Time To Buy This 13% Dividend Monster: Newcastle Investment

| About: Newcastle Investment (NCT)

There are many reasons why now is a great time to purchase Newcastle Investment (NCT) stock for your portfolio. With solid fundamentals, a 13% dividend yield, and management who are clearly aligned with shareholders, this equity has a bright future.

Why Newcastle Investment?

For one, this 13%-yielding equity has increased its quarterly dividend payment by 100% over the past nine months.

Here is a description of the company from Newcastle itself:

Newcastle Investment is a real estate related investment and finance company. Newcastle invests in, and actively manages a portfolio of, real estate securities, loans and other real estate related assets. The company conducts its business through four primary segments: investments financed with non-recourse collateralized debt obligations (CDOs), investments financed with other non-recourse debt, investments financed with recourse debt, including Federal National Mortgage Association (OTCQB:FNMA)/ Federal Home Loan Mortgage Corporation (FHLMC) securities and unlevered investments.

While the above businesses are complex for any company to navigate, Newcastle has shown it is capable of executing an effective business plan.

Newcastle historically has been an owner of various CDOs composed of thousands of residential and commercial real estate loans. These pay Newcastle consistent cash flows in the form of rent payments on a monthly basis.

The company owned these assets previous to the housing bust and has been working to maximize shareholder value from continued improvement of these instruments. However, in the current business environment, there exist more attractive investments for Newcastle. I will discuss the exciting new strategies being employed by the company a bit later in this article.

Newcastle's Trading and Fundamentals

Newcastle's stock price is currently hovering around $6.15, down from a 52-week high of $6.75 hit on March 21 and well below the previous high of $8-plus in February 2011.

The quarterly dividend has gone from a dime in 2011 to the current amount of twenty cents. If the current dividend rate was doubled to $0.40 per quarter, then a 10% yield would put this share price at $16. An 8% yield would put the share price at exactly $20.

This dividend increase would take continued management execution and the ability to raise money and invest in similar deals, but it is certainly achievable. Here are three reasons why this dividend rate is likely in a one- to two-year time frame.

  • It is likely that the same management team is able to keep effectively running the core business and continue the path of successful execution, rather than suddenly becoming incompetent.
  • Management has proven to shareholders that their incentives are correctly aligned, and have behaved accordingly. They are major shareholders in the company and have bought into previous secondary offerings to show support to investors.
  • Investing in Excess Mortgage Servicing Rights (Excess MSRs) is proving to be a lucrative and sustainable business model, and Newcastle has the ability to greatly increase related earnings in the future.

Excess MSRs: The Next Frontier

Here is an explanation of MSRs from Investopedia:

The mortgage servicer must supply an annual statement outlining the duties that were performed. In return for this assistance, the servicer is compensated with a specific fee outlined in the contract established at the beginning of the agreement. Mortgage servicing rights can be bought and sold, resulting in the transfer of any administrative obligations.

Many vertically integrated lenders today will service their mortgages in-house, which means they will also own both the loan and the servicing rights. These firms will also save money in the process. The business of selling servicing rights for mortgages represents a large business niche, and is a multibillion dollar industry.

Newcastle is buying these servicing rights for a very high return on initial investment. Newcastle stated that it expects 20% internal rate of return (IRR) from Excess MSR investments. This sector represents a huge growth opportunity, providing Newcastle with the ability to drastically increase its market share.

Also note this, according to Bloomberg's Kathleen Howley:

Banks are retreating from the approximately $10 trillion mortgage servicing market, once a cash cow that generated monthly revenue of 0.25% to 0.4% of loan balances. Federal and state probes of foreclosure practices led to new regulations that are driving up costs, and a pending change in bank capital requirements also made the business less desirable.

'Smaller servicers have an opportunity to pick up market share because they aren't facing the same regulatory issues and the same capital issues as banks," said Diane Swonk, chief economist at Mesirow Financial Inc. in Chicago. "We're in big trouble if they don't -- banks are so completely overwhelmed with defaults and regulatory issues, some of them can't even handle a refinance request.'

Newcastle sees great opportunity for profits where large banks are unloading these Excess MSRs by the billion. Newcastle's small size, agility, and expertise in this sector will allow it to increase returns beyond what was capable by previous owners.

There is enormous potential for investing in Excess MSRs, and Newcastle is an aggressive early mover in this investment niche. The experience the company has gained by successfully servicing these rights will help it secure more deals in the future and continue to gain valuable insight into these investment vehicles.

Fear of Dilution: Secondary Offerings

One of the common complaints with Newcastle management has been related to equity dilution through secondary offerings. I find this argument to be short-sighted and invalid, more akin to a trader's worry than a long-term investor's concern. To a savvy investor, the company has shown the value of the secondary offerings by investing the money wisely and zealously returning profits to shareholders.

The most recent secondary offering was priced at $6.22 on March 28 at a meager 4% discount from the current trading prices. This is a great sign for the company in multiple ways. It shows there is strong institutional interest in accumulating the stock at current prices, and the small discount offered proves management's efficiency at raising capital. The company will now reinvest these proceeds in additional Excess MSR deals(at IRR rates of 20%), as well as buy back its own collateralized debt obligation (CDO) at a discount and further supercharge its earnings.

There is also some comfort in being on the same side as the big money institutions that spend 100 million on this type of deal. These institutions have vast resources and perform extensive due diligence, offering smaller investors confidence as to the company's future prospects.

It also behooves investors to remember that Newcastle is structured as a REIT and, as such, issuing secondary offerings is the most common way to raise funds for investment.

Future Prospects

This company represents a unique opportunity that is being overlooked by most long-term investors, and offers a great yield as well as the potential for significant capital gains.

To wit, here is a quote from CEO Kenneth M. Riis:

I am pleased to announce our second common dividend increase since it was reinstated in the second quarter of 2011. Our ability to increase our dividend is a result of deploying capital at attractive returns and improving our overall operating results. As we complete new investments, we expect our operating results and cash flows to improve further.

With overbought stocks still ubiquitous throughout the market and long-term interest rates hovering around all-time lows, Newcastle stock represents great value to the prudent investor.

A 13% dividend yield will provide me with the patience to allow the exciting Excess MSR investments to become accretive to Newcastle's earnings flow, and helps solidify its place as one of my top buys for 2012.

I am currently down to a token position in this equity, as I sold out during the price increase leading to the recent secondary offering. However, I am currently attempting to accumulate shares on a broader market selloff and will purchase Newcastle shares below $6.00. I firmly believe management will lead this stock higher with astute business deals and increase my quarterly dividend in the process.

For the more income-focused or risk-averse folks out there, check out NCT.B, NCT.C, and NCT.D preferred shares for safer yields above 8%.

For my other recent investment ideas and write-ups, please click here.

Disclosure: I am long NCT.