The following article was published on 05/30/2016 for subscribers of The Mortgage REIT Forum.
My current view on RSO remains the same as it was when I published this article for subscribers. As a quick note, RSO's book value so far in Q2 may have moved up some due to fair valuations on the assets. The critique on their business model and uses of cash remains highly accurate, in my opinion.
Resource Capital Corporation (NYSE:RSO) is one of the most complex mortgage REITs to analyze. That level of complexity can drive away most analysts and caused me to put the company on the back burner for research until I rolled out the subscription system. Without a subscription platform it simply doesn't make economic sense to dive deeply into these issues. RSO has a strong dividend yield, but few investors (or even analysts) can see deep enough into the mortgage REIT to assess the future of the organization. While RSO's external manager, Resource America, Inc. (NASDAQ:REXI), was acquired by C-III Capital Partners, LLC, the fundamental operations of RSO seem unlikely to be dramatically improved.
This article was prepared on the morning of 05/30/2016. It will be available to subscribers first.
What Does RSO Do?
Resource Capital Corporation invests in non-agency assets to earn a higher interest rate on each dollar of loans. The company also creates high expense levels that leave less cash for shareholders. This look inside RSO should make complex operations simple, yet it will be disheartening to any shareholder that believes there are better days just around the corner.
Normal Mortgage REIT Returns
By my estimate in this economic environment a mortgage REIT can reasonably hope to turn around 11% to 12% on book value before paying any operating expenses. This level of "pre-operating expense" return comes after any hedging costs and after paying interest expense. The logic here is fairly simple. It relies on the level of returns available to the typical mortgage REIT through the standard process of buying MBS and financing them at short term rates. If the securities create significant duration risk (agency MBS create some, non-agency MBS create very little) then hedging costs become necessary.
If a mortgage REIT uses more leverage to juice returns it generally requires more hedging. Remember that leveraged investing in bond portfolios is inherently a risky activity and the companies loaning funds to the mortgage REITs don't want to be taking on this level of risk themselves. Therefore, it is not feasible to use infinite leverage. When a mortgage REIT indicates that they have an asset class capable of producing leveraged returns in the "mid-teens" or "low twenties", they are talking about a heavily risky asset class. It is not feasible to use high levels of leverage and to build the portfolio exclusively out of these assets. If the portfolio is going to emphasize assets with credit risk, then leverage will be limited to a materially lower level.
Dividend Sustainability - Introduction
This section will use many rounded numbers. I encourage investors to remember the advice of Benjamin Graham. We do not need to know precisely how old a woman is to know she is old enough to vote. We do not need to know precisely how much a man weighs to know he weighs more than he should. While my calculations are done in a spreadsheet, there is a strong emphasis on finding opportunities where the risk profile is heavily skewed. These opportunities should have a clear conclusion even if the math were approximated by hand.
Dividend Sustainability - Equity
As of the end of the first quarter RSO had total shareholder's equity (non-controlling interest excluded) of about $789 million. Out of that $789 million, there was a total liquidation value to preferred shares of $285 million. If we value preferred shares at the liquidation value rather than the net proceeds from issuance, the result is only $503 million in common shareholder's equity.
Dividend Sustainability - Operating Expenses
Operating expenses in the first quarter were $16 million. As a percentage, that is 2.04% of total equity (including preferred shareholders). On an annualized basis that comes out to a little over 8%. If you're realizing that paying 8% in operating expenses in a sector where normal returns prior to operating expenses would only run around 12%, then you're catching the major flaw in this business model. If you think high operating expenses are necessary to run this kind of business, I suggest checking into Chimera Investment Corporation (NYSE:CIM) or MFA Financial (NYSE:MFA). Their operating expenses are running around 2.1% to 1.5% of shareholder's equity. I'm not speaking to the pricing of shares on those mortgage REITs; valuing them will be the topic of other articles. The point here is that mortgage REITs are capable of investing in credit sensitive assets without operating expenses devouring so much equity.
Dividend Sustainability - MSRs
RSO's assets include MSRs (Mortgage Servicing Rights). Investing in MSRs has been such a failure that American Capital Mortgage Investment (NASDAQ:MTGE) recognized their purchase of a "Servicer" was not working out and sold the servicer. They externalized the servicing function to the company they just sold and predicted the operating losses would stop by the end of 2016. While they ran the subsidiary it produced operating losses in each quarter.
Owning a subsidiary costs real money. It goes on the balance sheet and replaces assets that could have been more productive. A subsidiary that loses money quarter after quarter is creating a negative contribution to the sustainable level of dividends. The subsidiary, PCM, had operating expenses of over $30 million in 2015. If you want to believe that this investment is a home run that allows RSO to generate stronger returns, you'll have to believe that they can run this kind of business vastly better than MTGE. I find that idea absurd.
Dividend Sustainability - Clear Language
To preface this section, I want to emphasize that "equity" will refer to the combination of both preferred shareholder's equity and common shareholder's equity unless otherwise stated. I have attempted to remove the impact of non-controlling interests. The non-controlling interests are small enough to be relatively immaterial, but for accuracy sake I aim to be specific in defining each term. If we do not have clarity about the meaning of words, then discussion is pointless.
The operating expenses for Q1 of 2016 were lower than one quarter of the total operating expenses for 2015. Taking operating expenses and dividing by total ending equity gave us 2.04% for one quarter or 8.14% on an annualized basis (rounding error). In 2014 the operating expenses were 6.95% of ending equity and in 2013 the operating expenses were 7.88% of ending equity.
In 2015 they were 14.62% of ending equity, but they were much higher because the company recognized a huge impairment loss during the year. The average operating expenses relative to the ending equity for each year was 9.82% over that 3 year period, so I believe 8.14% as an assumption is on the light side.
Dividend Sustainability - Priorities
Who gets the first rights on receiving cash from the company? If you picked an answer other than "management", you can go back and change your answer. Operating expenses, including money paid to management, gets paid first. Preferred shareholders get paid after that. Common shareholders get whatever crumbs remain. The current yield doesn't look like crumbs, but economically it looks like a return of capital to me.
As a quick note, I am not including companies that loan money to RSO in this example. I am only looking at the capital that remains after the repurchase agreements are executed.
Dividend Sustainability - Quarterly
I'll simplify everything down to Q1 of 2016 to make these numbers easy. If we assume that RSO could reasonably generate 12% on equity before expenses, then we would reach a "pre-operating expense" estimate of $24.566 million (note the decimal place, values will be in millions with decimals). The operating expenses in the first quarter were $16.051 million. Preferred dividends were $6.048 million. If the mortgage REIT only generates 12% on equity before operating expenses, how much does that leave for common shareholders? Subtract out the operating expenses and preferred dividends and you get $2.467 million. On the balance sheet date there were 31.217 million shares outstanding.
Dividing the $2.467 million left for common shareholders by the 31.217 million shares outstanding leaves $.08 per common share for common dividends. That doesn't sound so great when you consider that the last quarterly dividend was $.42. Back in 2014 the quarterly dividend was $.20, but that as before a "1 for 4" reverse stock split. Adjusted for that reverse stock split the quarterly rate in 2014 would've been $.80.
I don't expect management to immediately move to cut their common dividend to $.08 per share, but I don't believe it will be maintained at $.42 either. If the quarterly dividend were maintained at $.42, it would result in liquidating the company within the next decade. Within the next few quarters I expect the dividend to get slashed. I believe a slash in the dividend will trigger another selling event.
Annual Dividend Sustainability
The following chart should make this fairly easy to interpret on an annual basis:
The first quarter figures for each expense were multiplied by 4. The estimated annual net interest income is reached by applying a 12% rate to total equity.
Was 12% A Fair Estimate?
By my math 12% on book value seems reasonable, but is it really fair? If investors check the 10-Q for Q1 of 2016 they will find the net interest income (this is before operating expenses) was $24.326 million. That seems fairly close to my rough estimate of $24.566.
Will Investors Bet on C-III Capital Partners?
Do investors believe that C-III Capital Partners bought REXI so they could reduce the fee income REXI generates? That would be a very strange strategy for investing. I can't see any logical argument for fees to suddenly become dramatically lower.
Will RSO be able to sell off their lending segment that generates a substantial portion of their total operating expenses? That might be possible, but MTGE had to take some material impairment charges when they sold theirs. How would the market respond to that kind of loss in book value?
Should Operating Expenses Exceed Common Dividends?
In the first quarter of 2016 the cash for common dividends came to $13.073 million. That sounds like a ton, but it is rare to see a mortgage REIT with less cash going to common dividends than operating expenses. As a reminder, operating expenses were $16.051 million.
For comparison, MFA Financial reported $14.459 million in operating expenses during the first quarter. Their dividends declared on common stock came to $74.215 million.
Working on a Pair Trade
I'm putting in some hours working on a pair trade to capitalize on the expected damage to RSO's common shareholders. The shares ended last week trading at about 73.83% of trailing book value. That is one of the largest discounts in the mortgage REIT sector so the pair trade has to be designed carefully to mitigate the risk of the market bidding up shares in the short term. I think the pair trade suggestion may surprise many readers.
I'm avoiding mentioning the other half of the pair trade here because I expect to publish this article publicly after a dividend cut. I'm also still working on the due diligence for the pair trade opportunity to ensure that I'm comfortable suggesting the trade.
RSO is a mortgage REIT with a complicated investment strategy that emphasizes credit risk. Because of the complexity of their operations there are few analysts that are both capable of digging into the mortgage REIT and eager to do so. Even if an analyst digs into the company, few analysts are willing to publish a scathing review.
I believe the common dividend is unsustainable and is primarily serving as a return of capital to shareholders regardless of the way dividends are characterized for tax purposes in any given year. Shareholders that are long in the common shares of RSO as a long term investment are putting themselves in a position to dramatically underperform the sector. I expect the dividend to be slashed and the share price to be punished. Due to the market becoming less concerned about credit risk during Q2 of 2016, the book value figures for RSO might look better at the end of the quarter if the current optimism continues. A single quarter of better performance should not be seen as reversing a fundamentally losing proposition.
I expect long term underperformance by RSO so it easily warrants a rating of strong sell. Because the discount to book value is so large it doesn't make sense to use it as a short target until the right hedge is selected. I'm working on putting together a viable pair trade. RSO closed trading on 05/27/2016 at $12.64.
At the time of publication to subscribers the share price was still within a few cents of that level.
I believe it will be very rare for me to establish a "strong sell" rating on a mortgage REIT that is trading around 74% of trailing book value.
Things I Might Buy
I referenced MFA and MTGE in this article. I am interested in the preferred shares of both of those mortgage REITs if the right price is available. I may leave buy-limit orders on those preferred shares that could be triggered if a liquidity event drove the price down. I'm also contemplating the common shares of MTGE.
There is currently a two week free trial and 50% off for the first 100 subscribers. Each subscriber automatically locks in their price against any future increase, so even when prices go up the subscriber maintains their discounted price for as long as they keep the subscription. With the 50% off, subscribers can sign up for only $240/year, which comes out to $20 per month.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MTGE, MTGEP, EITHER PREFERRED FROM MFA over the next 72 hours.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.