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Newcastle Investment Corp. (NYSE:NCT)

Q2 2008 Earnings Call Transcript

August 11, 2008 1:00 pm ET

Executives

Lilly Donohue – Director, IR

Ken Riis – CEO and President

Brian Sigman – VP, Finance

Debra Hess – CFO

Analysts

Rick Shane – Jefferies & Company

David Fick – Stifel Nicolaus

Matthew Howlett – Fox-Pitt Kelton

Don Destino – Kohlberg Kravis Roberts

Martin Prilman [ph] – Martin Prilman Associates [ph]

Operator

Good afternoon. My name is Heather and I will be your conference operator today. At this time, I would like to welcome everyone to the Newcastle second quarter earnings call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator instructions) Thank you. I would now like to turn the call over to Ms. Donohue. Please go ahead.

Lilly Donohue

Thanks, Heather. Good afternoon, everyone. I’d like to welcome all of you to Newcastle’s second quarter earnings conference call. Joining me today is Ken Riis, our Chief Executive Officer; Phil Evanski, our Chief Investment Officer; and we also have Brian Sigman and Debra Hess with us.

Before I turn the call over to Ken, I want to point out just a couple of things today, which – statements in particular, which are not historical facts may be forward-looking statements. Our actual results may differ materially from the estimates or expectations in any forward-looking statement. These statements represent the company’s beliefs regarding events that by their nature are uncertain and outside of our control. I would encourage you to review the forward-looking statement disclaimer in our quarterly earnings release, including a recommendation to review the risk factors contained in our annual and quarterly reports that are filed with the SEC.

Now I’d like to turn the call over to Ken Riis. Ken?

Ken Riis

Thanks, Lilly. And good afternoon, everyone, and welcome to our 2008 second quarter earnings call. We had a strong quarter with respect to our operating income results of $0.52 and our adjusted book value increased $3.73 to $20 per share at the end of the second quarter. However in the quarter, we did take further impairments, which Brian will walk through in more detail later in the call.

What I want to focus on is we continue to make significant progress towards strengthening our balance sheet. As we have talked on the last few calls, our main focus has been on two things; increasing liquidity and reducing recourse debt. I’m happy to report that we made good progress in the second quarter relating to these two things. We currently have unrestricted cash of $170 million on our balance sheet, a $69 million increase from the end of the first quarter. Recourse debt was reduced by $57 million in the quarter, and non-agency recourse debt now totals $330 million.

So, why is this important? It’s important because in this environment, liquidity is a premium and financing is scarce. Our liquidity premium is – our liquidity position is strong and getting stronger. And we are focused on reducing our non-agency recourse financing risk further before we aggressively utilize our capital to make new investments. To date, what we have been able to do is take advantage of our $4.1 billion of CDO debt that is non-recourse to the company. These financings offer tremendous value as they are long-term with an average life of 5.7 years and were issued at very low funding costs of 40 basis points over LIBOR.

Let me give you an example of why this is so valuable. At the end of the first quarter we had restricted cash in our CDOs of $54 million. And in the second quarter we had $36 million of asset prepayments that were yielding 8%. We reinvested $63 million of our CDO cash in new assets with an average yield of 11.5%. Even though this investment activity was relatively small for us, it will generate $0.06 per share of additional income annually for the company. These opportunities will continue in the coming quarters as we expect further prepayments in the future and I’m very excited about the opportunities we have to invest this restricted cash in the coming quarters.

Finally, as you may have seen in our recent press release, I’m pleased to welcome Brian Sigman as our new CFO effective August 13. I’m delighted to welcome him to his first results call. On behalf of the entire Newcastle team, we want to thank Debra Hess for her leadership, dedication and hard work over the last five years. I’m sad to see her go and wish her the best in her new job opportunity.

I will now hand it over to Brian to take you through the second quarter numbers in more detail and then I will come on and give some closing remarks when he’s done. Brian?

Brian Sigman

Thanks, Ken, and good afternoon. Really excited to be here today. As Ken just walked through our assets and liabilities, I’m going to focus on our shareholders’ equity and the financial results for the quarter. As Ken mentioned earlier, our adjusted or FAS 159 book value increased $3.73 per share to approximately $20 per share or $1.1 billion at June 30. We think this is a better way than GAAP to measure our financial worth as our adjusted value marks all of our financial assets and liabilities to fair value.

The increase in our adjusted book value was primarily due to three things; the timing of credit spreads in our CMBS portfolio, income we generated in excess of dividends we paid, and a decrease in the value of our CDO liability. We disclosed this breakout of amounts used to calculate the adjusted book value in footnote six of our 10-Q.

On to our income. In the second quarter, operating income, net of the preferred dividends, was $0.52 per share. We also earned $0.07 per share of net non-recurring income, including the following three items. One, $0.12 per share of realized gain from the sale of assets in the quarter. The bulk of this gain is included in equity and earnings on the income statement. Two, $0.04 per share of income earned on consent fees, exit fees, and loan resolution. And offset by three, a loss of $0.10 per share, which represents our entire loss on our operating real estate assets that were sold in July, but classified as held for sale at June 30. This loss is included in discontinued operations on the income statement. By combining the above operating income, the net gain on sales, and other income, we earned $0.59 per share before any impairment.

Now let’s talk about the impairments. This quarter we booked impairment charges of $119 million. The four primary drivers of the impairment were; one, $69 million on our subprime securities portfolio primarily related to the 2005 vintage and resulting from lower projected cash flows discounted at a 15% yield. Two, $33 million on our two subprime residual interests resulting from increasing our default and severity assumptions in our first portfolio and slowing the prepayment assumption in our second portfolio, both discounted at a 20% yield. Three, $11 million charge on a B-Note that is secured by residential land. And four, a $6 million charge that is isolated to two specific corporate bank loans. Adding the above components gets us to our net FFO loss for the quarter of $88 million or $1.66 per share.

With that, I’ll turn it back over to Ken.

Ken Riis

Thanks, Brian. We are not happy with the impairments this quarter. What we’ve done though is written down the value of our subprime investments to a level where they offer pretty good relative value as we go out to buy – making investment today, we definitely want to buy these assets at our basis today. So – even though we are disappointed with our impairments, I feel pretty good about where we are today related to that part of our balance sheet and our portfolio.

During the first two quarters, we have been pretty conservative with our balance sheet, fortunately being relatively passive on the acquisition side and aggressive with asset sales has been fortuitous for us as credit markets have continued to be volatile and asset prices have been pretty much in decline for most of 2008. Today liquidity in the capital markets is at an all-time low and credit spreads have widened dramatically creating good opportunities for us. Today I believe that spreads on assets we invest in are so wide and priced so conservatively that the upside now outweighs the downside. Also our CDO liabilities are trading at very low dollar prices and so far this year have been – we’ve been able to buy back $24 million of our debt, realizing $16 million of value for our shareholders, but there is a lot more to do.

Our stock is trading at a price that offers the most accretive use of capital, but up until now, we have resisted reducing our capital base, which has been the prudent thing to do. The current market gives us a lot of opportunity to increase value to our shareholders. That is why we are keenly focused on executing our current initiatives to position us in the fourth quarter to be more aggressive on the investment side with our capital.

With that, I’ll turn it over to the operator for any questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Rick Shane with Jefferies & Company.

Rick Shane – Jefferies & Company

Hi, guys. In terms of – strategy has varied over times in terms of what types of asset gathering opportunity you guys would go after. Right now, where do you see the best opportunity? What’s the most interesting to you?

Ken Riis

Right now in terms of relative value, I think that the residential market and debt securities offer very good value I know. And in the quarter we did purchase some residential assets that are highly rated, AA+ on average, at very high returns. And currently today I would say that the residential senior bonds, AAA or AA rated, offer the best relative value. So –

Rick Shane – Jefferies & Company

Are those investment grade securities backed by prime mortgages, Alt-A mortgages, subprime mortgages? And if you could give us some sense of sort of what the credit enhancement underneath those? And again, I don’t think AAA per se means AAA any more, but if you could give us some sense as to what types of credit enhancement levels you are getting, what sort of discounts you are paying so we can get a sort of cash-on-cash kneeled [ph] to maturity and also some sense of how much credit you could absorb and still hit those thresholds?

Ken Riis

Well, I can give you an example of what we purchased in the second quarter. They were eight different securities backed by subprime and option ARM collateral. We invested $39 million, and the average dollar price was $0.61. The average rating was AA+, as I mentioned. And the average credit support I think was around 25%.

Rick Shane – Jefferies & Company

And that’s with the existing losses in the pools or was that inception?

Ken Riis

Yes, that was at the current subordination level is.

Rick Shane – Jefferies & Company

Okay, great. Perfect. We’ll sit and run the math, and we appreciate the help. Thank you, guys.

Ken Riis

Okay.

Operator

Our next question comes from the line of David Fick with Stifel Nicolaus.

David Fick – Stifel Nicolaus

Good morning. Can you walk us through what currently composes your bank loan portfolio, your loan portfolio and your corporate loan portfolio? What charges were there?

Ken Riis

All you want to know is the impairment charges?

David Fick – Stifel Nicolaus

What composes the portfolio at this time, if you can give us any details?

Ken Riis

Well, what we did, we have – in our press release we outlined our corporate loan portfolio. I think that’s what I would refer you to in terms of the overall portfolio. As it relates to the two bank loans that we wrote down, Brian, why don’t you give a high level on that?

Brian Sigman

Yes, there were two bank loans – two senior bank loans, and we took a charge of $5.6 million. And at this point we’ve written our basis down to about $17.5 million. And we think that reserve –

Ken Riis

In those two investments.

Brian Sigman

Yes, in those two investments, and we think our reserve is adequate.

David Fick – Stifel Nicolaus

Okay. On your commercial real estate portfolio, can you – you have a 65% LTV at this point. I assume that that’s based on current. How many loans or what portion do you have that are 90% or greater in your current assessment of LTV?

Ken Riis

Are you referring to sort of the mezzanine B-Note home loan portfolio?

David Fick – Stifel Nicolaus

Your entire real estate portfolio, yes, including the mezzanine.

Ken Riis

Yes. Most of what we have in the commercial side, obviously, we invest sort of higher up in the capital structure. So right now we actually don’t have anything over 90% LTV based on sort of original underwriting. There are most probably about $100 million in assets that are probably close to 90% if you look out on the current values today. So, not a significant portion in sort of the plus 90% LTV.

David Fick – Stifel Nicolaus

Okay. And which assets were revalued this quarter to produce the increase in the rate [ph]?

Ken Riis

It’s our overall investments held for sale. It’s $4.1 billion of securities that we mark-to-market every quarter. And that’s what resulted in the increase in book value. Also in marking to market the liabilities, all of our liabilities – so we mark all of our assets and all of our liabilities. The adjusted book value changed a little bit more than our GAAP book value and that was a result of a decline in the price of our liabilities that we’ve issued.

David Fick – Stifel Nicolaus

Okay. And then lastly, do you have any current sense of your taxable income to book income reconciliation of where you might come out on the year, as well as where you think your dividend is going forward?

Debra Hess

Yes. We don’t actually give any guidance about our taxable income. What I could tell you is what we’ve said consistently, which is we may intend to make distributions such that we meet our redistribution requirement. What I would tell you is, as we get closer to the end of the year, we probably would have a better idea of that information.

David Fick – Stifel Nicolaus

It’s pretty important information and I would think that it would be good if we could try to get something out there. Even though you don’t give guidance, obviously people are trying to invest partly on the basis of how reliable the income is going forward. Thank you.

Ken Riis

We will adjust that on the next call.

David Fick – Stifel Nicolaus

I appreciate it. Thank you.

Operator

Our next question comes from the line of Matthew Howlett with Fox-Pitt Kelton.

Matthew Howlett – Fox-Pitt Kelton

Thanks for taking my question. Just a follow-up on the taxable income side, do the impairments impact actual income? Outside the core number, does that influence the actual number that you declare for taxable income?

Debra Hess

It’s possible, it may. But it may or may not. It is obviously a big driver of taxable income.

Ken Riis

We are in the process of evaluating that. And that’s why we are a little bit vague on the issue right now. But there is a chance that impairments will reduce taxable income depending on which assets you impair. So we are going through that analysis right now.

Matthew Howlett – Fox-Pitt Kelton

Okay. Okay, great. And then just on your plan to reduce recourse debt going forward – and I’m obviously more concerned with the recourse debt against credit risk assets, not the agencies. But what’s the plan going forward? I mean, what’s the pace you can do it that or you’d like to do it that? And at what level do you feel comfortable at?

Ken Riis

We are very engaged. We are very focused on that part of our business. And what I can tell you is that we have several initiatives in place. We are going to have some assets paid down, we may sell some assets, but the net effect will be that we feel that by the fourth quarter we’ll be in a very good position. And we’ll then look to really start aggressively deploying our capital in the marketplace. And I will say that there are a lot of opportunities right now. I don’t think those opportunities will go away over the next few months. But I think that by the fourth quarter we are in good position to take advantage of these opportunities.

Matthew Howlett – Fox-Pitt Kelton

And when you say deploying your capital, will you be deploying your capital and assets using no leverage, no securitizations, no term facilities, just sort of buying bonds and loans?

Ken Riis

Yes. What we could do is we can buy back debt. We could buy back assets unleveraged or with a moderate amount of leverage and earn pretty high returns. Buy back stock. There are several opportunities for us to – that are accretive to shareholders and create value. So those are the just three things that we are looking at. And what we mean by deploying capital is, as we get capital returned to us either through prepayments or asset sales, what we’ve done to date is retained it as cash on our balance sheet, so – or paid down debt. So I think in the fourth quarter we’re positioned to do something other than keeping it as cash on our balance sheet. And we can use it for more accretive investment opportunities.

Matthew Howlett – Fox-Pitt Kelton

Fine, got you. Okay, great, thank you.

Operator

Our next question comes from the line of Don Destino with Kohlberg Kravis Roberts.

Don Destino – Kohlberg Kravis Roberts

Hi, Ken.

Ken Riis

Hi, Don.

Don Destino – Kohlberg Kravis Roberts

Two quick questions for you. One, just little bit more on the cash. When you look at the $170 million in unrestricted cash and then I’m sure you run kind of liquidity stress test models, how does that $170 million come out when you stress test, for example, that – well, all of the assets that are funded on recourse lines?

Ken Riis

I would say that – we look pretty good actually. I mean, it’s a very manageable – our financings currently are very manageable. It’s not at a place where I would feel comfortable deploying it aggressively, but our recourse debt position, a lot of it is agency – on agency securities, which are highly liquid. So if you focused on just the $330 million of recourse debt on our non-agency securities, that is where I focus on the stressing of prices et cetera. And I feel very comfortable with where we are right now.

Don Destino – Kohlberg Kravis Roberts

Got it. And then could you talk just a little bit about where you ended the quarter in terms of kind of an operating earnings run rate after the impairments, after the asset sales and the acquisitions, where we ended up kind of on July 1st?

Ken Riis

Yes – Don, it’s a tough one for us because we don’t give earnings guidance. But I guess the only thing I could say is that I think that our dividend at $0.25 to the – well below our operating earnings, even on sort of a going forward run rate basis. And –

Don Destino – Kohlberg Kravis Roberts

How about directionally? I mean, was there anything in the – to what extent did the impairments affect the rate at which you accrue earnings on those assets going forward?

Ken Riis

Yes. Our impairments do reduce the earnings that we book on the assets that we impair, and –

Don Destino – Kohlberg Kravis Roberts

So would it be safe to say that whatever the – if we stripped everything out and came out with a true kind of recurring operating earnings for the second quarter, that the run rate on the first day of the third quarter was below that considering the impairments?

Ken Riis

Yes.

Don Destino – Kohlberg Kravis Roberts

Okay. That is it. Thank you.

Ken Riis

Yes.

Operator

Our final question for today comes from the line of Martin Prilman [ph] with Martin Prilman Associates [ph].

Martin Prilman – Martin Prilman Associates

Hi. You threw out a couple numbers and I wasn’t able to jot them down fast enough. You said you repurchased $16 million in debt and the profit on it was $24 million?

Ken Riis

No, what we did in the first two quarters of this year is we repurchased $24 million of our CDO debt and realized a $16 million gain in doing so. Meaning that we bought the assets at a very deep discount to when they are originally issued. So that generated $16 million gain.

Martin Prilman – Martin Prilman Associates

Right. Thank you.

Operator

That was our final question for today. Are there any closing comments?

Lilly Donohue

Well, thanks everyone for joining us this afternoon. If you have any follow-up questions, just give us a call. And again, we’ll talk to you next quarter. Thanks.

Operator

This concludes today’s Newcastle conference call. You may now disconnect.

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