This article was published for subscribers on 08/01/2016 during market hours.
I owe a "thank you" to a subscriber for encouraging me to review ZAIS Financial (NYSE:ZFC) again. I often criticized ZAIS for the way their buyout was structured. I referred to it as the worst of the buyouts, which I still consider a fair assessment. However, the share price of ZFC has been suffering, and as an incredibly tiny REIT with uncertainty regarding the merger and a lack of professional coverage, the share price can deviate materially from estimates of intrinsic value.
Warning on Tickers
Don't confuse ZAIS Financial Corp. with the ticker ZAIS. That is an affiliated company.
Following the expected merger (if it occurs, medium high probability), the company will be renamed "Sutherland Asset Management Corporation" and trade under the ticker "SLD". The new mortgage REIT would be primarily focused on commercial mortgage operations, which is the major area of operations for Sutherland. The company would be externally managed by Waterfall Asset Management, LLC. I don't care for another external management structure, but that part of the deal isn't bad enough to make me overlook an otherwise appealing opportunity.
ZFC structured a merger with Sutherland. The deal will create a new company but it will also allow shareholders to opt to receive cash instead of shares in the new company. The total volume of cash available is limited, so if the tender offer is oversubscribed then shareholders will get a mix of cash and shares in the new company. I'm not particularly interested in the new company, but the tender offer (even after a 5% fee for taking the option) represents a very attractive return.
The following table calculates the adjusted book value per share for the merger.
However, this deal was set up with a fairly strange method that involves creating other metrics like "further adjusted book value per share". I ran through those calculations as well.
To get to the further adjusted book value per share, investors need to adjust for three additional costs. One is labeled "mystery expense". There is currently no expense associated with it, but management has indicated that other expenses could be incurred.
Based on the expectation that ZFC would own 23.88% of the combined company, their share of additional costs come to $.32. That brings the "further adjusted book value" to $16.80. Since the tender offer is supposed to be priced at 95% of the final book value, the estimated amount of the tender offer would be $15.96. My calculations matched the values management provided in their June presentation:
ZFC's latest share price is $13.68. If an investor bought at that price and was able to take the tender offer for all of their shares at $15.96, it would mean a return of 16.65% (before transaction costs).
The weak share price reflects several uncertainties.
The most notable issues could be that the shareholder felt ZFC had over $16.00 per share in cash and liquid assets. Management's response on the topic is largely, "our assets are not that liquid". They make some strong arguments for the new combined company trading at a much smaller discount than ZFC, though ZFC has to lose quite a bit of book value (primarily in adjustments) to make it work.
The Performance Issue
All the values used for estimating book value come from the end of the first quarter. Since ZFC is taking on substantial risk and the market viewed risk very favorably, I believe their book value may have performed reasonably well (excluding transaction related costs).
They issued a press release indicating that they sold a large chunk of their portfolio.
From that press release, we know that the loans carried a UPB (unpaid principal balance) of $430.7 million and that they were sold for $362 million.
That was followed by an announcement clarifying that the pool of loans that were sold included loans that had already been written down to $0 in asset value.
Since ZFC indicated that their loans were not very liquid and they wouldn't have been able to distribute all the cash shareholders would want in a liquidation, I really wanted to know more about the assets. The portfolio is heavy on level 3 securities:
When a mortgage REIT agrees to sell themselves for substantially less than their book value, that concerns me. When I see tons of level 3 allocations, that also concerns me.
The following table breaks down the assets by the UPB (unpaid principal balance) and calculated fair value:
I added a green box around the positions that were listed as "held for sale" but were previously "held for investment". The sale of certain assets was a requirement for the transaction to go through. After the sale to Citigroup Global Markets Realty Corporation, a substantial portion of the proceeds were used to close out a repurchase agreement with Citibank N.A. It should not be too surprising that Citibank was involved in both transactions. Since they were the one loaning on the portfolio, they should already have completed some work on assessing the value of the portfolio.
Note that the sale indicated $430.7 million in UPB, but the chart shows $411 million. My theory is that the assets written down to $0 (with UPB of $27 million) may have been excluded from the prior charts since they were "worthless". That would make sense with the timing of the transaction as well. Management had estimated this portion of the portfolio to be worth $368 million. If Citibank agreed and offered to pay pennies on the dollar for the "uncollectable" accounts, the purchase price would match nicely. I searched through the filings looking to confirm this, but couldn't find confirmation. If I contacted the company, they would be unlikely to respond. If they did respond, it would be material non-public information. Consequently, nothing positive can come from asking.
The biggest concern for shareholders might be the idea that the mortgage loans held for investment, UPB of almost $32 million, could have been included. The disclosures don't match that theory. The press release specified:
"On May 26, 2016, ZAIS Financial Corp. (the "Company") entered into a contract providing for and completed the sale of certain seasoned, re-performing mortgage loans with an unpaid principal balance of $430.7 million to Citigroup Global Markets Realty Corporation ("CGMRC") for $362.0 million."
These loans were classified as being both seasoned and re-performing. The loans that were still classified as "held for investment" at the end of the quarter were further described in the 10-Q filing:
Newly originated loans, by definition, are not seasoned or re-performing.
In a Nutshell
I see the sale to Citigroup as a favorable development that increases the probability of the merger going through. Further, I believe it supports my opinion that the value of the portfolio should have performed reasonably during the quarter.
The large position in MSRs (mortgage servicing rights) should have weak performance since the end of the first quarter, but not as terrible as it was in the first quarter. Credit sensitive positions should have performed decently. The high operating costs combined with the dividend should weigh against book value. On the net, I am figuring values won't be too different from Q1.
Which Book Value Do I Watch?
As a reminder, the "book value" I care about is the estimate of the "further adjusted book value" since the tender offer price is driving my analysis.
One of the major reasons ZFC had a difficult time finding a buyer was their ownership of a subsidiary. The subsidiary is GMFS. GMFS is subject to a tolling agreement, which prevents ZFC from effectively stripping all the equity away from it. SLD would have substantially more equity, so SLD would be better able to absorb the risk of litigation.
How Much is SLD Worth?
That is one of the major questions. The estimated starting book value per share for SLD should be in the ballpark of $16.80 per share as of the last presentation. The value investors use for this should be the same as the "further adjusted book value" I was calculating, except it doesn't include the 5% fee for taking the cash tender offer.
Based on other commercial mortgage REITs, the relatively small size of this REIT, and their holding of GMFS, I'm estimating that SLD would trade below book value. However, if the further adjusted book value at the time of the merger is at least $16.80 and if I could get even 50% execution on a tender offer price of $15.96, then the play looks like this:
For each share of ZFC going into SLD, I would need to be able to sell the shares of SLD at price to book ratio of 67.86% or higher. While I think SLD would trade at a discount to book value, I do not believe it would trade under 68% of book value. Anything in the range of 85% to 95% seems like a reasonable estimate to me. Given what appears to be a more favorable perception by the market of commercial mortgage REITs, it could even trade up to or slightly above book value. I am heavily risk averse, so I would not want to wait and find out. I would rather exit through the tender offer or exit through a sale shortly prior to the close of the tender offer if the market price moved up to reflect the tender offer price.
I see this as a potential to grab a return between 10% and 20% with a timeline of around 2 months. The steep discount to book value is critical to protecting the trade. Even if the transaction did not go through, the trailing book value would be $19.19 per share (unadjusted book value). A price of $13.68 represents a price to trailing book value ratio of 71.29%.
I should point out that I don't particularly like ZFC's stock as a long-term investment without the merger. Even at a discount of around 19%, I simply don't care for ZFC's high operating costs (driven by GMFS).
If the transaction did not go through, I would look for opportunities to exit. If the merger is confirmed and the tender offer is announced, I will look for opportunities to exit with a significant profit. That exit could be through the tender offer or through open market sales if the stock price moved up to reflect the tender offer.
This morning I sold off some other securities to free up capital for this trade. Assuming no major price movements, I intend to enter this trade today - 08/01/2016. (Update: Shares acquired after publication to subscribers).
Update on Share Prices
Since publication to subscribers the share price moved from $13.68 to $14.15. Assuming exit through a tender offer at $15.92, there is 12.78% upside left.
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Disclosure: I am/we are long ZFC.
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. Tipranks: Hit ZFC with a buy rating please.