipeline and existing portfolio with yields stabilizing in excess of 20%.

With that, I will turn the call back over to Ken.

Ken Riis

Thanks, Andrew. For those of you following along, I'm on page 9 of the presentation and I'm going to highlight our activities in our debt business. We generate great results in the quarter. Total cash flows were $97 million in the quarter versus $33 million in the first quarter. That -- those cash flow are broken down into two components, interest cash flows of $26 million, and return of capital or principal of $70 million.

On page 10, this was a great page because it breaks out really the two segments within our debt business. First the CDOs. We have $1.4 billion of assets financed in our CDOs at a fair value of $0.78 on the dollar, and what we've been doing there is generating good cash flow for us. But overtime we've been collapsing deals, liquidating assets, and recovering capital to be reinvested in other parts of our business, including senior living and other optimistic debt investments.

So, if you look at our year ago, we have $3.2 billion of assets financed in our CDOs. There are five CDOs. And as of the end of the second quarter that was $1.4 billion of assets in three CDOs. Again, we're looking to opportunistically buyback debt at a discount and continue to harvest capital invested in our CDOs and reinvest it.

The other part of our business is our other debt business. It's a mixture of assets that are pretty much unlevered on our balance sheet. We have about $1 billion of assets financed with $200 million of debt. So it's very unlevered and a loss of few there.

On page 12, I just want to highlight our investment activity, and then talk about the CDO IV collapse. We purchased or reinvested about $190 million in the quarter in debt related assets, $43 million of equity was used to buy back $117 million of CDO VIII notes at $0.88 on the dollar. So again focused on buying back our liabilities at a discount and hope to collapse that deal over the next quarter or two.

And then to highlight a collapse we did in the second quarter, which is CDO IV. We had $153 million of face amount of assets that we sold at 95% of par generating $145 million of proceeds, $77 million of the proceeds were used to payout third-party debt that we did known and $68 million of proceeds came to Newcastle. The highlight there is we owned $60 million of face amount of CDO debt that we repurchased at $0.52 on the dollar. So of that's $68 million of the proceeds, we really generate $29 million of so accelerated recovery of discount on the CDO bonds that we have purchased in the past.

Last thing I want to highlight, which is a very small part of our business, was the new page that we put out, which is our Agency ARM division. Its $312 million of Agency ARMS that I wanted to put out to show what we own because it's important what's happened in the quarter interest rates rising; it's a very benign sort of low-risk asset class risk in terms of duration. It's about a one year duration and you can see that of our $80 million of equity investment the assets in total only went down about 35 basis points even with rates rising as it did in the second quarter. So I think it's important there everyone sees at least what we own there and how short the duration is of that portfolio. So that's all we have. I'll pass.

Sarah Watterson

Now, I would like to turn over for questions please, Holly.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Douglas Harter with Credit Suisse.

Douglas Harter - Credit Suisse

Press release that much of your cash has been deployed, I guess in July, you highlighted the senior living. Can you talk about where else money has gone?

Wes Edens

We've made a couple of our investments in opportunistic debt investments in particular. We had been buying in one position in particular that we think is a good restructuring opportunity if not quite at a point where we're prepared to talk about it in its fullness. But I think in the next quarter or two we're optimistic that it could turn into something, which is a very, very interesting and high yielding opportunity for us.

So, but there is really just been that. The primary investment other than that debt was as Kenny mentioned buying back some of the CDO debt that we then collapsed and then a lot of focus is with Andrew in the pipeline of the senior housing investments.

Douglas Harter - Credit Suisse

So then, I guess as we go forward to the $200 million of equity that you looked to deploy into senior living throughout the end of the year. Should we expect that to be funded through CDO collapses?

Wes Edens

You know as we said before our goal is with the legacy debt businesses to as we can I don't wind down if we can use the profitability to do so. The base case is capital say investor through restoration, which is another couple of years but as Ken said, we've gone and collapsed roughly two-thirds of the position over last year, so it's been very productive. But I think that the plan for the rest of this year is to do exactly that as to base, we could move that capital out of the debt business into the senior housing business.

Douglas Harter - Credit Suisse

And then just one question, your other operating expenses were higher, the G&A expenses were higher this quarter, were some of that related to the spin and should we expect that to come down in future quarters?

Wes Edens

Yeah, there's all -- there really there's a lot of one-time stuff just in imagination for the spend itself, so.

Douglas Harter - Credit Suisse

So we should think of that number going sort of back to where it was, first quarter or last year?

Wes Edens

Yes.

Operator

Your next question comes from the line of Bose George with Keefe, Bruyette & Woods.

Bose George - Keefe, Bruyette & Woods

Actually just on the pipeline that you guys provided I'm just curious if you could just give a little more color in terms of the bigger, big chunk small pieces or the typical sellers how many bidders and any things of that nature?

Wes Edens

I think the way in which we close handled the couple of ways of transactions to-date where there has been kind of one large transaction handful single asset deals is I think a good way to think about the pipeline going forward. So of the $800 million or so of stuff that's in the near term pipeline that's not in contract, there are a handful of somewhat larger deals and then handful single asset deals that we think we kind of watch out the pipeline. So the largest stuff is obviously a little more binary, if it hits, it doesn't obviously the number stood down, but I think that's why we got the range of $600 million to $800 million. So we will give it of a mix.

Bose George - Keefe, Bruyette & Woods

And then, if you turn to the move that we've had in rates recently, has that had any impact on the pricing of the stuff that you guys are looking at?

Wes Edens

Well, two ways it affects us one is cap rate and the other is financing cost. And I think on the cap rate side, because we're dealing with Mom & Pops, we really haven't had, this is really isn't good price transparency at the single asset transaction level. In some cases, we're actually working to educate the Mom & Pops about what a cap rate is, and how to think about it. So we really haven't seen a kind of direct correlation between the rising rates and the cap rates, although I think the cap rate for the segment close to-date has been 100 to 150 basis points wide of kind of big market deals.

On the financing side, we did see as rates fell there was a bit a floor in terms of the financing cost as spreads widened, and we've seen as rates have risen we haven't really seen point-to-point flow through. So it's about half of the 100 basis points that's flown through to incremental borrowing cost but. So, I really I think seeing movement on both sides, but no meaningful change in terms of the expected returns for the rest of the pipeline.

Bose George - Keefe, Bruyette & Woods

And then just one last thing on the CDOs, the moving rates has that had any impact on your expectation for collapsing the CDOs or the market outlook for that?

Ken Riis

No, actually in the quarter the portfolio increased in value by about 25 basis points. So really a benign change in price in the collateral and the CDOs versus what happened in the interest rate, so no real change there.

Operator

Your next question comes from the line of Jason Stewart, Compass Point Research.

Jason Stewart - Compass Point Research

On the senior living acquisitions any reason why none of those were close into Q&A, were all close to Q?

Wes Edens

No reason I think just kind of the deal dynamics of working with Mom & Pop sellers, it's sometime not a institutional process just it might be a couple of days, so. But I think we had targeted the first week of July and some of the stuff was first week of July and the rest was on August 1st, so just based on the deal dynamics.

Jason Stewart - Compass Point Research

So anything that the pipeline there's nothing that would elongate closings of the rest of the pipeline, I mean that's sort of going as expected for you?

Wes Edens

Yeah, I mean it's hard to predict. But I think there's just no reason to think that should stretch out unduly.

Jason Stewart - Compass Point Research

On the other investment activity, the opportunistic investments was, is this all post subsequent to June 30, in that same restructuring opportunity?

Wes Edens

No, the position that we've been adding to over the course of the year and some of that was actually closed in quarter some of that actually at the end of the quarter. We're at that point now where the deal dynamics as such but it looks like it is an actionable restructuring and I think of it is as we speak.

So I'm hopeful we will have great information disclosed. I'm really excited about the opportunity. And I think its used end product, it's different from the other stuff we have, but it's a business we know lot about and we're very excited about it. So I would love to talk about it soon.

Jason Stewart - Compass Point Research

We all are early waiting. And on the agency side, is there any reason to keep the agency positions once the senior living portfolio continues to bill? Is there any pre-requirement that you're going to keep those for?

Wes Edens

4DIAC (ph) requirement. And if the entire company was translated into senior housing, wouldn't have a 4DIAC (ph) requirement. So it is just merely a matter of 4DIAC (ph) compliance. As Kenny outlined, we thought that there is not questions about Agency ARMS and I think that different people have dealt with it in different ways. We've taken a lot of duration, we've taken a lot of exposure. These are basically ARM securities that have effectively a very, very large cap, that's never really hit. We reassess they really are treasured bill, treasury note like durations. And a) just trying to be very detail in terms of disclosure; b) showing the actual price change, we think should outline any concerns people have about that, so.

Jason Stewart - Compass Point Research

Okay. That was great disclosure and exactly what you said it was.

Wes Edens

Yeah.

Jason Stewart - Compass Point Research

So, we all appreciate that. One last one, any update on CDO VI and perhaps, how you could execute the collapse there if anybody at the bond net structure the transaction continues to be a blocking, in a blocking position there?

Ken Riis

Well, we own all of the senior tranche of CDO VI, where almost all the recovery is going to be. So there's a couple things we can do, we can hold it and just collect assets payout, collect our money back and or we could sell the physician at a fairly high dollar price today or we could collapse the deal and dealing with third parties. My preference would be to deal with the third parties and collapse the deal. So we're working on it, but there is no update from last quarter on that.

Operator

(Operator Instructions) And your next question will come from the line of Matthew Howlett, UBS.

Matthew Howlett - UBS

My question, yeah Ken just get me back on the mechanics on collapsing the remaining three CDOs. Looking at CDO VIII and IX those ore ones that you're getting the big cash flow to the residual $6 million I think it was this quarter from each of them. Is it just simple as just going to the trustee, and just say we will pass our optional call or give me back bondholders just par and we're going to go sell the loans in the market? Is it just as that simple, and how do you do the timing, you do one per quarter given that you don't want to lose that cash all right away given it's time to redeploy.

Ken Riis

Yeah, it is past the call date so we could sell all the collateral and pay up the debt and that would be it. The collateral in the CDOs are not all of them are securities. So take a little bit longer to sell the collateral. But yeah we have that option to do it now and if they are generating good cash flows for us and the way I think about it, it's really a timing of a capital need, and how we optimize the collapse in terms of what we own on the liability side. So it's timing of cash, its timing of when we need the money, and can we optimize the P&L of the collapse through other acquisitions of CDO debt.

Matthew Howlett - UBS

So, it's different what you do with CDO X right, which is more of a negotiated deal. I guess when the collateral is where the high 70's or whatever you expect to get on this. There's -- you're going to free up collateral that you hold underneath in terms of the overcollateralization, which you hold, right. Just look at the recovery on stuff after you pay the bondholders at par?

Ken Riis

Oh yeah, yeah.

Matthew Howlett - UBS

Okay. So it's just all the timing and then just based on your need, primarily on the senior living side in terms of closing of those deals in that order that we should think about timing.

Ken Riis

Yeah, its timing and optimization and then and that's basically two things we're focused on.

Matthew Howlett - UBS

And then just moving towards into on the senior living is this, what's the timeframe in terms of hitting the 20% to 25% ROE target. You're up the high teens on the stuff you already closed late last year. I mean can you get, is there similar ramp on the stuff that you're closing on?

Wes Edens

We're certainly set up to try and hit the earlier timeframe. I think we have kind of always spoken about two to three year ramp up and have kind of underwritten the recent acquisitions in our underwriting the current portfolio with that kind of timeframe. But we're obviously pleased with the performance of the stuff we closed last year and in terms of the profile what we recently closed and the stuff in the pipeline. There's no meaningful difference between what we have and what we hope to have in the near future. But I think we've kind of thought about it as a two to three year ramp up.

Matthew Howlett - UBS

And each deal is structured similar to what you're sort of coming in and replacing the manager and brining in your own people to go out and drive the P&L?

Wes Edens

That's right.

Operator

And that concludes today's conference call. Thank you for your participation in today's Newcastle call. You may now disconnect.

Wes Edens

Right. Thank you very much guys.

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