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With all of the recent news regarding the subprime implosion, I thought it would be a good time to revisit the short case on Downey Financial Corp (NYSE:DSL). I had discussed the short case for DSL in a previous post and since that time the stock has fluctuated between $68-$76. The more important issue is that data released since that period show that DSL’s underlying fundamentals continue to deteriorate.

Table I illustrates the growing impact capitalized interest from negative amortization [CINA] loans has had on DSL’s EPS. While the Company’s 2006 interest income from loans exceeded 2005 figures, the key aspect is that over one quarter of interest income was represented by CINA as opposed to just 18% and 4% in 2005 and 2004, respectively. The significant contribution of CINA to EPS suggests a serious degradation in the quality of earnings.

DSL 1

The Company’s balance sheet has also experienced difficulties as well. This is illustrated in the significant rise in delinquent loans and non-performing assets shown in Table II.

DSL 2

DSL’s current financial statements and valuation assume that CINA is 100% money-good with a low likelihood for impairment. At $70 per share, DSL is valued at a reasonable 9.5x LTM EPS. This may seem like a fair price until one considers the potential for CINA impairment. Since it’s impossible to estimate a targeted impairment rate for CINA, a sensitivity analysis of implied EPS based on the level of CINA impairment was conducted. Table III lays out the level of EPS overstatement based on the level of potential CINA impairment.

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DSL 3
DSL 3 cont

Table II demonstrates that EPS could be overstated by as much as 28% for 2006 if CINA is impaired by 25%. Valuation could also be completely accurate if cash interest materializes from those loans with negative amortization. The main point is that Table II demonstrates that even with a slight level of impairment, the Company’s valuation comes into question.

The percentages in the sensitivity analysis may appear high but on an absolute dollar basis they are reasonable. For example, a 5% CINA impairment in 2006 would represent just $14.3MM or roughly half of the Company’s provision for credit losses. The main takeaway from Table III is the growing trend on an annual basis for EPS to be increasingly driven by CINA, particularly in 2006, makes the Company’s earnings growth and quality questionable.

It’s important to note that DSL is not a subprime lender, but the basis of this short position is the belief that regional thrifts utilizing engineered loans will also experience a significant correction. Only about 8% of DSL’s portfolio is in subprime credits, or approximately $1.0 billion, but 85% of its residential portfolio consists of adjustable rate mortgages subject to negative amortization with the majority structured as option-ARMs.

Further, about 4% of its loans feature interest-only payments. Despite focusing on a higher credit consumer, DSL is still entrenched in the realm of exotic mortgages and should not be completely immune to the dynamics impacting the subprime industry.

Disclosure: Author manages a hedge fund that is short DSL.

Source: Downey Financial: Underlying Fundamentals Continue to Deteriorate