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Five Oaks (NYSE:OAKS) is one of the smallest mortgage REITs still trading on the exchanges. With the company's exceptionally small size, it is a prime candidate for deviating from intrinsic value. The company released its quarterly results recently and declared a deficiency dividend. The market completely misunderstood what happened and the price on OAKS went nuts. This is a call I've been waiting on for months. The big issue that kept this play from going out was the lack of a suitable price for execution. Now the price is there and Five Oaks is one of the most compelling short opportunities I've seen.
Heavy on Math
This article is going to show quite a bit of math because the analysis absolutely relies upon being able to get at least a rough estimate of current book value. My estimates are quite rough, but I think they have a good shot to be within 3% or so and that would be close enough to make the play work.
I'd love to have a better way to lay this math out, but I don't have the time to conceive of the perfect layout. We start with some data from the end of Q3 2016:
Data Begins From the End of Q3 2016
It reported BV
Shares Outstanding at End of Q3 2016
Nice and simple so far.
Two Book Values
Let's dive a little deeper into the book value. The company uses preferred equity for a large chunk of financing and those shares are on the balance sheet at a value materially below the call value. That is very important because the preferred shares carry a much higher-than-normal coupon rate. If any other mortgage REIT were going to buy OAKS, it might want to pay off the preferred shareholders at the call value of $25 rather than continue paying the rate on the shares.
This is where I start splitting the math in two. I'll provide book value projections based on "my method" and "their method". The strategy used for "my method" will be enforcing $25 per preferred share which causes the total preferred equity to rise from $37,156,972 to $40,250,000.
Harder Than Most of My Articles
This piece will be harder than most. This is really designed for the big investors on here that are comfortable shorting stocks. For any investor that is long OAKS, this is a strong call to get the heck out.
The company declared a deficiency dividend to meet the rules on distributing income to shareholders. This seemed to put the stock into a fierce move higher. I believe the market completely misunderstood this event. The company was required to pay out to shareholders, but it didn't create new book value to do it and it didn't have enough cash available to pay the dividends so it is issuing shares to existing shareholders as a stock dividend. This increases the total pool of shares outstanding without changing the total value of equity. Any cash paid as part of the dividend (up to 20% could be taken in cash) would lower total equity values. My numbers assume that enough investors elected for cash to max out the option. If fewer investors took cash, then even more took shares. Since the shares are issued materially below book value, the impact would be slightly more dilution than I'm projecting here.
Here is the math:
That is a significant increase in the total shares outstanding. Investors are still treating this like an extra dividend coming from some magical place. It was not that. It was simply the REIT diluting its equity value by sending out shares to the shareholders. If an investor wants an easy comparison, think about a stock split. If Intel (NASDAQ:INTC) declares a stock split and your share volume doubles, did the value of your total investment change? No, you would still own the same percentage of the company.
Updating Book Value for That Event
By deducting the cash from common equity and adjusting the number of shares outstanding, we can calculate the new estimated book value per share again:
The result would be the stock trading at about 83.1% or 80.7% of book value. That would be an exceptionally small discount compared to where the discount was so far in 2016. The other mREITs in the sector didn't suddenly see their discounts decline. Did the market suddenly realize that this is a great mortgage REIT? If so, the market would be wrong.
Annualized Run Rate of Costs Paid Before Common Shareholders
Take a look deeper into the financial statements and you'll understand why OAKS usually trades at such low valuations:
Preferred dividends are not counted as an "expense", but for the common shareholder, it would be wise to treat it that way. Those preferred dividends come before the common dividend.
Is That Bad?
Operating expenses and preferred dividends would need to be measured relative to total equity to determine how well the mortgage REIT is doing. There are some cases where excluding preferred dividends and applying to common equity works just fine, but in this case, we want to get a feel for how much net interest income needs to be generated through leveraged positions. Consequently, I'm charting things relative to total equity:
The operating expenses are extremely high (clearly this purely opinion) relative to common equity and the combination of operating expenses and preferred dividends are extremely high relative to total equity.
Investors are stuck hoping that the spread between 16.18% and 12.90% can cover the dividend. If you're familiar with my work, you already know this is unlikely. Let's take a look at the new value for common dividends. Remember that there are even more shares outstanding, so the amount of common dividends has to go higher if the rate per share does not change.
A 38.66% coverage ratio is terrible. That dividend is already in line to get chopped.
What happens when a mortgage REIT chops the dividend? The price usually gets hammered. This is a huge catalyst for sending shares lower. However, I'm afraid the values I've provided for net interest income may be too favorable. As you already know, the 16.18% ratio for net interest income to total equity is already very high. How did it get so high? If a mortgage REIT hedges its duration exposure through LIBOR swaps, it is stuck paying the "net interest cost" on its positions. However, if a mortgage REIT uses EDFs (Eurodollar Futures Contracts), it only records valuations gains and losses. Those gains and losses are eventually realized and payments must be made in cash, but it is not an "interest expense" that way. There is nothing wrong with using EDFs, but investors and analysts sometimes forget to factor it into their analysis. Would you care to guess which hedging strategy OAKS uses?
Even Analysts Can Fail at EDFs
The other important thing here is that an investor looking at the notional balance on the hedges could dramatically overstate the amount of hedging. This is not akin to having the same value in swaps. It is not even close. Notice in the disclosure that no quarter involves more than $716 million in expiration. Each EDF contract applies to a single quarter. If you had a pack of EDFs that expired evenly on every quarter for the next two years and each pack had a notional value of $100 million, the total notional value would be $800 million across eight contracts. Your position would be economically equivalent to having one swap position with a two-year maturity and $100 million in notional balance.
Analysts may have overvalued OAKS on the belief that these positions are going to create a massive gain. They certainly should create a gain, but it will not be massive based on rate movements so far.
Fair Valuation Adjustments
I believe it is fair to say that Q4 2016 has been a fairly positive quarter for using agency ARMs (adjustable rate mortgages) and hedging through LIBOR swaps or EDFs. Capstead Mortgage Corporation (NYSE:CMO) is in a solid rally from running that kind of portfolio. OAKS has its largest exposure to the Agency ARM, so it should be a similar story there. If you look at the balance sheet it appears that its largest exposure is in multi-family CMBS, but this is an impact of consolidation. Its equity investment in that position is quite small. Due to extremely high leverage, it can still produce some nice gains, but I believe this is still primarily an mREIT running agency ARMs.
Since the yield curve steepened materially, the expected prepayment rate on agency ARMs declined. That means much lower amortization charges in future periods and I believe investors should be willing to pay more for them, especially for current reset ARMs. Since this is a bearish call, I calculated the valuation changes with fairly optimistic assumptions for the company. I always want a margin of safety, so I did this in the way that would favor creating a higher book value. The result was projecting a net gain between portfolio positions and hedges at $3.8 million.
Using that value, I ran through the accruals for expected cash flows so far this quarter that would be below the "net interest income" line.
The net result is book value calculated my way at $6.29 or their way at $6.47. The result is a price to book value ratio, based on a recent price of $5.10, at 81% of book value or 79% of book value. Such a discount seems large, until you remember that Annaly Capital Management (NYSE:NLY) is trading around 84% or so of book value and Anworth (NYSE:ANH) was recently trading as low as 76% or so of book value.
Remember how Resource Capital Corporation (NYSE:RSO) got blown up on Monday? Remember how New York Mortgage Trust (NASDAQ:NYMT) got blown up a few quarters ago? Remember when Orchid Island Capital (NYSE:ORC) was blown up in summer of 2015? Now the pieces are aligned for OAKS to get hammered.
One thing most mREITs should have that Five Oaks specifically does not have is fiduciary duty from its external manager. Under the law, some fiduciary duties are required, but the disclosure in its 10-K indicates that employees of the manager are only under fiduciary duty if they are also elected officers of Five Oaks.
Here is the relevant section from page 35 (bolding and spacing is OAKS's):
"Our Manager's liability is limited under the management agreement and we have agreed to indemnify our Manager and its affiliates against certain liabilities. As a result, we could experience poor performance or losses for which our Manager would not be liable.
Pursuant to the management agreement, our Manager does not assume any responsibility other than to render the services called for thereunder and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our Manager maintains a contractual as opposed to a fiduciary relationship with us, although our officers who are also employees of our Manager will have a fiduciary duty to us under the Maryland General Corporation Law, or the MGCL, as our officers. Under the terms of the management agreement, our Manager, its officers, members, managers, directors, personnel, any person controlling or controlled by our Manager and any person providing sub-advisory services to our Manager will not be liable to us, our directors, our stockholders or any partners for acts or omissions performed in accordance with and pursuant to the management agreement, except because of acts constituting bad faith, willful misconduct, gross negligence or reckless disregard of their duties under the management agreement, as determined by a final non-appealable order of a court of competent jurisdiction. In addition, we have agreed to indemnify our Manager, its officers, stockholders, members, managers, directors, personnel, any person controlling or controlled by our Manager and any person providing sub-advisory services to our Manager with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from acts of our Manager not constituting bad faith, willful misconduct, gross negligence or reckless disregard of duties, performed in good faith in accordance with and pursuant to the management agreement. As a result, we could experience poor performance or losses for which our Manager would not be liable."
Five Oaks is now trading somewhere in the ballpark of a 20% discount to book value despite having little net interest income left for common shareholders after paying its operating expenses and preferred dividends. This is the case even when net interest income is strengthened by using EDFs rather than Eurodollar Futures Contracts to push the hedging costs away from net interest income. The dividend is clearly unsustainable and when it gets axed the stock should get hammered and give investors an opportunity to close out any short positions.
The most logical fear might be that the stock would move up to trade near book value, but there is no reason to believe that would happen when Capstead Mortgage Corporation still trades at a discount. Even if the stock did move to trade at a smaller discount, its book value is bleeding out through the dividend. Some investors may look at the mandatory payout and say: "See, that proves this mREIT is actually earning their dividend!" Sadly, it means nothing of the sort. This was a necessary payment to settle an issue from a prior period and investors failing to understand what was happening sent shares to trade at similar discounts to dramatically stronger names.
I would expect OAKS to move back towards a 35% discount to book value. Based on the projected BV range of $6.29 to $6.47 sets a price target range of $4.09 to $4.21. Compared to the last price of $5.18, shares have a 20% downside to reach the middle ($4.15) of that range.
Want to know when great income investments go on sale? Consider joining The Mortgage REIT Forum. For the cost of one lunch per month, you can get access to the research I'm using for managing my own investments. On average, I publish about three subscription articles per week. One is for calculating new estimated book value for several mortgage REITs and finding the current discounts to those estimates. Another covers the preferred shares for each mortgage REIT that has preferred shares. The third is used to either preview articles I'm working on for the public or to provide real-time updates on liquidity failures where prices for a small number of securities detached from other similar stocks.
Disclosure: I am/we are long ANH, CMO-E, NLY, NLY-D, RSO, RSO-B.
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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