This article was co-produced with Williams Equity Research ("WER").
More market-moving news was announced for Newtek Business Services Corp. (NASDAQ:NEWT) in the month of August than in several past years combined.
That encompasses more than the proposed conversion from a Business Development Company ("BDC") to a bank holding company, but that is seemingly what moved the stock.
Don't take my word for it; take a look at the below one-month chart of NEWT.
Source: Yahoo! Finance
You guessed it, the fall from $35 to $25 per share was the day the announcement was made. Dire articles suggesting a minimum dividend cut of 40% were quick to follow.
This was not the only recent news we should pay attention to, however. Today's article will be a little different than the typical quarterly update as we are going to tackle three questions simultaneously.
First, what are the pros and cons of the proposed conversion from a BDC to a bank holding company?
Second, we'll discuss what are the theoretical motivations for the change and whether these theories make sense.
Lastly, we'll evaluate how Newtek performed in Q2 and what are our expectations going forward, regardless of the company's structure.
There are often valuable nuggets of information and perspective buried in the wasteland of website comment sections, Seeking Alpha included. In this case, the comments surrounding the conversion of NEWT away from a BDC aligned perfectly with the ~30% intra-day drop in the stock price: extreme displeasure.
If these comments were the only available information, you would have bet, and with high confidence, that the stock experienced a serious decline.
This begs the question: why would management voluntarily take action that caused nearly one third of their company's market capitalization to evaporate? It could be that an unethical external manager devised a plan to extract more fee income from the company long-term. It wouldn't be the first time. Not the case here - NEWT is one of the few internally managed BDCs.
Not only that, but insiders purchased shares in every single quarter of 2020 and the last sell transaction occurred in Q3 of 2019. Maybe it's everyone but the decision maker picking up shares without knowing the full story?
The CEO, Barry Sloane, is listed more than anyone else and that's the case no matter how far you go back (part of that is due to his compensation structure, but it is still true). He owns over 1,000,000 shares of Newtek stock. Mr. Sloane has been the CEO of Newtek since 1999 and his last reported total annual CEO compensation was around $1.5 million.
This all to say that on the day the news was announced, Mr. Sloane personally absorbed a hit to his net worth of $10 million or over six years of his average annual total compensation. It's recovered a little since then as the stock has traded back to $27, but not much. In aggregate, senior management and the Board own over 5.0% of all outstanding shares.
So, if it isn't in the CEO and Chairman's personal best interest, and there isn't any behind-the-scenes scheme involving an external manager, why on earth would management take this course?
There are only two options, and one assumes management is incompetent (or worse). That's hard to get on board with given Newtek is one of the best performing BDCs in history, and is even a top performer among small cap stocks (it has easily surpassed the performance of both the Russell 2000 and S&P 500 for well over a decade).
For context, as of August 5th, Newtek was up 42% year-to-date ("YTD"). Not bad against the S&P 500, and massive outperformance relative to BDCs (or most banks). Its three-year return of 71% is even better, as that absorbs all of the pandemic panic of 2020.
Source: Newtek Q2 2021 Earnings Release
The five-year return of 222% is where things start to get a little silly, but the icing on the cake is the 10-year return figure of 755%. As the CEO pointed out in the most recent earnings call, a 10-year return of a company paying a steady 10% annual dividend is 200%.
NEWT has generated an excess return of 554% above and beyond a company paying a 10% annual yield. The company shattered expectations in 2020 and continues to do so in 2021 (as we'll discuss later). It is hard to reconcile that kind of consistently impressive revenue and cash flow growth with a management team that doesn't know what they are doing.
The other option is management did not anticipate this kind or reaction and or expects it to reverse over time. Otherwise, it makes no sense. You can probably guess which we think is the case.
Source: Newtek Second Addendum to August Earnings Report
This same management team made the decision to convert to a BDC in November of 2014. As shown in Newtek's own chart, it took a few quarters before the "rotation of our shareholder base" completed and the stock saw new highs.
The same management team, by the way, grew the $3.15 dividend projected for 2021 by 53% year-over-year. That's on top of a similarly impressive growth metric from 2019 to 2020. With that, let's move on to the first of the three major items for this article.
Those are excellent questions and we'll walk through each one. First, a bank holding company is what it sounds like: a corporation that owns a controlling interest in a bank but does not function as one.
For example, Bank of America (BAC) and JPMorgan Chase & Co. (JPM) are banks but are operated by holding companies. Bank holding companies fall under the domain of the Federal Reserve while banks without an overseer are primarily regulated by the Office of the Comptroller of Currency.
Upon the acquisition of National Bank of New York City, Newtek had no choice but to become a bank holding company.
It is worth reiterating a couple points. Newtek decided to become a bank holding company the instant it agreed to buy National Bank of New York City - there was no separate decision.
Additionally, the conversion away from a BDC does not automatically result in nor require any changes to its current business activities outside of what's involved in managing National Bank of New York City. Newtek already operates more like a bank than a BDC and that's evident from a five-minute review of any quarterly filing.
So why did the stock price fall dramatically and fail to recover?
As a BDC, Newtek is required to distribute 90% of taxable income to investors. There are numerous misconceptions about BDCs and REITs suggesting they cannot retain earnings because of this rule.
Without exception, these individuals do not understand or at least do not convey an understanding of what taxable income represents from an accounting or tax perspective.
Many REITs and BDCs have annual cash flow payout ratios in the 60-80% range - this immediately indicates that there is significant retained income.
Oddly, I've seen the same individuals claim REITs and BDCs have "unsustainable" business models because they must pay out all their cash flow in distributions then go on to criticize companies of those types for having payout ratios above 80%. Then again, we live in a confusing world.
Speaking of accounting, this is the income statement from Newtek's Q2 10-Q filing. I highlighted all line items mentioning depreciation, the only non-cash expense of any importance.
Unlike REITs and some BDCs, there isn't much here.
The chief "Depreciation and amortization" line item is $79,000. Not $79 million, $79 thousand. Because Newtek doesn't usually have a material amount of non-cash charges, its taxable income is relatively high compared to its operating income. As Newtek has rapidly expanded its business, it has been necessary to increase its dividend payouts proportionately.
As a bank holding company, this rule will no longer apply and Newtek can retain as much of its earnings (in the literal sense, not necessarily per U.S. GAAP) as it likes.
This strikes fear into the heart of income investors, and the stock sold off as a result. This reaction makes little sense long-term, however, as Newtek's intrinsic value does not change based on its dividend payout ratio. The value to an arbitrary income investor certainly might, but not its market value.
Provided NEWT was reasonably priced at $35 as a BDC, it is very difficult to argue that it is now worth $27 simply because it no longer must pay out 90% of taxable income to investors.
This is especially true because Newtek has an excellent return on equity, as suggested by its almost unrivaled three-, five-, and 10-year performance statistics (more on that in the valuation section). Over time, we'd expect other types of investors to fill the gap created by income investors fleeing their ownership interests.
There has been speculation that Newtek is moving toward a traditional corporation independent of the bank acquisition and constraints of the BDC structure. I won't attempt to cover all the theories (there are some interesting ones...), but a popular one revolves around cost of capital.
The idea is that the cost of capital for BDCs is more expensive than what Newtek could achieve as a bank. This isn't without some merit, as the mere existence of NASDAQ:NEWTL and NASDAQ:NEWTI confirms. Newtek has issued several tranches of baby bonds over the years with coupons between 5.50% and 6.25%.
The problem with this thesis is there is no evidence to support it. In an article focused on Golub Capital BDC (GBDC) published in March of 2021, we noted that BDC issued $400 million in unsecured notes maturing in 2026 at a 2.5% fixed interest rate. Ares Capital Corp. (ARCC), another BDC, has bonds maturing in the same year with a 2.150% coupon (the bonds now trade above par too, meaning their effective yield is even lower). Unambiguously, the BDC wrapper is not a roadblock to cheap debt financing.
The idea that NEWT must convert from a BDC to a bank to raise cost efficient capital doesn't hold water in our opinion. NEWT's cost of capital is based on its liquidity, credit profile, asset base, and the durability of its ability to service debt obligations. None of that changes except a potential improvement in its ability to service debt by loosening the requirements of its required distribution to investors.
We've read our fair share of S&P and Moody's credit reports, and that's not a reason why companies are upgraded or downgraded because the distribution can always be cut as needed.
For the last piece of this specific puzzle, some have said management has been unable to issue equity and that has strangled CapEx. Shares outstanding increased by roughly 8% in the past year from 20.82 million to 22.43 million.
As of June 24, 2020, the company had sold 1,716,517 shares of its common stock under the Amended 2019 ATM Equity Distribution Agreement and received net proceeds of $37.6 million.
Per the latest 10-Q, Newtek only sold 1.72 million of the 3.0 million shares available under its previous equity issuance program. As of June 30, 2021, there were still 1,546,951 shares of common stock under the 2020 ATM Equity Distribution Agreement.
Source: Newtek Q2 2021 10-Q
At least until this ATM program is exhausted, there's no evidence that management can’t acquire permission to issue more shares. Since NEWT trades at or near the highest premium (~70%) to NAV of the BDC sector (even after the recent drawdown), the ATM equity issuance makes significant accounting and economic sense.
Every share sold well above NAV is immediately accretive from a financial perspective. That's not to say it's the perfect way to raise capital in every scenario, but there's nothing here that explains the desire to convert away from a BDC.
Management could be reacting to a future situation in which they believe issuing shares will no longer be economical or possible, but now we are digging several layers into speculation. As a side note, in Q2 of 2021, Newtek purposefully kept earnings at the portfolio company level at the portfolio companies and did not pull them "up" into the BDC.
That has the effect of reducing the current required distribution, increasing future distributions, and increasing cash available for general purposes. Newtek has levers to pull to manage its distribution requirements and CapEx needs.
Another potential driver of the move away from the BDC company structure are the restrictions it places on corporate activities. Outside the often-discussed regulated investment company ("RIC") 90% rule, BDCs are also subject to much lower leverage limits than banks.
The types of businesses they can engage in, while still broad, are narrower than a bank holding company. The 70% minimum of a BDC's assets that must be invested in private companies comes to mind, as does the same minimum required to be invested in U.S. companies.
Mr. Sloane mentioned in the quarterly call he anticipates the conversion to a bank holding company to:
...potentially broaden our investor base to include more institutional stock ownership, investors that invest in index funds comprised of companies included in indices such as the Russell and S&P, and investors that have been discouraged from investing in BDCs due to the acquired fund fees and expenses (AFFE) rule.
There is at least some merit to this expectation, but we won't have hard data until after the conversion takes place. As it stands now, many BDC investors indisputably ran for the hills but investors dependent on the conversion's completion cannot yet take their place.
To be fair to Newtek, I don't see any practical way to avoid this temporary conundrum. In fact, this is the same situation Newtek faced when it originally converted to a BDC in 2014.
The double taxation of the traditional C-corporation is a significant potential negative compared to the one layer of taxation attributable to BDCs (and REITs), but C-corp investors may qualify for lower tax rates on their dividend income.
That won't matter if you are investing qualified money only, but the ordinary tax rate on BDC income received in a retail/individual account can really put a dent in after-tax returns.
This is one of those axioms that is easy to say but rarely implemented. Most humans prefer to fight a losing battle rather than admit defeat, much less join the other side. In the case of Newtek, a good portion of their business activities, particularly in 2020, are directly tied to the government.
Newtek is actively and successfully capitalizing on the expansion of SBA 7(A) small business and PPP loans. As the government seemingly encroaches on more and more areas of the economy (whether you are a big fan or have a different take), Newtek is happy to step in and collect a new revenue stream.
As much as it personally annoys WER, the trajectory of the government's influence in the economy is growing at a trillion-dollar pace. The money claimed to be spent on the coronavirus alone is nearly $3 trillion. That's on top of the estimated $1 trillion in projected federal infrastructure spending.
In all, the estimated $6.6 trillion spend by the federal government in 2020 equates to 31.6% of that year's Gross Domestic Product ("GDP"). Trillions of dollars are being moved around by the federal government, and an investment in Newtek allows us the possibility of receiving a few dollars of that tax money back in our pockets.
The acquisition of 100% of National Bank of New York City equity cost Newtek $20 million and was valued at 1.0x tangible book value. That's an excellent evaluation in today's market.
Newtek paid for NBNYC in cash and expects to close on the deal in six to 12 months. NBNYC's Board of Directors will resign (Newtek's will be control) but senior management will remain in place and continue to operate the company.
Source: Newtek Second Addendum to August Earnings Report
The publicly traded stock is described by the data on left of the above chart. The $1.4 billion in total assets represents significant growth for what remains a small company.
Total investment income ("TII") for Q2 2021 was $36.6 million or a 21.6% decrease compared to Q2 of 2020. Adjusted net investment income ("ANII") held up better and saw a decline of 12.3% over the same period. These are still strong numbers compared to past years, but particular quarters in 2020 included non-recurring revenue that bolstered results.
If we compare the first half of 2020 to the first half of 2021, the metrics smooth out. TII for the first half of 2021 was 14.1% greater than TII in the same period last year. NII rose 4.4% over the same period but declined 3.5% on a per share basis due to equity dilution.
ANII, the final earnings metric we like to use when evaluating Newtek, was $2.25 per share in the first half of this year or an increase of 42.4% on a per share basis compared to the first half of 2020.
As you skim over those data points, it becomes evident that nuance is necessary to see the forest for the trees as results are more volatile (mostly due to uneven distribution of PPP income) than your typical BDC invested almost exclusively in stable first lien loans. Overall, Newtek continues to rapidly grow cash flow and NAV per share.
Pro forma leverage was 1.16x debt-to-equity and the total investment portfolio increased by 7.4% to $696.1 million. This is slightly above the peer average for BDCs at the moment, but is not elevated or worrisome.
Critically, the net asset value per share grew by 6.0% from $15.45 at the end of 2020 to $16.38 per share last quarter. Shares outstanding have risen modestly from 20.815 million to 22.431 million in the past year, as noted previously.
Whether a bank holding company or BDC, Newtek will be valued based on its projected cash flows and its market value compared to its book value. 2020 was an unusual year for most companies, but it that was even truer for Newtek.
We do not anticipate certain business silos, like PPP loans, to meet last year's numbers. That said, we'll start this exercise assuming NEWT remains valued as a BDC, as that's the prudent thing to do. We'll finish the section with adjustments if the conversion to a bank holding company occurs.
Newtek reaffirmed the 2021 annual dividend to $3.0-$3.30 per share or an 11.6% current yield at the midpoint using today's stock price. This same data indicates that there is $1.05 per share in remaining dividends for 2021 - that's an eye-opening 123.4% increase over the Q4 2020 dividend of $0.47 per share. Management stated in the last quarterly call that they'd provide "additional transparency and forecast a dividend for Q1 2022."
Given Newtek's cash flows have a strong correlation with their dividend, this will tell us a lot about their expectations regarding next year. In aggregate, we think applying a moderate 10-20% growth rate on 2019 financials is the conservative and correct play in our view. 2020 is too much of an anomaly and future performance is more likely to resemble 2019, regardless of whether the bank acquisition is approved.
We are going to tackle valuation three ways: cash flow yield, price/book value, and premium/discount to NAV.
Cash flow yield is nothing more than the distribution rate adjusted for the payout ratio. Focusing strictly on a dividend yield as an indication of value is akin to determining how fast a vehicle is based on the number of cylinders. It appears to be a good short-cut but doesn't mean anything without other key pieces of information.
Using the more conservative ANII measure, Newtek will generate around $3.25 per share in cash flow in 2021 or a 12-13% cash flow yield at today's share price of $27.50. We land at the same number by instead taking the expected annual distribution of $3.15, dividing it by the payout ratio, and dividing the output by the same share price.
Looking back to 2016 to 2019 when Newtek's share price was relatively stable, the stock traded with a cash flow yield of 12-18%. In what will become a pattern, Newtek was expensive by this metric when it was trading in the $32-$35 range applicable prior to the August 2nd acquisition announcement. It's also fairly valued based on cash flow yield at today's share price closer to $27. The same applies to cash flow yield on book value, which is another worthwhile metric but not one we'll cover in detail here.
According to SEC filings and our institutional data provider, FactSet, in recent years prior to 2021, price/book value was steady in the 1.2-1.3 range. It jumped to 1.7 at the end of Q1 of 2021 then to 2.2 by the end of June. This was one of the main reasons we took profits on our Newtek position in the low $30s and again in the mid-$30s.
As painful as it is to reduce our stake in an amazingly fast and high quality income stock, it must be done when the valuation becomes too extended. The current price/book ratio is right at the level of Q1 2021, meaning it is 30-40% higher than historical norms. Newtek has also been growing cash flows more rapidly in recent years, so part of this premium is justified.
Moving on to premium/discount to NAV, the most reliable metric for BDC valuation in my opinion, Newtek trades a lot like Main Street Capital (MAIN) in that a 20-30% premium to NAV is usually an excellent entry point and anything over 80% signals elevated risk.
NEWT trades with a 68% premium today, down considerably from Q2's 100-120% premium. Once again, today's pricing is about average for Newtek with last quarter's valuation squarely in overheated territory.
Source: Newtek Second Addendum to August Earnings Report
Now let's consider if the conversion to a bank holding company occurs. This chart was created by Newtek and we'd be naïve not to take this with a grain of salt and perform our own independent assessment of the data. The classifications used are not the easiest to verify (e.g. what exactly defines a "high profitability bank" or "fintech enabled bank") but we did find a few examples and none were collectively so out of line that they suggested this data was inaccurate.
As one example, Ally Financial Inc. (ALLY) is a good example of a fintech enabled banking institution (albeit with a mixed reputation), and it trades at a surprisingly modest 6.5x forward earnings.
On the other hand, SoFi Technologies, Inc. (SOFI), a leader in that segment, doesn't have a dime of earnings and is worth $11.5 billion as of August 25th's close. The 18x price to 2022 EPS assumed in the above chart is associated with Axos Financial (AX), Meta Financial (CASH), Live Oak (LOB), Silvergate (SI), The Bancorp (TBBK), Triumph (TBK), Green Dot (GDOT), and LendingClub (LC).
Source: Newtek Second Addendum to August Earnings Report
Our independent earnings guidance is somewhat dependent on management's estimates, which is not usually the case, but it nonetheless reconciles with their conclusions. Using Earnings Per Share ("EPS") for the combined entity of $2.10 in 2022, fair value for the new company is between $20.16 (assuming it is classified as a traditional but highly profitable bank) and $37.80 (assuming it is priced as a fintech enabled bank).
To give Newtek credit, its projected and likely return on average tangible common equity ("ROATCE") and return on average assets ("ROAA"), two common measures of bank's profitability and asset quality, are above even the most richly valued peer group. Add in expected growth in 2023, and a $40 share price is reasonable. That wasn't an attractive proposition back when the stock traded at $35, but that's a 45% capital gain from today's level plus dividends.
It's only prudent to expect the distribution to be halted or reduced after the conversion takes place. Unlike what a headline including that suggests, that is not an indication there is anything wrong with the business. It does suggest that Newtek is taking a different approach, and one that may be more attractive to a total return seeker than the BDC company structure provided.
In conclusion, we are not running from Newtek, and despite a considerable amount of due diligence, did not find a single good reason to do so. The stock isn't terribly inexpensive, but the recent sell-off was a blessing for those looking to initiate a position in the stock.
Investors expecting the company to remain a BDC are best suited to look for an entry point closer to $25. For those that think the bank conversion is imminent and will be a long-term plus, today's share price is situated to provide at least 50% total returns over the next couple years.
Note: Since posting this article on the iREIT on Alpha marketplace I have attempted to reach out to NEWT's CEO for an interview (for iREIT on Alpha members).
Author’s Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.
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This article was written by
Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 6,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.
The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha). Thomas is also the editor of The Forbes Real Estate Investor and the Property Chronicle North America.
Thomas has also been featured in Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox. He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, and 2019 (based on page views) and has over 102,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley).Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha (2,800+ articles since 2010). To learn more about Brad visit HERE.
Disclosure: I/we have a beneficial long position in the shares of NEWT, ORC either through stock ownership, options, or other derivatives. 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.
Additional disclosure: WER has a beneficial long position in the shares of ARCC, NEWT, GBDC, and ORCC either through stock ownership, options, or other derivatives.