Newcastle Investment Corp. (NCT) is a hybrid REIT operating as an affiliate of Fortress investment corp. The following analysis will first break down and outline most of NCT’s operations, and then provide some insight into the possible future risks and catalysts, in order to support the thesis that NCT is cheap given its cash flows. (dividends: .15/quarter = 12.8%, 4.66/share, 490.12 million market cap, 12/30/2011)
The Balance Sheet
NCT currently has quite a variety of REIT qualified assets that we’ll split into recourse and non recourse segments for the purposes of this analysis. In the non-recourse segment, NCT owns two manufactured housing loan portfolios worth about 296 million, 40.8 million in residential mortgage loans, 404.5 million in sub-prime mortgages, 44.2 million in other real estate securities, and 7.7 million in actual real estate properties. In addition NCT operates about 5-6 CRE CDOs with an aggregate collateral value of about 1.68bb.
These assets are offset by about 2.4 billion in CDO notes against the 5 CDOs, 212 million against the two manufactured housing loan portfolios and the residential mortgage loans, and 406 million against the sub-prime loans. Because this particular slice of NCT’s assets is financed by non recourse debt, the fact that the debt appears dramatically higher than the value of the assets is material only in the sense that the book value of equity for this particular set of items is negative. Its economic value has a lower bound at zero though we suspect that certain assets will turn out to contribute substantially positive equity in the future.
In the recourse segment, NCT owns 230.5 million real estate securities (mostly agencies financed by repo), 6.6 million in real estate related loans and about 150 million in unrestricted cash (205 million in cash reported in the most recent 10Q, but 44 million have since been invested in MSR so we estimate roughly 150 million currently).
If we write all non recourse assets and liabilities to zero (worst case scenario), Newcastle common stock is worth 150 million (cash) + 250 million (other assets) +44 million (msr) – 212 million (repo) -51.25(notes)-21 million(other) – 61.6 million (preferreds) = 98.17 million or about .93 dollars a share. We'll explore the value of its non-recourse assets (primarily value from their CDOs) later on in this analysis.
The balance sheet gives us an idea of what “businesses” NCT operates but since all assets are marked to market values and liabilities, despite being mostly non recourse, are marked at face, the book value of the company does not immediately suggest value. The value, if any, is coming from the cash generated from ongoing operations. This is where we believe most of the value exists. A quick peek at the latest string of 10Qs tells us that net interest income is quite stable at about 38-40 million a quarter. We believe this is will be a steadily growing number as more capital is deployed but this assumption is not required to justify our investment thesis.
Let’s subtract out 1.1 million in loan servicing expenses, another 1.5 in SG&A, and lastly 4.5 million for the management fee paid to Fortress and we have about 31 million in cash flow a quarter. This is our zero adverse occurrence estimate, but to get a snug fit between our numbers and reality we should really shave off about 5 million in other than temporary impairments to arrive at 26 million a quarter or 104 million a year, which translates to just under 1 dollar of earnings of power per share. Newcastle should be able to comfortably support a $0.20 common dividend even after subtracting the 1.4 million preferred dividends.
Now we will try and see how these cash flows will behave going forward. Substantially all of NCT’s cash flows are coming from its CDOs, MFL portfolios and other non recourse financing operations (these categories in sum make up 99.89% of NII in 2011) So let’s take look at those CDOs.
For the purposes of this write-up we’ll only look at the distributions to the preferred tranche and ignore the snr and sub management fees, though these are necessary to arrive at the net income in any rigorous analysis. Of the 6 CDOs we’ve mentioned above only 3 currently pay a distribution to the equity, 2 are essentially deconsolidated and CDO VII failed its OC test in November 2008. We’ve compiled the monthly distributions for each of these three CDOs from the tranche reports.
Recently these CDO distributions have generated 9 to 12 million a quarter. Across all CDOs another 8.9 million was reinvested in collateral or to pay down CDO notes, and 14.3 million of interest was used to pay down senior tranches.
In our opinion NCT is privileged to have an unusually intelligent message boards (relative to your average message board) and a prevalent opinion we’ve noticed on various forums and message boards is that Newcastle’s CDO distributions are not strong enough to maintain a $0.20 dividend.
While this may be true, we do not believe this should detract value from the equity because many CDOs that are not paying a distribution today may very well have substantial residuals by the time the notes mature. A typical structure will stipulate, for example, that the equity piece (the piece NCT owns) can’t get paid the excess interest on the collateral pool unless the market value of the collateral is equal to 120% and the interest collected is 150% of the interest owed on all the notes senior to the equity piece.
In such a deal, if the collateral is worth 105% of the senior notes, all the excess interest will be used to pay down the most senior tranche and will not produce a cash flow to the equity owners. However, when all is said and done the remaining 5% plus all that excess interest will go to the equity piece. If over the life of the CDO another 2.5% of excess interest went to pay down the senior tranches, NCT would be able to collect 7.5% all else being equal. We are simplifying quite a bit, but we feel this widely misunderstood fact is one of the obstacles that stand in the way of price appreciation. Below is a table of collateral values to CDO notes and interest rate coverage.
CDO 10 (PASS) Collateral/Notes - 109.4%, Interest coverage – 396.5% to 438.1%
CDO 9 (PASS) Collateral/Notes - 121%, Interest coverage – 462.9% to 870.2%
CDO 8 (PASS) Collateral/Notes - 116.7%, Interest coverage – 451.9% to 745.5%
CDO 4 (FAIL) Collateral/Notes - 101.4%, Interest coverage – 207.5% to 427.36%
To be fair, the high interest rate coverage is somewhat misleading since most notes are based on 3 month libor and there is a complex portfolio of swaps attached to hedge a lot of the excess interest away but we know from the tranche reports a substantial amount of excess interest is being directed to paying down the super seniors.
The remaining interest comes from the manufactured housing loan structures. We know from the filings that it generates approximately 4.8 million in net interest every quarter.
The essential point is that CRE and all sorts of “toxic” structured mortgage products ironically comprise some of the most attractive paper in the fixed income world. Newcastle owns billions in securities that are priced below what management views as fair but nonetheless will be recorded at market value in their SEC filings. An equity analyst will typically look at NCT’s holdings and see a pile of toxic waste and will further discount the bonds because they don’t trust that the bond market has sufficiently discounted them.
The fact that these securities are financed with non-recourse debt signals to the equity analyst that this company has some downside protection but possibility that the bond market might be seriously under pricing the collateral rarely occurs to equity investors. In reality NCT and many other CRE REITS are buying back this downside protection and increasing their exposure to this toxic collateral. This double discounting is one major reason why we are writing about a stock instead of a sector of the bond market. As an added benefit the portfolio of bonds is managed by veterans in the sector who have access to cheap leverage, superior access to information, and call-like optionality on a volatile slice of the bond market.
Another obstacle to price appreciation is related to two separate equity offerings. Common stock offerings are often labeled as dilutive to the stock price because holders of the stock generally value the stock more than new buyers of the stock (this is a well documented behavior trait in humans). As such NCT would not sell its shares at the current market price and thus rarely approves when management does, even if the money will be invested at high rates of return. We have no answer to this because it depends on how much each investor believes the stock is actually worth. Given that the MSR deal yields 20%, an investor will call it a wash if he expected the stock to be worth 5.46 in one year (4.55 *1.2).
This leads to the peculiar implication that management seems to value the stock less than the investor (of course management is also paid a salary, but let us assume that NCT is trying to maximize shareholder value for a moment). To answer this anomaly let us consider a longer period of time, say 5 years. A 20% compounded yield translates to a 248% return, meaning it would be a wash if management expect the stock to be worth 11.32 in 5 years. That management has a longer term view is actually not so strange if you consider the fact that the CDO notes mature in about that time frame. It makes sense for management to raise funds now for new future business, because it is not clear that NCT will be able to raise funds in the future for its old business (issuing more CDOs at a favorable rate).
New Business: Mortgage Servicing Rights
On December 13, 2011, Newcastle announced what seems to be a watershed investment in mortgage servicing rights. Your average person might think of these instruments like IOs off some sort of pass through but there are all sorts of upside benefits MSRs have that IOs do not. In addition it seems that Newcastle was able to negotiate for additional rights on mortgages that are refinanced but recaptured by Nationstar which will substantially decrease prepayment risk. Newcastle put out a press release detailing the investment vehicle and providing what we feel are rather conservative projections on the yield of these investments.
While currently the MSR deal is contributing no more than $0.02 a quarter per share, we see substantial upside in this business. If the remaining 150 million were to be invested at a similar rate, simple arithmetic tells us to expect an additional $0.06 a quarter. Mortgage servicing rights have traditionally been a business dominated by the large banks that originate our mortgages. As the large banks move away from this business it is possible to see REITs like Newcastle move in to finance these assets. Given the right financing vehicle, we believe Newcastle will transform its business entirely to pursue these attractive investment vehicles.
We believe that market is pricing Newcastle off its current net interest cash flows and ignoring the true value of CDOs and its growth potential in MSRs/other mortgage related businesses. With regard to most CRE REITs the market is very much of the “I’ll believe it when I see the cash” attitude. We feel that NCT is priced like an equity undergoing liquidation when it should be priced like a bond. It is clear that Newcastle is yielding about 20% (25% if you exclude cash) in earnings power, and this is a prudent expected return for a risky equity, but the structure of Newcastle’s business is more akin to a levered fixed income portfolio than a risky stock.
The analogy is actually quite apt because CDOs are essentially levered portfolios of bonds. A prudent investor could conceivably require far more than a 20% return on an equity they know little about, which is why we see NCT yielding 20% but a twenty 20% yield on a 10 year bond with the recovery we assumed in our worst case balance sheet analysis suggests that the probability of default is 60% when discounted to swaps. We feel that the probability of NCT collecting nothing from its non-recourse financed assets is almost surely zero.
When we say Newcastle is cheap on a cash flow basis alone, it is important to understand that much of the perceived “cheapness” is due to our belief that these cash flows are far more assured and have more upside potential than other securities that currently yield 13%. Readers will have noticed that this write-up has refrained from pricing the company. This is because pricing, contrary to popular belief, is actually a subjective endeavor. Investors intuitively understand this when shopping for tangible items but academia has largely proceeded on the assumption that risk is a homogenously perceived quantity. In reality, buying risk is dependent on everything from someone’s personal information set to the vagaries of innate preference.
For what it is worth, given our information set and our various proclivities we think the appropriate discount rate on all present and future cash flows is about 10%. We were encouraged to publish our research after discovering Newcastle along with a few other REITs had a following of intelligent message boards and independent researchers who might appreciate an effort to strip away much of, what we feel are, unnecessary complexities found in the filings. As a word of caution, it is likely that future quarterly reports and MSR deal announcements will not be quite sufficient in and of themselves to drive a full price correction. A steady and increasing dividend may be the only driver of price appreciation, however, unlike the increasing dividend, price corrections are hardly ever steady. In the meantime, it is not difficult to foresee the stock trading flat.
Disclosure: I am long NCT.