Ready Capital: Trading At A Deeper Discount Than Is Warranted

Summary

• This diversified mortgage REIT originates, acquires and services commercial loans, conducts residential mortgage banking and serves as a lender for the SBA’s Paycheck Protection Program.
• Ready Capital is trading at a 43.4% discount to book value.
• RC has a $4.2B loan portfolio composed of approximately 4500 loans with an average balance of about $900,000.
• 90% of these loans are current on payments as of April 30th.
• 99% of the loan portfolio are 1st liens with a 60% average LTV.
• This idea was discussed in more depth with members of my private investing community, Retirement Income Solutions. Get started today »

Investment Thesis

During the recent market selloff, Ready Capital (NYSE:RC) saw its share price plummet from $16.35 on February 21^st (the day before the market collapse began) to a low of $3.99 on March 24^th. Although RC has sharply bounced back off the recent lows, it has only thus far recovered to a price of $8.24 (as of 06/04/2020). This deflated share price presents an opportunistic entry point, given that the magnitude of the decline in book value (from $16.14 to $14.55 during Q1 2020) was markedly smaller. It is possible that RC will see further declines in book value throughout the remainder of the year due to the on-going impact of economic recession, but these declines are likely to be modest, suggesting that the current discount to book value is far larger than is warranted.

Ready Capital’s Primary Operating Segments:

Source: Company Investor Presentation (Data as of 03/31/2020)

SBC Originations

Small to medium balance commercial (SBC) loans are originated by RC’s wholly-owned subsidiary, ReadyCap Commercial, LLC. Some of these loans are placed into securitized structures, whereas others are held on the balance sheet as investments. Freddie Mac’s (OTCQB:FMCC) small business loan program is also utilized to originate and service multifamily loans, which RC typically sells.

Source: Company Investor Presentation (Data as of 03/31/2020)

SBA Originations, Acquisitions and Servicing

Ready Capital also originates, acquires and services U.S. Small Business Administration (SBA) loans through its wholly-owned subsidiary ReadyCap Lending, LLC. These loans are guaranteed by the SBA 7(a) loan program. RC holds an SBA license as one of only 14 non-bank small business lenders and maintains preferred lender status with the SBA. Of the loans RC originates under this program, some are held on its balance sheet as investments, some are securitized and others are sold off. As can be seen in the charts below, the collateral for these loans is diversified across many industries, but does contain a moderate amount of retail and hospitality, which are two sectors that are facing the greatest disruption from the coronavirus and the ensuing government-mandated economic shutdown.

Source: Company Investor Presentation (Data as of 03/31/2020)

Residential Mortgage Banking

Residential mortgage loans are originated through RC’s wholly-owned subsidiary GMFS, LLC. The loans that are originated by GMFS are eligible to be purchased, guaranteed or insured by Freddie Mac, Fannie Mae (OTC:FDDXD), the Federal Housing Administration (FHA), U.S Department of Agriculture or the U.S. Department of Veteran Affairs. Rather than being held on the balance sheet, these loans are typically sold to third parties.

Loan Acquisitions

This segment of RC acquires performing loans as well as non-performing SBC commercial loans. The acquisition of performing loans typically varies in expected return and risk profile within a moderate range. Acquisition of non-performing loans, however, presents enormous upside potential but also unfortunately carries very elevated risk to the downside. A commercial loan is typically considered non-performing if the borrower is in default and payment is more than 90 days past due. A loan can also be considered non-performing if payments of interest and/or principle are less than 90 days past due but the lender no longer believes that the borrower will continue to make payments.

RC has a different strategy for handling acquired performing loans vs. non-performing loans. Performing loans are typically purchased at close to fair value and held to term. RC purchases non-performing loans at a discount to the unpaid principal balance when the company believes that it can achieve strong risk-adjusted returns. RC seeks to improve the value of these non-performing loans by utilizing proprietary loan modification programs. On the Q1 2020 earnings call, management stated that it believes that distressed loans may offer potential opportunities over upcoming months.

Successfully executing this strategy of the acquisition of both performing and non-performing loans requires very highly skilled underwriting abilities by RC. Those underwriting abilities are going to be put to the test by this sudden and unexpected recession resulting from the economic lockdowns put in place by state governors across the country.

Paycheck Protection Program (PPP) Loan Participation

Ready Capital has partnered with the SBA and Treasury Department to provide PPP loans to small businesses that have been negatively impacted by these lockdowns or by the impact of the coronavirus. During RC’s first-quarter earnings call, management provided an update with some useful data regarding the company’s participation in this loan program. In the first round of the PPP, RC approved about 40,000 applications for around $3 billion. At the time of the earnings call, about $2.1 billion of those loans had been distributed. Ready Capital had the largest number of loan applications and smallest average loan balance of all the financial institutions who participated in the first round of PPP lending. Half of loans were for less than $25,000 and more than 20% were for sole proprietors. Gross fees on these PPP loan originations range from 1% to 5% depending upon the size of the loan. Given that most of RC’s loans were very small, the average fee will be much closer to the 5% end of that spectrum.

Dividend

RC has been paying out a quarterly $0.40 dividend, which at current pricing represents a 27.26% yield. The dividend paid on April 30^th was almost certainly the last dividend of this size. During the Q1 2020 earnings call, management clearly stated that the dividend is expected to be “right-sized” by the board, but did clarify that at this time it does not expect this new smaller dividend to be paid in stock. No further information was given as to whether the dividend will merely be trimmed or aggressively slashed. The latter appears to be the more likely option, however, given that normalized EPS is expected to be markedly lower than $0.40/share in the 3^rd and 4^th quarter ($0.26 and $0.27, respectively) and consensus GAAP EPS is expected to come in at $0.19/share. I will not venture a guess as to precisely what the dividend will be cut to, but a cut down to $0.25/share or less in order to establish dividend coverage would not surprise me at all.

Source: Actual and consensus earnings data from SNL.com

Valuation

The most recently reported book value per share (as of 03/31/2020) was $14.55, which fell from $16.14 at the beginning of Q1. Tangible book value per share was $14.40, down from $15.76 over the same period. Given that RC currently trades at only $8.24 (as of 06/04/2020), there is a massive discount to book value of 43.4%. As recently as February 21^st (the day before the market collapse began), RC was trading at $16.35. Having fallen to a low of $3.99 on March 24^th , RC has since started to bounce back but remains at just over half book value.

Source: SNL.com

RC’s book value and tangible book value have steadily declined each quarter even before the liquidity crisis wreaked havoc on the mREIT sector in March. When factoring in the impact of the $0.40/share dividend, however, RC had modest economic gains to tangible book value in the 3 quarters prior to Q1’s sharp book value decline. The upcoming dividend “right-sizing” will significantly reduce the dividend yield of RC, but may help stabilize book value and could potentially even facilitate modest increases in the back half of 2020. However, given the uncertainty surrounding the magnitude of the dividend cut and the elevated risk of RC’s commercial loan portfolio in a recession, it is very difficult to determine a likely book value for RC in the mid-to-long term.

A disparity between share price and book value typically implies that investors expect book value to move in the direction of the share price. Thus, if an mREIT is expected to see a rising book value, it is more likely to trade at a premium to book value. Similarly, expected book value declines would typically result in the shares trading at a discount. For those who do not believe in perfectly efficient markets, it is important to determine whether the magnitude of such a premium or discount is warranted.

Conclusion

There is enormous uncertainty at this point in time on a number of fronts. The magnitude of the upcoming dividend cut is not yet known. Additionally, the ultimate return attained by RC on its PPP loans is yet to be seen. In the event that tangible book value holds in the $13-15 range through the remainder of 2020, RC could be a stellar opportunity. However, if the economic fallout from the government lockdowns and the resulting recession cause severe enough distress to the small and medium-sized businesses to whom RC has originated loans, there could be a devastating wave of loan defaults. I hope that over upcoming months RC will provide sufficiently detailed updates regarding all of these matters to provide investors with greater clarity. I am cautiously optimistic that book value will not decline nearly enough to warrant the current severely-deflated share price. This is a riskier position than most given the uncertainty, but appears to be discounted by more than is warranted. As a result, RC appears to be a potential opportunity at current pricing.

Analyst’s Disclosure: I am/we are long RC. 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.

2nd Market Capital and its affiliated accounts are long RC. I am personally long RC. This article is provided for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Information contained in this article is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions. Simon Bowler is an investment advisor representative of 2MCAC, a Wisconsin registered investment advisor. Positive comments made by others should not be construed as an endorsement of the writer's abilities as an investment advisor representative. Commentary may contain forward looking statements which are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts and findings in this article. Although the statements of fact and data in this report have been obtained from sources believed to be reliable, 2MCAC does not guarantee their accuracy and assumes no liability or responsibility for any omissions/errors.