Why Redwood Trust Has Upside To $10+

Summary

• RWT has recovered sharply since the panic low, but there is more left to the upside.
• Mark-to-market losses will largely be reversed, I believe, creating book value upside.
• I see conservative book value at $10 to $11, up from $6.32 at the end of March, driving a higher share price.

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The mortgage REIT industry has been turned upside down by the COVID-19 crisis. Some players are struggling to survive, while damage has been somewhat limited to others. One of the smaller players, Redwood Trust (NYSE:RWT), saw almost 90% of its stock market value wiped out in the span of a few weeks earlier this year. While shares have recovered sharply in recent trading days, the stock is still at just $7, down from nearly $18 before the crash. At today’s price, I think there is long-term value to be had with Redwood, and for enterprising investors that understand the risks with this one, it could be worth a look from the long side.

First, some notes of caution

As with any other mortgage REIT, Redwood is not for the risk-averse investor. The trust employs significant leverage to try and borrow at a lower rate than it can invest the proceeds, and while it works most of the time, when things go south, they tend to go south in a hurry.

That’s what investors were afraid of earlier this year as Redwood entered a free fall from $17+ to just $2.14 per share in a very short period of time.

Before we get to why I’m bullish, let’s take a look at some risks that can be represented by historical data. First up, we have total revenue and operating income, both in millions of dollars, for the past five years.

Source: TIKR.com

What we can see is that both revenue and operating income are very lumpy, the product of a variety of factors, including the size of the portfolio, borrowing rates, repayment rates, rates at which funds can be invested, and the list goes on. This huge and complex set of variables makes it difficult to determine with much accuracy what revenue or earnings will look like in any given year for Redwood. Uncertainty means investors need higher projected returns to compensate for that risk, which means valuations can remain lower.

That uncertainty is well-founded, as we can see the trust’s portfolio growth over time, combined with long-term debt, again in millions of dollars.

Source: TIKR.com

Redwood’s loan/lease receivable portfolio was just under $3.2 billion at the end of 2015, with a nearly identical amount of long-term debt to fund it. At the end of 2019, those values had ballooned to $14.8 billion and $13.4 billion, respectively. Recall, however, that although the portfolio nearly quintupled in size, revenue in that same period was up by roughly half, while operating income essentially doubled. In other words, boosting earnings for a mortgage REIT is nowhere near as simple as just buying more receivables.

This can be seen below as we have the trust’s return on assets and return on common equity for the past five years. These ratios negate the impact of simply adding more dollars to the portfolio, and instead measure the efficiency of assets. As we can see, the story isn’t a great one.

Source: TIKR.com

ROA peaked at 2.2% in 2016 and 2017, but last year, it was just half that value at 1.1%. ROE has fared better, but is still meaningfully down from peak values. This illustrates the same issue just about every mortgage REIT experiences in that producing growth is easy; profitable growth is something else entirely.

There’s yet another hurdle that Redwood shareholders must overcome, and that is the ever-rising share count. Below we have plotted the weighted average diluted shares outstanding for each of the past five years, as well as the year-over-year change.

Source: TIKR.com

The moves Redwood has seen in its share count are enormous, with last year’s value of 137 million shares dwarfing 2015’s at 85 million. The fact that Redwood issues shares in bulk isn’t uncommon for a mortgage REIT as traditional debt funding can be rather expensive. However, it is one more reason to be cautious because each time Redwood issues more shares, it makes your shares worth relatively less through dilution.

Why in the world am I bullish, then?

That’s a great question given I haven’t made one single bullish point yet. That’s on purpose, because I want anyone that reads this to realize that Redwood is not a safe investment. This is a high risk, high reward situation so positions should be kept small.

Now, there are a couple of reasons I think $7 is a value price for Redwood. First, I think the fact that management sped up the Q1 dividend payment is a big sign of confidence. The payment had been deferred to help bolster capital ratios during the crash, but management was confident enough to speed it up by more than a month, implying there is more than enough liquidity to go around. That’s a huge step for a mortgage REIT to take in terms of putting investors at ease, and I don’t think investors should ignore its importance.

Earnings are less important at this point given where we are in the recovery, but for what it is worth, the rebound in EPS is currently expected to be very sharp into 2021.

Source: Seeking Alpha

The first quarter produced a GAAP net loss of $8.28 per share, for a stock that is trading for just over $7 per share as of this writing. It was ugly out there in the mortgage securities market at the end of Q1, and mortgage REITs like Redwood had to mark-to-market for losses that were sustained, realized or unrealized.

This caused book value per share to plummet from $15.98 at the end of 2019 to $6.32 just three months later. That’s an enormous loss of value, but the CEO said the trust believes about two-thirds of lost value was from mark-to-market losses on investments that were still on the balance sheet, and that it was confident of an eventual recovery of “meaningful” value in those securities. In fact, I’d be willing to bet that over two months later, with the unprecedented fiscal and monetary support markets have received, that much of that value has likely already been recovered.

That is primarily why I’m bullish, and here's the math to support it. Book value was $15.98 at the end of 2019, and $6.32 at the end of March, a decline of $9.66 per share. Redwood says about two-thirds of the decline was due to mark-to-market losses that it expects to see meaningful recoveries in during the ensuing months. If we take 60% of the decline (slightly less than two-thirds), that’s $5.80, and then if we apply a 75% value recovery rate to those losses, we are left with $4.35 in book value per share that could fairly easily be recovered. I think there is good cause to be more bullish than that, but for a conservative scenario, this will do.

If we add $4.35 in projected recoveries to $6.32 in actual stated book value from March, we have projected book value of $10.67 per share, which I think maybe achieved by the end of Q2, but with a great chance by the end of this year. Markets are open and functioning, so there’s simply no reason for the fire-sale valuations on securities like we saw in March.

Shares traded for right at book value near $16 as December ended, so I have to imagine we’ll see 1X book value again. If that’s the case, we should easily see Redwood back at $10 to $11, which is up sharply from today’s $7.08 share price. That, of course, also excludes any dividends you may receive between now and then, which simply juices the total return picture.

This stock is not for retirees that need to count on their income to pay living expenses. It is not for any risk-averse investor for that matter, but I think that there is a lot of recovery still left in this one despite its already-massive rally. If you can stomach the risk and volatility, Redwood is a buy on book value and valuation recovery.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RWT 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.