2 Stock Picks For the Subprime Mortgage Crisis

Often several times a year, whole market sectors find themselves in sudden free fall, gripped by investor panic. Such is the case in the sub-prime industry right now, and to a lesser degree in anything associated, including homebuilders, even the country's largest residential brokerage, Realogy (H), which is being priced irrationally.

It happened to the poultry industry last year during the bird flu scare. Chicken prices plummeted as overseas demand was sapped by consumer fear (despite the fact that you can't get bird flu from eating cooked chicken). Chicken prices fell, and poultry stocks dropped precipitously, including diversified giant Tyson (TSN), as well as specialized names such as Sanderson Farms (SAFM), which we still hold.

Since that time, producers cut back on supply, chicken prices have recently rebounded sharply, and consumers returned to eating birds. In the case of SAFM, the stock is up 70% off the low it hit during the scare.

Back to sub-prime. Like many financial companies, you have tremendous leverage employed, and a company's loss assumptions can be inaccurate or in some cases fraudulent. So in the current situation, it's best to stick with more conservative plays.

H&R Block (HRB), at $19.70, is presently being deeply discounted as they work on selling their Option One mortgage business. Analysts are now questioning whether the business may end up being worthless; Block has said the business will likely fetch more than its $1.3 billion book value. We think Block is worth at least $28 based on a sum-of-the-parts. The company has a strong balance sheet and the rest of their businesses generate good cash flow.

Delta Financial (DFC) is one of the more conservative of the pure-play sub-prime names. The company eschews riskier loans, issuing primarily fixed versus floating rate mortgages. As a result, their portfolio of loans is much higher quality than the industry average. At $7.60, DFC is selling at 5.6 times estimated 2007 earnings. While the company may experience increased default rates, in the 4th quarter they saw only a modest rise.

Disclosure: We hold shares of HRB and DFC.

H vs. DFC vs. HRB 8 month chart:

Comments

[rchelap:]

Totally agree with your DFC pick/ suggestion. Classic case of throwing out the baby with the bath water!! If you also consider the following points, DFC is at extremely attractive levels:

> The book value based on Fair Values in the latest 10K show that at Dec 31st, 2006 DFC has a book of $345 Million vs the carrying book value on the reported balance sheet of $149.6 Million. In other words, if the fair value of the financial instruments is close to what has been stated in the 10K, we are looking at a company trading at ~0.6x Fair Value book!!

> One can be assured that the management has been conservative in their underwriting standards given their significant holdings (nearly 30%+ of the company is owned by directors and execs; the CEO Hugh Miller owns 27.6%). Furthermore, some well-known value players have dug into the name in the last few months. For example, Mohnish Pabrai (a value investor with north of 25% annualized rate of retun over the last 6yrs+) currently owns approx. 20% of the shares o/s after accounting for his recent purchases.

> DFC is primarily a fixed-rate mortgage shop (92% of Q4 06 loan originations) and such loans have historically done better than ARMs in all economic cycles. Basically, the borrowers don't have to worry about their monthly rates going up and thus investors have to worry less about increased foreslosers because of this reason.

> Because of DFC's focus on credit quality within the subprime space and risk management they have been able to squeeze above average Gain on Sale margins on the sale of their loan poprtfolios. The ABS marketplace is also likely to be more receptive to their loan portfolios once they see that they are much better placed than most in the sub-prime space.

> Significantly, the existing ABS DO NOT have recourse to the company's assets unles, and only unless, there has been false documentation or fraud. The company also does not have any debt on its balance sheet.

> DFC management has displayed considerable willingness to focus on profitability rather than volume. The industry players who have blindly gone for volume at all costs are paying the price now!!

> DFC in the last Q conf call were talking about expanding their hiring given the distress in the industry and about taking market share.

> The following Q3 06 factsheet tells a good story about DFC's standout profile. Q4 06 results were pretty much in line and as expected:
www.deltafunding.com/f...

Truly looks like a bargain.

2007 Mar 14 09:49 PM