Why Does Resource Capital Corporation Remain At A 33% Discount?

| About: Resource Capital (RSO)

Summary

RSO is one of the mREITs with a discount to trailing book value that exceeds 30%.

The mREIT has a few severe problems that investors should know about.

Their acquisition of PCA (now PCM) gave them a residential mortgage lending segment that is still losing money.

The presence of four segments combined with a larger than normal termination fee make the buyout prospects weaker.

Resource Capital Corporation (NYSE:RSO) is one of the few mREITs left trading at a dramatic discount to their fourth quarter book value. Most are now trading under 25% discounts, but RSO remains at about a 33% discount. To make matters more difficult, most of the mREITs that I considered to be exceptionally high quality are trading at discounts of less than 15% to trailing book value. The mREITs that remain at discounts greater than 30% would appear, at least upon a mere glance, to be excellent targets for buyouts that would create an immediate return for any investor buying in before the announcement. However, the investor should also be prepared to hold the shares over a longer time period.

Why Resource Capital Corporation

I was interested in Resource Capital Corporation for a couple of reasons. The huge discount on the common stock was one major reason but Resource Capital Corporation also has three series of preferred stock. Those are all trading at a material discount to liquidation value and offer exceptionally high yields. To know if the preferred shares are worth owning requires quite a bit of research into the company and that research has a substantial amount of overlap with what common shareholders need to know.

In a Nutshell

The mortgage REIT has a few key characteristics that investors should know before they try to dig through all the filings. The first is that the company is being sued for misleading investors. I find these lawsuits to be fairly pointless because lawyers are expensive and the company will obviously defend themselves. Since the shareholders are paying the bill for the defense, this tends to be a negative scenario. Theoretically, the plaintiffs are also the shareholders, so the big winner in these cases is usually (in my opinion) the lawyers.

Without getting into the merits of the suit, the basis is an argument that the company failed to recognize and impair one of their loans. The result was a fairly substantial loss when the company announced that the loan was not expected to recover. When there are questions regarding the accuracy of a company's accounting quality, there will usually be a much weaker share price.

A subsidiary of the company is also being sued by Lehman Brothers Holdings Incorporated. I am neither a lawyer nor judge, so I will render no opinion on the merits of that case.

The company has two other significant flaws that should be holding down the share price. Shareholders in mREITs despise few things so much as a cut in their dividend.

The company opted to buy a subsidiary in October of 2013. They paid $7,600,000 to acquire a company known as PCA; they also provided an additional $800,000 of the company's restricted stock to a key employee. After acquiring PCA, they changed the name to PCM. PCM stands for "Primary Capital Mortgage, LLC." Since acquiring the company, they were able to significantly expand its operations and expenses. As PCM grew, it went from producing moderate losses for RSO to producing a smaller loss. RSO does a great job of breaking down the company statements by reporting segment in the 10-K. The document is fairly thick though, you'll need to go to page 192 to find the breakdown for 2015. That breakdown is demonstrated below with a few colored boxes added for easier descriptions:

Click to enlarge

Red Box

The red box is demonstrating the cost of general and administrative expenses that were created specifically by this subsidiary.

Green Box

The green box represents one of the major goals of the subsidiary. The company wants to originate residential mortgage loans and then sell those loans at a profit. So far, the costs have been too high for the segment to be very effective, but the gains on mortgages was growing faster than costs so this segment might become useful in the future.

The major challenge here is that mortgage REITs operate in a sector with an extremely high required rate of return. Shareholders of utilities or consumer staples may see a 5% growth rate as perfectly acceptable but a mortgage REIT is expected to return closer to 10% per year to justify the risk. This creates a bit of a mismatch because this is a slowly growing business that still isn't turning a profit and it is funded by an organization with a high cost of capital.

Orange Box

The orange box indicates the overhead charges that were not specifically allocated to any of the segments. Eventually, the total cost of overhead gets applied to the segments based on how much each segment contributed to "adjusted pre-tax net income." I love the presence of the segment level reporting, but I don't see this as a high-quality method for allocating overhead expenses. It seems improbable that the creation of overhead expenses is actually a function of adjusted pre-tax net income. As a result, shareholders don't get as much clarity on the actual costs and it is difficult to assess how profitable the segment might be since the costs are not allocated based on which segment caused the cost to be incurred.

Conclusion

Resource Capital Corporation is trading at a materially larger discount than peers due to a combination of factors, which may include lawsuits and concerns about their accounting. In the 10-K, management made some exceptionally clear statements indicating that no other loans were in the same position as the one that failed. Despite those assurances, the company remains at a substantial discount. Finding a buyout could be materially more complicated to the combination of the four operating segments and the management contract requiring four times the annual fee if the contract is terminated.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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