New Residential Continues Its Best-In-Breed Performance

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About: New Residential Investment Corp. (NRZ)
by: John Windelborn
Summary

Mr. Market reacted favorably to the Q4 earnings report, with shares rising 3%.

11.5% yield remains well covered by core earnings.

Q4 book value decline was largely due to the December sell-off and has probably recovered half of its loss. BV still grew 6% YoY despite the stumble.

Management continues to de-risk and diversify the business.

After a rough December, shares in New Residential Investment Corp. (NRZ) gained nearly every day since the beginning of the year to settle in around their pre-crash levels at $17 a share. I’ve been very bullish on this stock, publishing articles in July and November of last year. While the stock bounced after both the prior articles were published, I recognize that overall, the stock price has slumped. However, with the $2 per share annual dividend, those that chose not to sell continued to receive their ~generous 11.5% yield. This is why we support buying shares of stellar companies that are undervalued and love to target ones that pay a hefty dividend. You can be paid to wait for the share price to recover.

Image from finviz.com

New Residential reported fourth-quarter 2018 results Tuesday morning and the early market reaction to the news has been positive. Shares are up almost 3% compared to most peers being flat in morning trading.

Image from Seeking Alpha

Some readers will point out that GAAP EPS was disappointing, coming in at $0. However, people familiar with mREITs will understand that non-GAAP EPS, or more precisely core earnings, is what we should focus on. Quarterly core earnings of $0.58 per share with a $0.50 dividend is an 86% payout ratio. While I’m perfectly happy with my ~12% yield on cost, some will be wanting NRZ to raise its dividend, which has been flat at $0.50 per quarter since June 2017. I would rather the company reinvests any excess back into growing its portfolio, so it doesn't have to issue shares to raise capital as often.

Image from Q4 2018 NRZ earnings call supplement

Reinvesting to grow the portfolio would help grow book value, which was up 6% YoY but took a hit in the fourth quarter due to the market decline bringing a fall in bond rates. Since roughly half of NRZ’s assets are mortgage servicing rights, which are more valuable when mortgage rates are higher, the slip in rates caused the associated decline in book value. Peers with MSRs such as Two Harbors Investment Corp. (TWO) and AGNC Investment Corp. (AGNC) had similar book value action. However, on a positive note, these companies have said in earnings calls that roughly half of that decline in Q4 has already recovered YTD. Therefore, while critics will point out that book value of $16.25 is a setback from $16.87 in the prior quarter, the number is most likely closer to $16.55 per share in February.

Image from Q4 2018 NRZ earnings call supplement

The main thing that I took away from the presentation is that a lot of the operating metrics are improving from where they were earlier in the year. The biggest risks facing NRZ are early refinancing, delinquencies/defaults and counterparty risk. As you can see above, net prepayment speeds are nearly half as much as they were two years ago, falling to 8% in the most recent quarter. This is a function of higher mortgage rates causing repayment to be unpalatable for 91% of clients. NRZ also has 100% recapture “insurance” on its MSRs, which adds some safety to that negative refinancing. While MSR multiples have fallen a little from their high in November, we should remember that they are near recent highs and barring a recession and a new wave of QE, rates should be fairly steady here. CEO Michael Nierenberg said that he expects that the Fed will “hold” here with rates staying relatively range-bound at their current levels. This will be a boon for NRZ as the extended lives of the MSRs result in higher total lifetime yields.

As for delinquencies and defaults, NRZ has experienced a drastic and steady improvement in its non-agency bond portfolio. The company bought $4.2 billion of these securities for an average price of 85% of face value. The current mark-to-market value of this portfolio is substantially more than what NRZ paid for it, which shows that management has a knack for finding and creating value. In addition, while the monetary of NRZ’s call rights don’t show up on the balance sheet, the improving metrics are improving its ability to capitalize on these clean-up calls.

Image from Q4 2018 NRZ earnings call supplement

Lastly, for servicer advances, NRZ has continued to improve the amount of risk undertaken by reducing total outstanding balance owed and helping these companies with terms. By extending the maturity of the advance debt, it can squeeze more interest from servicers and give them flexibility in the short term.

Image from Q4 2018 NRZ earnings call supplement

“Capturing the Whole Pie”

CEO Michael Nierenberg uttered this phrase countless times over the earnings call Tuesday morning, and I like what NRZ has set its sights on. There is a desire to diversify the company's offerings and sources of revenue from MSRs to more of a well-rounded company.

Image from Q4 2018 NRZ earnings call supplement

NRZ has slowly become a more self-sufficient company, not requiring solely on buying MSRs from other companies. Now, or soon, NRZ will be able to originate mortgage loans and offer other related services to clients. On the call, it referred to developing relationships with clients and offering what essentially sounded like a bundle. While admittedly small in the grand scheme of NRZ’s business, this type of business model was mentioned as a future source of organic growth. If NRZ is able to capitalize on this plan it could lead to less lumpy earnings and a lower perception of the “riskiness” of the stock. A safer appearing asset would command a higher price-to-book valuation, leading to a nice share price appreciation and more profitable secondary offerings in the future.

Should You Buy Here?

Speaking of price-to-book, you can see from the following graph that NRZ is valued roughly in line with historical norms for the company. Assuming a current book value of closer to $16.55, the current P/B is about 1.04. The CEO said that he expected deployed capital in 2019 to result in an increase in book value, but that statement is hardly surprising or a certainty. Seeking Alpha author Achilles Research, who we think has historically excellent timing with his articles, called NRZ his top pick for 2019 in a recent article, but should you buy after the pop? Investors seeking income that don’t want to wait for a pullback should probably layer in and add more on dips. I think more patient and value-oriented investors should wait before jumping in.

Image from Seeking Alpha

Summary

I think that once you peel back some of the layers of the NRZ onion you see that the business is in a very good spot moving forward. The Q4 dip in book value was almost exclusively due to treasury prices coming off their recent highs, but remain elevated which helps NRZ’s business model. Management continues to de-risk its business and while we’d all like to see core earnings continue to grow at the same speed of the last few years, we should take solace in the fact that the 11.5% dividend is amply covered. This stock continues to stand head and shoulders above the rest of its peers and if you could only invest in one mREIT this would be the one.

Disclosure: I am/we are long NRZ, TWO, MORL. 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.