- NRZ has sold off with the market allowing for some new shares to be acquired at opportunistic yields.
- The Shellpoint acquisition may be the future of their growth strategy adding new servicing capabilities in addition to UPB.
- The non-agency market is likely dormant for them given float constraints but should provide a multi-year tailwind.
- The business model has many hedges to higher interest rates that should protect earnings as the long-end of the curve rises.
- The dividend is well covered by core earnings and even embedding no growth to the payout, the shares are cheap.
New Residential Investment Corp. - (NRZ)
NRZ recently issued its fourth quarter earnings and held its quarterly conference call. We thought it would be an excellent time to revisit the idea as it conducted some actions in the last few months and in light of the recent market volatility. For 2017, the shares returned 26% on a total return basis and it increased its dividend twice.
Shares of NRZ have fallen greater than the market as anything that is a yield-play has been clobbered. REITs have suffered the most since the start of the year after a terrible last year. NRZ is clearly lumped in with those securities and assets given that it is a mortgage REIT, albeit one with unique features. In fact, NRZ is so unique that it is virtually impossible to recreate another business like it today.
Fourth Quarter Review
- Acquisition of Shellpoint Partners - On November 29, 2017, NRZ announced an agreement to acquire Shellpoint Partners, a vertically integrated mortgage platform with origination and servicing capabilities. The cost of the deal was $190 million, net of financing. The purchase netted NRZ $8 billion UPB of Fannie Mae and Freddie Mac MSRs from Shellpoint in January 2018.
- Mortgage Servicing Rights ("MSRs") - NRZ acquired MSRs totaling $32 billion UPB for a total purchase price of $307 million. It also priced two fixed rate MSR notes in January and February of this year, totaling $930 million, at a weighted average cost of funds of ~3.6%.
- Non-agency securities and call rights - During the quarter, NRZ continued to accelerate the execution around its deal collapse strategy by executing clean up calls on 36 seasoned non-agency residential mortgage-backed securities with an aggregate UPB of $1 billion. Subsequent to the end of the fourth quarter, it completed another $727 million non-agency loan securitization.
- Servicer Advances - NRZ continued its focus on lowering advance balances during the quarter. Advances declined to $4.1 billion in the fourth quarter, down ~31% compared to last year.
We continue to monitor its portfolio, which is a measure of how much roll off it is seeing versus how quickly and cost-effectively it is replenishing the book. In this quarter for the first time, it broke out residential versus consumer loans. In the quarter, it added $15 billion of UPB from Shellpoint but also another $17 billion of MSRs from other counter-parties.
(Source: Investor Presentation)
Servicer balances (second line on the table in the chart above) continue to decline. On the call, management noted that it also paid Ocwen $280 million to acquire the remaining rights to MSRs on its legacy non-agency portfolio of $87 billion. It also priced two non-agency securitizations backed by MSRs. Total cost of funds on the two securitizations was 3.6% on a weighted basis, which proves the strength of the model.
As we detail below, it deployed capital into new full MSRs and excess MSRs at large discounts to par. The excess MSRs were purchased from Ocwen last year at a significant discount.
Core earnings rose to $2.83 per share in 2017 compared to $2.14 per share in 2016, an increase of 32%! In the fourth quarter, net income per share rose to $0.93 but core earnings fell three cents to $0.61 sequentially. The decline was due to a drop in the fair value of the investments in mortgage servicing rights compared to the third quarter.
The business isn't really valued using EPS but from book value, and to some extent, dividend yield. Total assets rose to $22.2 billion at year end, up from $21.4 billion in the third quarter. Book value per share increased to $15.26, from $14.87 three months ago, for an increase of 2.62%.
The Shellpoint acquisition adds new capabilities and verticals to its mortgage servicing and origination businesses. Its originator is New Penn Financial which has annual origination volume of ~$6.6 billion. In addition to the UPB that NRZ nets, it has a title appraisal business (Avenue 365 and eStreet) with appraisal volume of 20K units.
(Source: Investor Presentation)
The platform that it acquired complements its existing platform and portfolio of investments like its non-agency MBS. The origination and recapturing of its mortgage servicing rights provide additional optionality to earn returns on capital. In addition, the addition of more servicing capacity allows the company growth potential.
The acquisition was surprising given how conservative it is - though some of the last few of UPB purchases were thought to be a bit expensive. Management noted that the current investing climate "is not great" and that "the abundance of capital is causing most asset classes to be fully priced." The firm attempts to target a mid-teens return on all of its investments.
In total, it deployed $3.3 billion of capital in 2017, with $1.6 billion related to servicing related investments including Shellpoint. Another $700 million was deployed into its bond portfolios in residential mortgage-backed securities. Lastly, it invested $917 million in residential and consumer loan origination and acquisitions. Much of the investment in the last year revolved around servicing with some new UPB to boot. It also called a lot of deals, more than $4.7 billion worth which is the highest amount of deals it called since starting the call strategy.
(Source: Investor Presentation)
Management's capital deployment track record is commendable. In 2014, it redefined its core business to focus on MSRs, Advances, and its call strategy. In doing so, it refinanced its $2.6 billion SpringCastle consumer loan portfolio. The move helped unlock a significant amount of capital that was then used in subsequent UPB purchases from various third parties. The largest deals were in 2015 when it acquired HLSS for $1.4 billion which doubled the size of NRZs servicing business. When it conducted that purchase, it also bought $145 billion of call rights from Ocwen. This was a start of a $170 billion acquisition binge in 2016 that got the company fully licensed in all states by the GSEs.
SpringCastle is its legacy consumer loan investment done at a low point in its cycle. The current return on the portfolio is greater than a 90% IRR. The business model is a reflection of buying these rights at discounts to fair values, leveraging its platform to gain margin, and then holding until the securities mature. For example, it purchased approximately $800 million worth of non-agency MBS at 70 cents on the dollar. Today, the non-agency MBS index is just over 91 cents so the portfolio is clearly impaired, likely from foreclosures stemming from pre-financial crisis.
But by buying at a discount to par, it is able to generate a return on the underlying yield plus potential capital gains from the accretion towards par. This is a very similar strategy to the heavily-weighted non-agency MBS portfolios from PIMCO Dynamic Income (PDI) and PIMCO Dynamic Mortgage and Income (PCI). It then creates securitizations on those portfolios marking down the delinquent loans and improves the performance of the security adding an additional 1.5 to 2 points.
Future growth is likely to center around opportunistic acquisitions surrounding the originations business. As mortgage rates follow interest rates higher, mortgage applications are tumbling.
On the conference call, CEO Michael Nierenberg noted:
We always look for, what I would call strategic investments or strategic acquisitions that will benefit our shareholders. We continue to rate the fields for corn and we are out there in the markets and looking at everything. I mean there is nothing specific I can point today, but where we sit as a company and our success over the past few years, I would expect something to happen at some point, I just don't know when. The markets will, higher rates will likely lead to some kind of dislocation in the markets. You see the volatility in the stock market, you see rates rising. I do believe as we go through this year, if interest rates continue to - their upward trajectory, you are going to see more consolidation around the mortgage origination business, as origination volumes come down.
Hedge To Higher Rates
The balance sheet contains over $500 billion of mortgage servicing rights. MSRs are one of the few investments with "yield" that increase in value as a result of higher rates. That is because mortgages tend not to get refinanced when interest rates increase. The value of a MSR increases as the prepayment risk falls and the length of the investment increases.
As the above slide notes, it has a ~17% increase in book value last year alone. This is significantly better than the typical and largest mREITs like Annaly Capital (NLY), AGNC Investment Corp. (AGNC), and Anworth Mortgage Asset (ANH).
NRZ is not a growth stock but an income investment. Like REITs, it is mainly affected by changes in its payout structure (amount and payout ratio) and interest rates. As rates rise, income securities, mainly your yieldcos, utilities, and other higher dividend payers, tend to fall. But the offset, and the main differentiator to the names in the chart above, is a growing payment. NRZ consistently increases its payout roughly every three quarters. We expect that we could see another increase over the next three months as well to $0.52 per share.
Higher rates will also cause some dislocation in the mortgage origination market. Management, as we noted, is conservative in its acquisitions but the current environment characterized by increasing volatility surrounding interest rates is bound to cause more consolidation in the mortgage origination business, as refinancings and new loan volumes drop precipitously. For NRZ, this is likely a positive development over the last three months. Like many of its UPB purchases, the volatility and regulatory risks in the space has allowed the company to pounce and acquire new MSRs at times, at fire-sale prices.
This is the chart that it shows each quarter but given the move in rates, we feel compelled to show it again. It runs through the different areas in which the company operates and the effect of that segment if rates rise or fall. Overall, it is hedged to both higher and lower rates equating to a neutral exposure. When we see that, and not dissimilar to those PIMCO closed-end funds mentioned earlier, it becomes effective coupon tools. What we mean by that is that we can expect the coupon (in this case the dividend yield) plus a small amount of capital gains as the non-agency MBS accrete towards par. Interest rates, by and large, should not have a material effect on the book value of the underlying business.
The main driver of higher rates will come from the mark-to-market of its MSR book. In the fourth quarter, its full MSR portfolio was up $91 million and its excess MSR portfolio value was up just under $40 million. In total, the higher rates added almost $0.43 per share in GAAP earnings. Management noted that it is up marginally so far quarter-to-date in 2018.
The business model is predicated on the continual replenishment of its assets that tend to mature or roll off on a continual basis. As such, NRZ has to go out and acquire new assets to offset that roll off. For the last several years (and especially in 2015 and 2016) when Dodd-Frank made the business burdensome and risky, it was easy for the company to add new UPB. With a new administration and more confidence in our banking system, lenders and other banking institutions may be less willing to part with this profitable business. Additionally, it may only part with these assets at much higher prices than what NRZ has been accustomed to paying.
The other issue is management compensation structure. The management agreement stipulates that it pays the manager a fee equal to 1.5% of its gross equity. In its 10-K (page 8), the company defined it as "[generally] the equity that was transferred to us by Drive Shack on the distribution date, plus
total net proceeds from stock offerings, plus certain capital contributions to subsidiaries, less capital distributions and repurchases of common stock."
So it is in the best interest of the management team that it conducts secondary offerings from time to time in order to grow the asset base. It is that asset base that it derives its remuneration from. For investors in the stock, a secondary offering is a win and a loss. The loss stems from the dilution on its shares which are often accompanied by a significant drop in the share price. The win comes from the company having new fresh capital to which it can replenish its maturing securities by conducting acquisitions.
NRZ is an income play that is not without risks. As we noted above, regulatory risk remains the largest outstanding overhang that could push the shares materially lower. Couple that with the complexity of the business and this will always remain a high yield stock.
Typically with these higher yielding stocks, dividend coverage is the largest risk, especially when the shareholder base is so decidedly income-oriented. But in the case of NRZ, dividend coverage remains very strong with core earnings per share at $0.61 in the fourth quarter versus a $0.50 dividend payout. What we like is that non-GAAP and GAAP net income are very close ($2.83 per share versus $3.15) compared to $1.98 for the common dividend trailing and $2.00 forward. That equates to coverage in excess of 1.41x on the lesser figure.
In terms of valuation, the price-to-core earnings ratio fell to just 5.1x when the price of NRZ fell to $16.04. We highlighted the price to members around that time and added to our positions. But even today at ~$16.40, we are trading at just 5.3x 2017 core earnings.
We use a dividend discount growth model for valuing the shares. Applying just a 3% dividend growth rate to the $2.00 per share run rate today, at a cost of equity of 12% (incorporating the current risks and overhangs including the complexity) equates to an intrinsic value of $22.90. But our base case uses a 3-year 3% dividend growth rate and a 0% growth rate, thereafter, to incorporate the risks and potential roll-over of the market, the value is $18.05, or 6.4% above the current price.
We recommend keeping your sizing modest and typically advise members to stay at a 2% maximum allocation to individual equities. The business model of the shares and the industry in which they operate firmly place NRZ shares into our Speculative bucket. However, we are clearly being compensated for that given the current yield.
The economic growth trajectory and the strength of the housing market continue to be tailwinds for this firm. We watch the residential housing market closely. The increase in rates, while increasing the value of its MSRs, could have a secondary effect down the road of stalling the housing market. Mortgage applications have fallen sharply and with the new tax bill, deductions are maxed out at $10,000. This has not hit the market yet since the law effects 2018 income and beyond. Although supply in many markets remains VERY tight, we could be on the verge of a plateau in housing prices or worse yet, a decline.
That said, NRZ remains a high dividend stock with strong dividend coverage and hedges towards higher interest rates. The recent market selloff is allowing investors to acquire shares at a discount to the recent trading channel. Previous times when the dividend yield rose above 12% were nice buying opportunities. While there are many risks to these shares given the industry, regulatory environment, and business model complexity, keeping the allocation to a minimum and diversifying should allow your portfolio to weather any issues that arise.
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