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ZAIS Financial Corp. (NYSE:ZFC) declared a third quarter dividend of $.40. Since then, shares went ex-dividend. ZFC updated their book values for the merger to reflect the dividend payout. Shareholders approved the merger. ZFC released the tender offer. With those issues addressed, it is time for the analysis. The analysis will assume no trading costs, so slight adjustments are necessary. I will show the calculations, so it should be easy for an investor to replicate.
The tender offer is priced at $15.37 and up to 4,185,397 shares may be validly tendered under the program. As of 10/03/2016, shares closed at $14.33.
Impact on Book Value
After the merger, the new company will trade under the ticker "SLD". The most useful value for estimating the book value of SLD is the "further adjusted book value" of ZFC. This is the key value that all calculations will come from. As of 07/31/2016, the value (which includes expected costs) was $16.17. If the tender offer is fully subscribed, it would boost book value per share by about $.10 because the tender offer is only made at 95% of "further adjusted book value" (that means $15.37). See the demonstration below:
Impact for Investor
If the investor was able to get 100% execution on the tender offer, then their exit price would clearly be $15.37 (adjust for expenses as needed). On the other hand, I put together some math using different potential entry prices and different levels of inclusion in the tender offer.
If every single share was entered into the tender offer, then an investor would expect execution on only 47% of their tendered share volume. The math looks like this:
The grey values demonstrate the returns based on my average entry price of about $13.82. That was before shares were ex-dividend. That entry price made this a very attractive investment. The other 3 columns use the recent price of $14.33, an example at $15.00, and the tender offer price of $15.37. Clearly, buying shares at the tender offer price and then tendering them would be stupid. I included that column to reflect the necessary price to book ratio on SLD using the trailing book value figures.
Updated Note: Discounts in the section below are based on prices from 10/03/2016 and trailing book values from Q2 2016.
I think there is a strong chance that SLD trades above 82.4% of further adjusted book value. For comparison's sake, Prospect Capital (NASDAQ:PSEC) trades at about 84.2% of trailing book value. PSEC has a pretty negative perception among investors, and I don't believe SLD as a new company will have that kind of negative perception. Using a mortgage REIT that invests in CMBS would be a better comparison (PSEC is a BDC), so I'll pick one with a huge discount. Resource Capital Corporation (NYSE:RSO) was trading at about 77% of trailing book value. I don't agree with the way RSO calculates book value because I feel preferred equity should have a higher allocation, consequently I would view RSO's book value as being lower and the ratio as being higher. Those are the harshest possible comparisons.
On the other hand, Blackstone Mortgage Trust (NYSE:BXMT) is a commercial mortgage REIT trading at nearly 110% of trailing book value. In my opinion, BXMT is a more reasonable comparison than RSO. Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI) was trading at about 105% of trailing book value. I believe both BXMT and ARI benefit from favorable perceptions from investors.
While it is easy to suggest that SLD will probably trade somewhere between 77% and 110% of book value, the range is also so large it is meaningless. Given that SLD should have neither a positive nor a negative perception upon creation, I would expect it to fall much closer to the middle of the range. I think 85% to 90% would be a reasonable guess. Higher is certainly possible, but I'm going with the conservative figures. With 47% execution in the tender offer, the fair price would be a little higher than $14.33 and a little lower than $15.00.
How About a Higher Tender Percentage
What if fewer shares are tendered and the investor gets a higher percentage of their order to go through? I ran the same numbers using 75% fulfillment:
In this scenario, the $15.00 price would only require a price to book value ratio of 85.37% (beware transaction costs), which would put it on the lower end of my estimate on fair value. Given my desire to get the cash allocation in my portfolio higher, I would be willing to exit by that point.
Higher Quality Book Value
Some investors may wonder why SLD deserves a better valuation than ZFC carried. The simple answer is that SLD has a different portfolio. ZFC would not have elicited ARI or BXMT as comparable REITs. For SLD, those comparisons are viable. I don't think SLD merits the same ratio since ARI and BXMT have longer histories as publicly traded companies for investors to assess, but I think it will trade at a better value than ZFC.
Another issue holding ZFC back was their book value having inflation from intangible assets such as Goodwill tied to the purchase of a poorly performing asset. Those intangibles needed to be thrown out and the adjustments in the merger included throwing those values out. This lowers book value significantly, but it provides a more comparable valuation.
The number of votes cast in the proxy was dramatically lower than the volume of shares outstanding. Given that there was far less than 100% turnout for voting on whether this deal should happen, I have to believe that the many of the non-voters will not be actively managing their portfolio and taking the tender offer.
There were about 4.7 million shares counted as presented for the vote. There are about 8.9 million total shares.
If shares dip back to around $14.10, I would see it as an attractive opportunity to pick up a small gain in a market that is otherwise highly valued. If they hit around $15, I would consider the price close enough to fair value that the potential returns wouldn't be enough to offset the risk. I'll probably leave a limit-sell order open just under $15 and if I don't get execution on it, then I'll look to take the tender offer and root for a decent price-to-book ratio on the shares of SLD. I'm assuming 100% execution on the tender won't happen.
Update: I'm expecting to use the tender offer.
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Disclosure: I am/we are long ZFC.
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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