New Century: This REIT Yields Over 20% In a Cooling Housing Market

When house prices were rising sharply, New Century (NEW), a sub-prime lender, attracted home buyers with weak credit histories to take out loans. A booming housing market made these loans less risky, since the borrower could refinance an existing mortgage by using a rapidly appreciating house as collateral, if necessary.

The problem - what goes up must come down. Since the housing boom has faded, investors now worry that default rates will increase, the firm's loan base will dry up, and profits will suffer. New Century's share price, which is now trading near its 52-week lows, reflects these concerns.

No doubt the mortgage-lending market won't be as easy in 2007 as it was this past year, but many of the challenges ahead may be baked into New Century's share price.

Certainly, earnings are trending down. In the latest quarter, the lender posted a sharp drop in profits, to $1.12 a share, down from $2.04 a share last year. For the year, per share earnings estimates have steadily declined from $7.10 in September to $6.09 by the end of November. Next year's estimates tell the same story, with projected per share earnings falling from $6.73 to $4.18 in the past three months alone.

Lower earnings could affect dividend payouts. In its latest quarterly report, New Century's management committed to distributing at least $400 million to shareholders next year. That translates to about $7 per share -- roughly the same as this past year's trailing 12-month payout of $7.10 per share. The big difference is that management said the money would come either through dividends or else through share repurchases. In other words, a dividend cut could be in the works.

And yet, as a dominant player in the lucrative sub-prime mortgage market, New Century may continue to generate solid interest income and capital gains from its loan portfolio. Moreover, while the housing market is cooling, it's not crashing, and demand for sub-prime mortgages is widely expected to stabilize over the next few years.

As a real estate investment trust [REIT], New Century is required by law to distribute 90% of its taxable earnings to shareholders. Based on the 2006 and 2007 earnings estimates just given, we can expect the dividend to average about $5.00 a share over the next couple of years. That may not be as juicy as investors have come to expect, but it still provides a superior, double-digit yield at the current share price.

Trading at just 9 times next year's earnings, and roughly on par with its book value, New Century's shares are attractively priced for a stock that carries a yield of about 20%. Even with its reduced earnings picture and uncertain dividend outlook, the stock should provide steady income over the long term.

Action To Take: Like most mortgage REITs, New Century operates in a cyclical industry that's highly sensitive to changing economic conditions largely beyond its control. In other words, this stock is not for the faint of heart. That said, NEW could provide a solid income stream for risk-tolerant investors with a long-term orientation.

NEW 1-yr chart


Disclosure: Author has no position in NEW

Comments

[JonathanLiss, SAEditor]

Carla,

Thanks for the analysis. I've been looking at this one for a while and if I'm correct, it currently trades below book value. That being said, it sounds like this one may come down in price even more as its earnings continue to be negatively affected by a worsening housing market meaning it may provide even more of a 'steal' in terms of value in the not-too-distant future.

What are your thoughts on the likelihood of NEW dropping below 30 a share in the near future?

All the best,
Jon

[Yes, I'mshort]

Ask and ye shall receive...Pick it up now at $19 a share or so. Things could get real bad, count on a 60-75% div cut from here for at least the next 4Q's. All things considered, thats still a 10% yield at this price. Dont think BK is an overwhelming risk but it must be considered. Waiting until the restatement could see the shares pop $5-7 but could also head south another $4. Right now, assuming a steady 1.1x P/B multiple, the market seems to be discounting the Mortgage Loans Held for Investment 7-10%, or hacking a billion $ off of book value. The stock will move in step with the size of the restatement.

I went long today and sold long-dated, in-the-money calls. downside risk being bankruptcy or prices below $12.75