Contrarian Mortgage Plays: Friedman, Billings, Ramsey Group

Jun.25.07 | About: FBR & (FBRC)

Alex Troy, Troy CapitalNewsletter Value Investor Insight carried an interview May 30th with Troy Capital's Alex Troy, whose fund has returned an average of 23.6% annually net of fees since inception in March 2003, versus 15.8% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview in which he discusses Friedman, Billings, Ramsey Group (NYSE:FBR), which was trading at $6.31 at the time of the interview (current price here):

Friedman, Billings, Ramsey (FBR) is an ex-high flyer that has fallen hard. Why do you think it will come back?

AT: FBR is a regional investment bank and principal investor with a traditional specialty in financial institutions. I’ve known them for a very long time, starting when they came to us at Perry in the mid- 1990s with one great financial restructuring idea after another.

In 2004, the company made $408 million in operating income and the stock traded for nearly $30 per share. Very little has gone right since then and they lost a total of $350 million in 2005 and 2006. They’ve been hurt primarily by big losses at their First NLC subprime mortgage business and in principal investments that went very wrong as the yield curve flattened. I don’t at all minimize those problems, but it’s all a question of how the market is pricing them into the stock.

With the shares recently trading at $6.30, what’s your take on that?

AT: Our thesis is relatively simple and focuses first on asset values. By far the company’s most valuable asset is its Capital Markets subsidiary, which consists of the investment bank – the leading money raiser for companies with market caps under $1 billion – an institutional brokerage business and an asset management business. They’ve already sold 30% of FBR Capital Markets to a privateequity firm and are now in the process of doing a secondary public IPO. We think they’ll get at least the midpoint of the IPO price range, $17, which would put an 18x multiple on current, far from peak, earnings. At that price, FBR’s remaining ownership in Capital Markets would be worth around $4.50 per share.

This is a classic event-driven case, where successfully getting the offering done should help unlock the value of what’s left. What is left is the tangible book value of FBR’s remaining balancesheet assets, in the form of cash, marketable securities and – the wildcard – subprime loans that they haven’t sold off. Using the company’s mark-to-market assumptions as of March 31, the tangible book value of all that comes to around $400 million, which is another $2.30 per share. We’re comfortable that book value is real, partly because it ascribes no value to a $100 million residual held in already-securitized subprime loan pools, and partly from our analysis of the market pricing of comparable loans to those FBR still owns.

An asset value of $6.80 per share isn’t that exciting vs. a market price of $6.30.

AT: True, but I look at that as providing a great margin of safety, with great optionality on the upside in betting on a management I know very well, that is very entrepreneurial and – the last couple years notwithstanding – knows how to make money. The principal investments, primarily in mortgage-backed securities, will eventually generate higher returns than they have in the past two years. It’s hard to quantify a somewhat qualitative bet on management, but I think there’s an excellent chance the shares make it back into the double digits within the next 12 to 18 months.