Alesco Financial: Gem in the Garbage Pile

Alesco Financial (AFN) reports earnings on May 6. As a REIT it has gotten no respect from Mister Market for quite awhile despite very good performance. Basically it is a case of a story that sounds too good to be true, but in my opinion is in fact true.

Management has guided for a dividend this year of 25 to 30 cents a quarter. There is no reason to think they will not make it. A 25 cent dividend for Q1 has already been paid. At yesterday's price of 2.76 a share, 25 cents a quarter would be 36 percent for the year. Most investors look at a dividend like this and see a company in trouble.

Alesco has no potential liquidity problems. No debt is due until 2012. All investments are financed with non-recourse debt where the worst thing that can happen is that Alesco loses its investment. No margin calls can be issued to Alesco. The company has about 100 million dollars of unrestricted cash on hand which is about 1.67 dollars per share (as of 31 December). Liquidity is king right now and Alesco has it.

The frightening thing about Alesco is the huge losses it has reported in recent quarters. These have been due to an accounting technicality. Alesco lost its 30 million dollar investment in each of four Kleros CDO's. Although the loss was 120 million dollars GAAP accounting rules required Alesco to report a loss of over 1.2 billion dollars. This has resulted in a huge negative book value. SFAS 159, which took effect on 1 January, will correct this. The Q1 report will show a huge profit as the loss will drop from 1.2 billion to 120 million and Alesco book value will become a positive value around five dollars a share.

Alesco's major source of income is TruPS securities issued to over 300 banks and insurance companies, about 90 percent to banks and 10 percent to insurance companies. If you think large numbers of banks are going to fail in the next couple of years avoid Alesco. If you think the number of failures is going to be relatively small Alesco has a great risk-reward ratio. Even if the dividend is cut in half over the next couple of years the yield at the current stock price would be 18 percent. And the dividend may not be cut.

For what it's worth insiders have bought stock on the open market at higher than current prices but no insider has sold a share since the company went public.

Disclosure: Long

Comments

[Jeanne MCalamore]

It's about time Alesco Financial got some respect. I've been accumulating shares since mid-2007 and it's my largest holding in the m-reit universe. I can't believe how the share price has declined. Great yield though! Thank you for your insightful analysis.

[ganc]

Is there a significant risk that Alesco may lose REIT staus in 2008 ?

[Roger W.]

Yes there is but this would not necessarily be fatal. In the last CC management said one of the four Kleros CDO's is in default. The AAA tranche can liquidate it if they choose. If a second Kleros defaults and both liquidate early this year and Alesco does nothing they would lose REIT status. If both liquidate late in the year REIT status is OK for 2008 but not 2009. However Alesco could deploy their 100 million of unrestricted cash into REIT qualified assets. It is unclear if this would be enough to maintain REIT status. Management has stated in past CC's that one of their options is to convert to a PTP. As a PTP dividends would be treated about the same as in a REIT, taxed only at the shareholder level. Management has stated that they would try to keep a high level of dividends flowing in this case. The drawbacks of a PTP are that dividends of 90 percent of earnings are not guaranteed and reporting them on your income tax is more complicated.

Since all four Kleros CDO's are still generating income for the AAA tranches they may decide not to liquidate even if in default. A forced liquidation in the present depressed market may leave them with a loss instead of an income stream. I assume management will discuss the REIT / non-REIT situation in the 7 May CC as they have in the past.

[Roger W.]

Another possibility if REIT status is threatened would be for Alesco to merge with another small REIT whose assets are all REIT qualifying with the new company meeting the 75 percent of assets REIT qualifed test.

[InquiringMind]

Assume that all four Kleros CDOs default. They will, they're all crap (the last one is the best, but still not great). Do you still think the stock is a good value?

[Roger W.]

Yes I think Alesco would still be a good stock to own. At present Alesco has written off its entire 120 million dollar Kleros investment. All the income from Kleros is diverted to the senior tranches and Alesco receives a big fat zero. If all four default or liquidate there will be no effect on Alesco's actual cash income. Alesco makes enough to pay its current dividend if Kleros is abducted by aliens. Kleros can cause no further losses to Alesco.

However the income flow from Kleros, even though diverted to the senior tranches, is needed to keep Alesco REIT qualified. Alesco management has stated that liquidation of two or more of the Kleros would force Alesco to take action to maintain REIT status or else consider changing to a PTP or just dropping REIT and becoming a normal plain vanilla corporation.

A 36 percent dividend (down to 32 percent with the stock now at 3.05) is not available risk-free. The question that is a judgement call is whether the risk/reward ratio is favorable. My answer is yes. Time will reveal if I am right or wrong.

[greggula]

Excellent Report.
So I sold all of my TMA and BXXX and bought more AFN.
Now I'm relaxed!

[GaryS]

I enjoyed and appreciated this article. I have been an investor and fan of AFN and can't figure out why the stock is selling at such an apparently inexpensive price. Thanks.

[greggula]

Gary,
I think we all are surprized by the bargin prices and that we are in
rare oppertunity in time.

[wdzk]

If they wrote down 1.2 B and have only a 120M in actual loss, how does the other 1.08 billion reflect when it comes back on the books...... Would they pay out a one time DVD to shareholders in addition to its regular payout.

[Roger W.]

SFAS 159 affects GAAP earnings and book value. It will not affect REIT earnings and thus will not affect dividends. When Q1 earnings come out 6 May the GAAP profit shown will be in the neighborhood of 45 dollars. This will make the balance sheet look a lot prettier but have no impact on REIT earnings or dividends.
There may be a special dividend later this year if Alesco closes out the credit default swaps which currently have a huge profit. How the company is going to handle this situation and the tax/dividend consequences is uncertain. I expect this subject will be covered in the 7 May conference call. In any event, how to deal with the tax consequences of out-sized profits is the kind of problem I like companies I have invested in to have.

[CoverMe]

Roger-- I owe you some cookies for bringing this up on the radar. I researched the heck out of it after reading this article... and I'm up about 3k in the past week or so. Even if hadn't jumped the way it has, the dividend (and especially the dividend percentage considering my avg price was around 3.40) makes this something to stick with for a while.

[Roger W.]

Thank you CoverMe. Join us at the AFN Yahoo Finance message board. It's one of the better boards with some knowledgeable posters and we can always use some fresh blood.

[podiddly]

So, as a long term growth and income stock...AFN is scary, but it
delivers on the high side...e.g. 18% ++ dividend and eventual growth.
Anyone agree??

[Curiousguru]

What is your take of AFN in the wake of IMB's decision to defer interest payments? Has AFN's risk profile changed meaningfully? Would you recommend buying the stock at these levels (~$2.95)? What is your guesstimated upside/downside potential?

[Roger W.]

IMB deferring will cause 5 of 8 TruPS CDO's to stop paying income to Alesco. Alesco will lose about 40 to 50 percent of it's cash flow, an obvious downer. In about a year income from the first of the five CDO's will resume and by about two to two and a half years all five will have resumed paying Alesco. If IMB survives all deferred payments will be made up. The fate of the dividend depends on whether Alesco stays a REIT or not. The next dividend announcement date is about 10 June. We should know something by then about future dividends.

Alesco will not go bankrupt. It has about $2.50 per share in cash, about $2.00 of it unrestricted. No principal on any of it's debt is due until 2012. No one can issue a margin call to Alesco. It will still have cash flow of about 10 to 15 cents a quarter.

This IMB situation came as a surprise. Just two or three weeks ago the IMB CEO assured the street that the preferred would be paid. IMB has about 800 million in cash and total preferred dividends are only about 7 million a quarter. To make a bad situation worse IMB is the largest exposure in Alesco's TruPS portfolios, about 2.4 percent of the total.

As I write this Alesco is 2.54, down another 39 cents. I intend to hold on but I invest on a many year time-frame. Over the next few days and weeks I have no idea what is going to happen. If I was looking at Alesco for a new investment I would buy some now. The risk-reward situation is very good. But the risk is high so I would make only a small investment and only if I was prepared to hold it for several years. The situation will be clearer after the dividend announcement in early June and the annual meeting on 18 June.

[ganc]

Roger, would not the situation for Alesco get tougher if one or more of the trust preferreds in its portifolio, other than the IMB trust preferreds defer dividend payments ?

Is there a good probability that such a scenario could occur ?

[Roger W.]

There have been 5 or 6 deferrals so far amoung the 320 plus firms Alesco has bought TruPS from. More would obviously hurt but IMB is the largest one of the 320 plus. The 8 CDO's are set up so that it takes about three percent deferrals or defaults to temporarily stop cash flow to Alesco. The latest from Alesco on Thursday is that it will be 4 of the 8 CDO's which stop payments to Alesco and the period will be 4 to 7 quarters. Remember the banks pay interest on their TruPS to the CDO's not Alesco. The CDO's then split it up amoung the tranche holders. When deferrals get too high payments from the CDO to the junior tranche (Alesco) stop for a period of time and go to the senior tranche. The CDO as a whole is still collecting a lot of interest payments.

Assuming there are a modest number of deferrals in the future Alesco is OK. If a large number of banks flat out default Alesco is in big trouble. So far there have been 5 or 6 (hard to tell) deferrals and no defaults. Ten percent of the TruPS are from insurance companies and none of them have deferred.

Thursday morning's low for Alesco was 2.16. At that point it was selling for less than cash on hand and near unrestricted cash on hand. 125 million unrestricted cash for 59 million shares. You do not see situations like that often.

[Jezme]

Roger, I am just beginning to look at these REITS. They look 'too good'. How would you compare AFN as an investment to RAS, RSO, and CSE? Or is there another one you prefer? Also, is it better to own these inside an IRA or as a regular personal investment?
Thanks

[Roger W.]

RSO and CSE I know little about. If I was putting new money into REIT's I think I would prefer RAS to Alesco right now. Both look good but RAS seems to have less risk.

Alesco's stock price will be to a great extent news driven for a period of time. If IMB finds a source of capital Alesco may pop 50 percent or more in a day. A couple more bank deferrals and it may be at a dollar a share. The committee looking at strategic directions may find a buyer for the company at double the current stock price. Alesco may become a liquidating trust. There are many possible developments that could make the stock price pop either way.

About the only development I can not see is bankruptcy. With 125 million in cash and no debt due for four years I just don't worry about that. But there are a lot of things, good and bad, that could happen in the next few months.

As far as IRA or regular account goes I would put Alesco in a regular account. Your IRA is for retirement. My preference would be to keep boom or bust stocks like Alesco out of an IRA.

[mhaas]

I heard rumor at one point that if Alesco de-reited they would be liable for some large sum of cash. Not sure why or if this is unfounded. Any idea? Would they become liable for taxes in 2008, is this why? I havn't a clue.

[User 7350]

For Roger W. You sound like your really into AFN. Have turned into a very POOR Long on this stock having averaged down TWICE. Are you hanging in there?? The future looks bleak!!? Would appreciate your take on it today. Chas