Great Ajax: Short In The Making

| About: Great Ajax (AJX)

Summary

AJX is an mREIT focused on low-quality mortgages mainly originated during the financials crisis. I believe the market is not realizing the company’s risks; thus, downside is significant.

The company is reporting a non-cash profit, while actually in cash loss. The management is using dubious accretable accounting (based solely on the management’s expectations) to arrive at the ‘profit’.

The company then pays out a dividend on this non-cash profit triggering the need for additional cash. The company thus got itself into a vicious circle of raising cash.

The company structure and management is full of conflict of interests and dubious history, topped with the CEO being a convicted criminal (filed a fraudulent tax report).

All this is happening while the company is exempt from being audited on its financial controls as the company is labeled as ‘emerging growth company’ under the JOBS Act.

Great Ajax Corp. (NYSE:AJX) is a mortgage REIT (mREIT) that is specifically focused on acquiring non-performing mortgages (NPL) and re-performing mortgages (RPL) in the US. NPL is a loan where the borrower did not pay any installments in the last seven months. RPL is a loan where the borrower paid at least five out of the last seven months, although this segment can include several exemptions (such as a loan where the borrower only paid the latest instalment, but AJX arrived at an 'agreement' with the borrower).

Once it acquires these loans at a discount, it services them through a third-party and profit from the interest income from these loans. It can also potentially benefit from a foreclosure as it then can rent out or sell the underlying property. The company was incorporated in early 2014, when it bought its first loan portfolio, which was funded through private placements. Shortly thereafter, the company had an IPO and started to trade on the stock market in early 2015.

The company has no employees and is managed by Thetis Asset Management, a related third-party entity. The loans are serviced by Gregory Funding LLC, a related third-party entity.

The current portfolio is segmented in the following way (taken from company data);

With the following state of delinquencies:

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The majority of these loans were originated during the period of 2006-08 as can be seen below.

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Finally, 51% of unpaid principal balance (UPB) is tied to mortgages with fixed rates, 17% is tied to adjustable rates and 32% is tied to hybrid adjustable rates. The latter two products helped to trigger the financial crisis in 2008/09 and are susceptible to interest rate moves.

The company believes that while the nature of these loans is highly risky, it is able to select the right portfolio due to its 'proprietary' models, which are able to forecast which loans are most likely to be repaid. Moreover, it also believes that through servicing of these loans, it will be able to 'support' continuous and new payments from the borrowers.

I believe that the stock's risks completely outweigh any reward due to the points raised in the summary points, and that the stock is a candidate for a short position if the negative trends continue. Specifically, I believe that the company might need to keep on raising cash through equity offerings. The cash deficit that arises because of the way the company reports its profit is not going to be eradicated anytime soon. The company now holds roughly $53 million in cash while the deficit last year was $73 million. The management does not seem to convey that they would decrease their acquisition activity, which could then mean that the deficit in FY2016 might be similar and the company might need to perform another equity offering at the end of the year.

In this article, I will only cover the financial aspect of the company. The management and company structure will be part of another installment.

Regulatory Exemptions under JOBS Act

I believe that the overarching issue of the company is that no one can really know whether its reporting is rigorous enough and whether it is consistent with other public companies. The reason for this is that the company was able to label itself as an 'emerging growth company' under the 'Jumpstart Our Business Startups Act.

This law was primarily aimed at reducing the regulatory burden imposed by Sarbanes-Oxley for 'small' newcomer public companies with revenues under $1 billion. The most significant exemption is from the Section 404 (b) of the Sarbanes-Oxley Act. Under this exemption, AJX does not need to have a process of internal control over its financial reporting and is exempt from the mandatory auditing of these controls. This means that the company is under zero scrutiny over its accounting methods, and while it is still audited at the end, the company is able to arrive at the statements through its own unaudited reporting methods. The company will most likely continue to be exempt from this for the next 4 years.

This is obviously posing a risk for the investors as the management can potentially manipulate their statements. This risk is further enhanced in the case of AJX as the CEO previously had an issue with the law regarding fraudulent tax reporting and as the business is handling low-quality mortgage loans where the value of the loans is arrived at through numerous assumptions. These assumptions are completely at management's discretion and thus investors are left to only 'believe' in what the company is doing. Again, AJX is taking this risk further as it states that it uses its own 'proprietary' models that help it in its investment decisions as seen below:

Unlike other loan acquirers, who often rely on pooled estimates in analyzing and pricing portfolios, our Manager uses proprietary models and data developed by its affiliates to evaluate individual assets and to help determine cities, neighborhoods and properties that it believes will experience home price appreciation, or HPA. These proprietary analytics have inputs for economic and demographic data that include changes in unemployment rates, median household incomes, housing starts, crime rates, education, electoral participation and other variables that we believe closely correlate to property values.

Source: 10K FY2015

Another example of this risk is the fact that the company does not use FICO scores to determine creditworthiness of the borrowers, but rather it uses its own assumptions. I am always extremely skeptical of such statements as the management is saying that they know better than anyone else and can 'outperform' the market via their own models.

These statements would at least pose a smaller amount of risk if the company needed to comply with Sarbanes-Oxley regulation, but because the company is exempt from this, the investors can't be certain about the way the company reports and presents its financial statements. I believe this creates a fundamental challenge to any argument that would support this stock.

Company is reporting a net income, while actually at a cash loss

The second most important issue is that the company seems to be making money, but that profit is predominantly based on an accretable yield accounting for interest income from loans, where the borrowers are not paying their interest on time. The company actually lost money every single quarter since its IPO, and this is unlikely to rapidly change. The management is not transparent enough about this fact and mentions only that they use this method, not that the company is, in cash terms, in a loss.

I can utilize a simple scenario to showcase the issues with this accounting method. Bank X originates a loan of $10 million with a 5% interest rate and a maturity of 10 years. Say that the loan goes bad and the borrower can't pay (for simplicity in the very beginning). The bank wants to get rid of this 'non-performing' loan (due to capital controls etc.) and finds a buyer, AJX.

Instead of paying $10 million, AJX buys the loan at a discount as there is a risk that the face value of the loan is not going to be recovered. The company also forecasts the expected recovered amount after the loan matures, so that it can warehouse the loan on its books. This is just an opinion about a future event based on modeling. Let's say, that AJX buys the loan for $5 million and expects to recover $7 million at the maturity (in 10 years).

Now common sense would dictate that the company should only incur the interest income that is actually receiving in cash from the borrower, but because there is an accounting standard, FAS ASC 310-30, the company can do the following.

AJX can report an accretable interest income of $0.2 million each year, regardless of the fact if the borrower is paying or not. This income is then bundled with the real cash interest that the company receives from other loans and is reported on the income statement. The value of the interest is derived from the difference of the acquisition cost and the expected recovery value ($7m-$5m = $2m), which is spread out over the period until maturity ($2m/10 years = $0.2m).

This then makes the company's profit larger, but it does not in any way reflect the reality of the situation as the profit is completely based on the management's expectations. This issue is even more pressing when the management's expectations are not sufficiently audited as mentioned previously. Finally, if the management is ever wrong and the actual recovery value of the loans will end up lower than its forecast, it will need to impair the difference, which would not be unusual when dealing with low-quality loans.

We can see that if we remove AJX's accretable component and just leave the real cash interest, the company was losing money in each period since the IPO.

Period

Income (in 000's)

Non Cash Accretion

Adjusted Net Income

FY2014

$3,750

$(4,098)

$(348)

FY2015

$25,792

$(30,936)

$(5,144)

Q1 2016

$7,963

$(9,004)

$(1,041)

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Source: Company Data

The company does not disclose this reality in any way apart from a footnote, which segments the interest income, but does not show that the company is in a loss. The only time that the company mentioned the impact of this accounting was in its IPO prospectus. Since then, the company only discloses the accounting policy and scarce footnotes, but does not showcase the implications.

In the IPO prospectus, the company also mentioned that the 'phantom' income, as it calls it, should decrease over time as the borrowers are expected to start repaying the loans. This has been happening on a limited scale. I also believe that due to the fact that the company is likely to keep on acquiring new loans, the decrease will be small and thus a significant portion of the company's revenue is likely to keep on being non-cash, or in other words, non-existent. Below, you can see the actual state of the proportion for every quarter.

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Source: Company Data

I believe that the proportional jump in Q2 of 2015 is connected to the fact that the company acquired a significant amount of new loans, which might have spurred an increase in the phantom income. Vice versa, in Q1 of 2016, the company bought a substantially lower number of loans, and thus the phantom income slightly decreased. Although it still constitutes over 50% of the income, which is definitely not sustainable.

The main impact of this is on the business model, which I will cover in the next two sections.

REIT status & dividends

The fact that the company reports an income is then triggering the need to pay dividends, as the company is operating as a REIT and is obliged to pay at least 90% of its profits in dividends to shareholders. This means that the company created a liquidity issue for itself as it needs to raise additional cash from outside its operating activity. One can also see this as a corporate governance issue.

I will cover the aspect of the management in the second article, but just as an example, the CEO, Mr. Mendelsohn, holds 3.1% in his name and thus receives dividends, which were paid only because the company uses accretable interest. This dividend is on top of his compensation as the CEO of Ajax, and interestingly enough as a manager of Thetis, the 'third-party' manager of Ajax. He is also connected to the servicer of AJX's loans, Gregory Funding LLC.

This means that the insiders are able to take out additional cash from the company at the expense of the entity's liquidity as the pay-outs act as a strain on the operational cash flow.

The need for cash

Because the company will need to keep on paying dividends on a non-existent income, it will also need to keep on raising cash in order to sustain its operations. But because the company is also acquiring an increasing number of loans (management mentioned at least two new acquisitions during the Q1 conf. call), the phantom income will keep a strain on the cash flow.

This then creates a vicious circle whereby the more loans the company has, the more phantom income it should potentially generate, if it is to be consistent in its accounting and the company buys loans of similar quality, which it did so far. This, in turn, increases the dividend payouts. This then increases the deficit in cash and the circle turns again. The expenses of the company are also creating a strain as the related party fees (for 'servicing' and 'management') are based on book value and the amount of loans held by the company, thus the expenses are only going to increase as the company will acquire more loans.

While the company does securitize a portion of its assets, this is not creating enough cash flow as the company is acquiring increasing number of loans. Therefore, the securitized assets that are not used for REPO agreements and are sold to other investors are only used to fund these acquisitions, not to decrease the deficit.

Therefore, the company has only two ways to break this cycle. And only one of those is actually within the capability of the management, which is of course to perform equity offerings. Unsurprisingly, the company already did one in June, which raised $30 million. The company also prepared itself for potential further offerings as it has a shelf offering for $120 million ready to be triggered whenever the management wants. Even the group of insider shareholders has their own shelf offering, which constitutes that they can offload their stake at any time.

The other way for the company to break the cycle is to actually see increasing amount of real cash interest coming in, which would lower the amount of phantom income and the deficit would start being manageable and eventually would go to zero, which is the only way for the company to sustain its operations without the need for extra cash. This though completely relies on the strength of US economy, which needs to support the borrowers and on the management's investment decisions as they 'selected' the loans that they think are going to be repaid.

The former is arguably 'improving', but if the Fed raises interest rates, the strength of the borrower could crumble fast as almost 50% of AJX's loans have floating interest rates. The latter can't even be scrutinized as the management is not transparent enough and therefore the investors just have to believe in what the management is doing. This, I believe, is not a satisfactory argument when the CEO is a convicted criminal, and the crime actually involved similar low-quality loans operated by Wilshire Financials.

Now these company risks (macro risk and loan quality) are not unusual when looking at a mREIT, but the difference between AJX and others (apart from New Residential Investment Corp. (NYSE:NRZ), which is actually in loss as well due to the usage of accretable yield) is that AJX is completely reliant on borrowers repaying their loans, otherwise it can't ever get rid of the cash deficit. Therefore, the investors that are long are making a 'leveraged' bet on the US economy and the skill of AJX's management.

Likelihood of future equity offering

As one can't really know whether the company will be able to decrease its phantom income in the coming quarters, we need to look at the company's deficit to get a sense of the likelihood of next equity offering.

Last year, the company had a cash deficit (or cash outflow) of $22 million or $73.4 million, if we do not include the IPO proceeds. One possible way to assess the situation is to roughly estimate if the yearly deficit might be similar in this year by looking at the number of acquisitions that the company is doing. Because if the size of the deals is going to be similar, then we can expect similar securitization schedule, similar phantom income proportion and thus a similar deficit of $73 million in FY2016. The company acquired $347 million worth of loans in FY2015.

In Q1, the company was in $7 million deficit, which was lower than the historical average (of $18.3 million per quarter) because of a lower number of loan acquisitions as the company paid only $37.2 million for new loans as opposed to the average of $86 million per quarter in FY2015. Although, during the Q1 conference, the company mentioned that it has done two deals in April and May, which totaled $60.2 million, which is slightly 'compensating' for the slower first quarter. Thus the company is looking at $97.2 million loans acquired for the first five months, which is slightly lower than in 2015, where on average, it acquired $142 million of new loans.

The management though said that US banks are going to start offloading significant portions of their 're-performing' loans in the next two years to meet the increased capital controls and thus the company expects that it could see a similar amount of deals (as in April and May) going forward.

Thus, if the current acquisition streak is unbroken and continues at a similar pace, the deficit would likely be somewhere around $50.2 million. I arrived at this figure by taking the total of acquisitions in 2016 in proportion with the average of the same period from 2015 ($97.2/$142=68% -> $73.4*0.68 = $50.2). The company now has roughly $53 million in cash (including the June offering). Therefore, it might be likely that the company would need another equity offering in late Q4 as the cash position would start to dwindle yet again.

Although I understand that this is just a rough estimate of the situation and I have not accounted for many variables (phantom income, securitization etc.) that could significantly change the picture. I just wanted to showcase the current situation in one possible perspective. I will update this likelihood as soon as we will get more information about Q2, which should be most likely on Tuesday, the 2nd of August.

Conclusion

Notwithstanding the fact that the company could further dilute shareholders, I believe that the market is not properly accounting for the other risks present in the stock. The shares are trading at around the book value and despite the equity offering in June the share price is holding up.

Furthermore, when we compare the price to book value and dividend yield of other similar mREITs, it shows that the market seems to be slightly irrational as it accepts significantly more risk, but lower dividend yield when it acquires a stock of AJX.

Thus depending on what the company reports in Q2, the stock could be a short candidate if the following negative trends continue.

  • The phantom income continues to constitute a large portion of the interest income, which spurs the company to pay out dividends without actually having earned some of its profits.
  • The company continues to acquire a significant amount of new loans, which would maintain the deficit at a similar proportion to last year and the company's cash deficit could be similar to that of 2015, which might trigger a need for additional equity offering.

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.