NewStar Financial (NASDAQ:NEWS) is a classic book value play. The stock trades at 0.6x book value while generating a 6.3% return on equity, "ROE", as of 4Q16. On December 1, 2016, NEWS sold its equipment finance platform for $105 million cash to Boston-based Radius Bank. The five-year old business was sold at a valuation of 1.2x book value. The sale price of $105 million is worth roughly a quarter of the NEWS's market cap, a chunk which was used to buy back 8.4% of shares outstanding. This divestment was a major component of management's ongoing efforts to shift away from less differentiated non-core lending in equipment and commercial real estate.
NEWS is a middle-market commercial lender and asset manager with $6.7 billion of AUM. On the lending side, NEWS lends $10-150 million directly to companies through senior secured credit facilities. Borrowers typically have $10-50 million in EBITDA. As of 4Q16, new loans yielded 6.65%. On the asset management side, NEWS manages $1.3 billion of middle market loans with Blackstone Group (NYSE:BX) via its credit division, GSO Capital. NewStar also manages $2 billion of assets via CLOs with non-investment-grade loans and bonds.
"The Commercial Lending segment represents our direct lending activities which are focused on providing a range of flexible senior secured debt options to mid-sized companies with annual cash flow (EBITDA) typically between $10 million and $50 million owned by private equity investment funds and managed by established professional alternative asset managers."
"The Asset Management segment represents our investment advisory activities which are focused on providing opportunities for qualified investors to invest in a range of credit funds managed by the Company that employ credit-oriented strategies focused on middle market loans and liquid, tradeable credit."
Thesis & Catalyst For NewStar Financial, Inc.
Good Capital Allocation
The company's ongoing initiatives should get NEWS back to book value per share, "BVPS", of $15.12 or better, which coincidentally keeps rising as a result of share repurchases. In 4Q16, NEWS repurchased 8.4% of its shares, paying $34.1 million for 3.9 million shares. Shares outstanding as of 4Q16 were 42.8 million, down from 46.7 million at 3Q16. 4Q16 BVPS grew 74 cents quarter over quarter from $14.7 to $15.12, driven by 23 cents of EPS growth and 51 cents from share repurchases. As of 4Q16, NEWS has $154.5 million of unrestricted cash.
"Our financial results reflected the progress we are making as pre-tax returns on equity exceeded 11% in the quarter. Revenue was up nearly 12% over last quarter and 46% from the same quarter last year. Credit costs remained within expected ranges. Loan demand from M&A activity rebounded and our investment pace returned to expected levels. Importantly, we returned $43 million, or 6.5% of our average equity capital, to investors in 2016 and recently declared our first quarterly dividend. The board's decision to adopt a quarterly dividend policy was intended to provide more balance to our capital management strategy, reflecting our commitment to improve the investment value of our stock."
NEWS is undergoing a transformation from a bank-styled, diversified commercial finance company into a specialized middle-market direct lender with a focus on managing assets for institutional investors. It has identified which traditional lending markets are too competitive, primarily because of banks (i.e. equipment lending/commercial real estate), and is instead focusing on middle-market private debt/leveraged lending. As of 4Q16, 53% of credit investments are held in NEWS managed funds; management fee income doubled in 2016.
NEWS is also slashing overhead while streamlining the company; run-rate operating expenses, "OPEX", are down a whopping 33%. Year over year, the company slashed headcount by 43%, from 122 full-time employees to 69.
"We made significant progress on our key priorities in 2016 as we took important steps to streamline operations, reduce costs and reposition NewStar as a credit-oriented asset manager, while also returning a meaningful amount of capital to our shareholders. We sold two non-core businesses at substantial premiums, increasing our liquidity and financial flexibility. We reduced baseline expenses by 33% on a run-rate basis as of the fourth quarter, improving profitability. And, we continued to expand our asset management activities with the launch of two new credit funds and a separate account with target investment portfolios of approximately $1 billion. More than 53% of our credit investments are now held in managed funds and we doubled our management fee income in 2016."
Variant View - Lending is a Risky Business
As implied by its business model, NEWS holds NPLs. As of 4Q16, 2.99% of loans were considered non-performing, up from 2.66% in 3Q16. The increase was related to a single loan being reclassified as non-accruing on a discretionary basis because the counterparty is undergoing restructuring.
For 4Q16, net charge-offs were $18.9 million vs. $33.0 million for FY16. This should stay relatively stable as a function of vintage and diversification. Most loans were originated in the past five years; 97% originated post crisis. The single largest obligor only represents 0.8% of loans outstanding, and the 10 largest obligors comprised 7.6%. The loan book is diversified not only by counterparty, but also by industry. As of 4Q16, industry mix of the loan book was Industrials 29%, Business Services 23%, Consumer 18%, and Financial Services 12%, and Other 18%.
4Q16 P&L was underwhelming from the credit front. As expected from a middle-market lender, net interest margins can swing. 4Q16 NIM was 1.96%, down from 2.50% QQ and 2.39% YY.
"Increase in portfolio yield was outpaced by higher interest expense due primarily to debt prepayment expenses, increases in LIBOR index rates and wider credit spreads on new CLO issuance."
Disclosure: I am/we are long NEWS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.