Newcastle Disappointment
Sep/110
Yesterday was a sad day. My investment thesis on one of my favorite stocks blew up. It was Newcastle Investment. I’ve written about the company several times over the past 13 months. It is a commercial mortgage REIT that has come back from death’s door. Newcastle’s business didn’t blow-up. Instead, Newcastle’s management made a strategic shift at the same time as making a very poor capital decision.
Newcastle had been using their cash to repurchase their own CDO notes at attractive discounts. They were also making some new commercial real estate loans at attractive spreads. The stock trades at close to my calculation of its liquidation value and at a discount to my calculation of fair value.
In March, the story was derailed a little when they raised about $120 million in a follow-on offering of common stock. At the time, I thought it was a weird that management wanted to raise capital at what I perceived a discount to its value, but they claimed they had attractive investment opportunities in their CDO notes. Fine, the dilution wasn’t too bad and the capital allocation was consistent with previous capital allocation decisions. The deal was priced at $6.
Monday night with the stock closing at $5.65, Newcastle announced they were going to raise additional capital again. This was frustrating because the stock opened down 9%, so they were going to have to price the offering even lower than $6 to get the offering done. Plus, the number of shares they wanted to issue was higher than in March. In the morning, I held off on selling my shares because I wanted to better understand what they were seeing in terms of investment opportunities that was so compelling to sell additional stock at even lower prices.
What I heard from management was completely disappointing. They are going to use the new capital to purchase mortgage servicing rights on a pool of residential mortgages. This is a complete strategic shift, and it makes no sense for several reasons.
1. No expertise in interest rate risk – Newcastle is a commercial mortgage REIT. It specializes in commercial real estate credit risk. The few residential mortgage assets it holds are credit risk assets. Purchasing MSRs is an interest rate bet. If I want to make this bet, I can own American Capital Agency Corp. (AGNC) whose managers are experts in residential mortgage and interest rate risk. Plus, investing in MSRs has less flexibility than buying IO-strips. MSRs are relatively illiquid and would degrade the quality of NCT’s balance sheet.
2. Issuing stock at these prices takes upside from the existing business away from existing shareholders – Absent this offering, a fair price for NCT right now would be $7.50 with the expectation that it will rise closer to $10 as they recover value from their existing portfolio of commercial mortgage assets and continue to buyback their CDO notes at a discount. It looks like the this offering won’t get done above $5, so the company is selling shares at 33% below where I think it is fair. Plus, they are going to increase the number of shares by 30%, so any upside that comes from the commercial mortgage recovery will be spread over a greater number of shares.
3. Issuing stock at these levels shows the interests of Newcastle shareholders and Fortress have diverged – Newcastle has a third-party management contract with Fortress. Fortress benefits from Newcastle getting larger even if Newcastle shareholders are not better off. NCT hit $8.50 prior to the March offering. Without the March and now September offerings and the dividend announcements, I have no doubt that NCT would be above $8.50.
4. Expect continued dilution – Management makes it clear that this is the beginning of a large ramp into MSR investment. I expect additional share offerings from newcastle because Fortress will see “so many opportunities to put the capital to work” as the banks divest MSRs.
5. Mortgage Servicing is not an attractive business – a) New servicing rules are about to be released that could change the economics of the business. b) It is a commodity business that will be unattractive once MSR prices rise. c) The relationship between Newcastle and the Fortress affiliate that will be performing the actual servicing is undefined. What if the cost of servicing 6,000 delinquent loans costs more than the 6 bps the affiliate is going to be paid? d) Who is going to provide the credit to advance P&I on delinquent loans?
6. Residential REITs trade at lower multiples – NCT management will argue that the MSR purchase is accretive to the dividends. maybe the dividend rate will go from $0.60 to $0.84. This will move the yield on NCT to 17%. AGNC already trades at 19%. Plus, NCT has upside in its potential yield already. How much of the move in the dividend from 60 cents to 84 cents will come from the MSR purchase versus the existing CMBS business?
Maybe buying these MSRs at cheap prices will turn out to be good for Newcastle. It is too big a risk, in too different a business for me to wait around and see. It destroys the great investment story of recovery Newcastle had built from the lows of March 2009 at $0.27 of balance sheet recovery and taking advantage of opportunity in the CMBS market.
Peerless: Trading for Cash, Launching Closed-End Fund
Jul/110
This is an excerpt from my most recent quarterly letter. If you would like a copy of the entire letter, please email your full contact information to me, derek.pilecki@gatorcapital.com.
I recently purchased a new position in Peerless Systems . Peerless is a micro cap company with three interesting attributes: 1) It holds more net cash on its balance sheet than its market capitalization, 2) it has a profitable albeit declining business, and 3) the CEO, Timothy Brog, has a background as an activist value investor and has made several savvy financial maneuvers in the recent past that give me confidence that he’ll be able to use the company’s cash to create additional shareholder value.
An investment in Peerless appears to be a free option on Brog’s ability to create shareholder value. Brog became Chairman at Peerless in 2007 after starting a proxy battle for a board seat. Prior to Brog becoming Chairman, Peerless had squandered about $75 million through wasteful R&D spending. Since becoming Chairman, Brog stopped the spending and has steadily managed to extract cash flow from Peerless’s declining business.
In 2009, Brog generated additional profits for Peerless through an activist investment in Highbury Financial. Brog used Peerless’s cash to accumulate a stake in Highbury at extremely attractive prices. At the time, I coincidentally owned a position in Highbury and had posted my investment thesis on Highbury to SeekingAlpha. Brog pressed Highbury’s management team to pay a special dividend to shareholders instead of making an acquisition as management desired. A few months later, management sold the company to Affiliated Managers Group for a price approximately 300% higher than Brog’s initial share purchases of Highbury less than 12 months earlier.
Brog continued to create shareholder value at Peerless in late 2010 with a Dutch tender offer for most of the shares. After liquidating the company’s stake in Affiliated Managers Group, Peerless had about $55 million in cash on its balance sheet and 16 million shares outstanding, or $3.46 per share. The company repurchased 13.2 million shares at $3.25 in the Dutch tender. The result of the tender combined with additional cash flow from the business, increased the cash per share to $3.70. Importantly, the share count declined dramatically from 16 million to 3.4 million, so any future cash flows from the existing business will make a greater impact to shareholder value. This is a small but important point. If the existing business or any new business throws off $1 million a year for five years, the cash balance will increase $1.47 per share with just 3.4 million shares as opposed to $0.31 per share with 16 million shares. While this may not sound like much, it is a potential of an additional 31% return over five years.
The existing business of Peerless has been in steep decline, but it still generates a little cash. Peerless holds the patents on a few pieces of imaging technology that are important for manufacturers of copiers. The business generated operating profits of $1.8 million in the last four quarters. I expect Brog to continue milking this business while he finds a way to create additional shareholder value. He owns approximately 14% of Peerless’s outstanding shares.
Late in the 2nd Quarter, Peerless issued a press release which helps to clarify how Brog will create additional value for Peerless shareholders. In the press release, Peerless announced that the company will attempt to form and sell shares in a new closed-end fund managed by a subsidiary of the Company. Drawing on Brog’s activist experience at Peerless and Highbury, the closed-end fund will take an activist approach to investing. The offering is still in its early stages, so we don’t know the potential size of the closed-end fund and how much revenue it will generate for Peerless. However, we do know that as an inducement for investors to purchase shares in the fund, they will be given warrants in Peerless with a strike at $5. While this could be viewed as dilutive to our stake, I think the path for Peerless’s shares getting to $5 will be much clearer if Brog is able to complete the offering of the closed-end fund. The stock closed the quarter at $3.63.
Disclosure: Long PRLS.
Disclaimer: This is not investment advice. This intended to be a window into my thinking when analyzing of PRLS. Please do you own work before making an investment. My positions listed in the disclosure may change without further update.
Time Arbitrage with Primerica
Jun/110
There is an opportunity to time arbitrage the stock market by owning shares of Primerica. The market is not assigning any premium to the expected low-risk growth at Primerica over the next 5 years. The growth is expected because Citi shrunk the size of Primerica prior to the IPO. Over the next few years, Primerica will replace the term life policies that were removed with new policies. This will translate into attractive earnings growth, but Primerica trades for 1.1x book value and under 9 times this year’s estimated earnings per share. Buyers of the stock can earn an attractive return assuming no multiple growth by relying on the expectations for earnings growth in the coming years.
Last July, I wrote a bullish article about Primerica. I saw an opportunity because the company’s balance sheet was restructured prior to its April 2010 IPO. Through March, the investment thesis played out as Primerica reported 4 quarters of better than expected earnings. The stock rose from $20 last July to $26.
In April, Citigroup announced that it was selling a second tranche of Primerica, which has beaten up Primerica’s stock as the market has struggled to digest the additional supply of shares. This recent decline is an opportunity to buy shares in a company with solid earnings growth prospects at a low valuation. At these levels, I believe there is assymetrical risk / reward in the shares of Primerica.
Read the rest of this post which has my investment thesis on Primerica at Seeking Alpha.
Short Thesis on Green Dot
May/110
This post is an excerpt from the 1st Quarter Investor for my hedge fund. If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.
Green Dot targets unbanked consumers and provides them with a convenient reloadable card so they can participate in the cashless economy. The bull case for Green Dot is 1) pre-paid debit cards are a growth market because the number of unbanked consumers is growing, 2) Green Dot has agreements with a high percentage of the retailers focused on low-end consumers so they have the best distribution, and 3) pre-paid debit cards don’t face regulatory risk. I believe this investment thesis is flawed for a few reasons.
1. Pre-paid Debit Cards are a Commodity Product – Every bank in the country can issue a pre-paid debit card. There is nothing proprietary about the product. Green Dot may continue to grow its volumes at high rates, but its margins will decline due to pricing competition. Competitors will compete on price and use their established brands like Western Union or U.S. Bank.
2. High Customer Churn – The average Green Dot customer uses their card for eight months. This high frequency of customer turnover shows that switching costs are low. Basically, Green Dot doesn’t have strong hooks into its customer base. This allows competitors to pick-off Green Dot customers when they go to get a new card. As a basis of comparison, checking account customers of a typical bank stick around for 10 years.
3. Wal-Mart is their Largest Customer – In 2009, Green Dot signed a 5-year deal with Wal-Mart to provide the Wal-Mart’s private label Wal-Mart Money Card. This deal accounts for over 60% of Green Dot’s new card issuance. Green Dot pays Wal-Mart a revenue share as commission for cards it sells. Green Dot also gave Wal-Mart a 5% equity stake as an inducement to enter into the deal. When this deal comes up for renegotiation, Wal-Mart will squeeze Green Dot to improve its own economics. Even if Green Dot wins a renewal deal with Wal-Mart, its economics are going to get worse.
3. Pre-IPO Owners are Selling – The existing owners of Green Dot have been regular sellers of the stock. At the IPO last summer and in the secondary offering in December, all of the shares sold came from existing shareholders. The company never raised any money even though the valuation of its stock is high. I expect insiders to continue to sell.
4. Valuation is Rich on a Questionable Pro-forma Income Statement – Even after the decline during this quarter, Green Dot’s stock still trades at 28x 2011’s estimated EPS. Based on Green Dot’s guidance, sell-side analysts exclude both the equity compensation paid to Wal-Mart and the cost of employee option grants from Green Dot’s estimated earnings. I believe these non-cash expenses are real costs to shareholders over time. Even if Wal-Mart doesn’t get equity in the next negotiation, I can’t imagine a scenario where Wal-Mart gets paid less if the deal is renewed.
I believe a short position is even more compelling now then last fall because Green Dot’s stock can no longer be considered a momentum stock. Plus, it is easier to borrow the shares since the secondary offering was completed in December.
Wintrust Financial: A Cheap Growth Bank
Apr/110
A winning strategy to owning bank stocks is to focus on banks with superior loan generating and deposit gathering capabilities. Another way to succeed in bank stocks is to own acquisitive banks during a period of low valuations such as in the early 1990’s coming out of the S&L crisis or today coming out of the credit crisis of 2008. One bank stock that is compelling is WinTrust Financial (WTFC) because it is one of the few banks with the ability to grow organically, and they are enhancing their franchise through low cost acquisitions. In addition, Wintrust’s valuation is reasonable given their ability to grow.
Background
Wintrust is the bank holding company for a group of community banks in suburban Chicago and Milwaukee markets. The bank was formed in 1991 by a group of experienced Chicago bankers when they formed Lake Forest Bank & Trust. They have grown the company by starting nine de novo banks and purchasing 12 other existing banks. After consolidating some of the acquisitions, the company owns 15 banks with 87 total branches. Each of these banks is used as a growth platform to grow loans and deposits in their respective communities. Wintrust has a history of organic growth.
Investment Thesis for Wintrust:
- Organic Growth – Wintrust has one of the best tracks records in the industry for organic loan and deposit growth. Since its formation, Wintrust has focused on taking market share from the large banks in Chicago. The company focuses on providing a better customer service to its customers by providing a local relationship. Wintrust expects each of its banks to grow loan balances $75 million in 2011.
- Valuation is low historically and in-line with peers – Wintrust trades at about 140% of tangible book value. From 2001 until the credit crisis hit in 2007, Wintrust traded between 215% and 360% of tangible book value. As the company’s credit costs decline and the bank’s earnings power is realized, I expect the valuation to reach at least 200% of tangible book value. Wintrust trades in-line with many of its peers who have lower growth rates. Some analysts will point to Wintrust’s more expensive Price-to Earnings multiple, but I believe these analysts underestimate the earnings power of Wintrust.
- Earnings power is underestimated – Wintrust has more earnings power than most investors believe. The two sources of their earnings power are lower credit costs and redeploying their excess liquidity into higher yielding assets. Most analysts correctly forecast the benefit of lower credit costs, but they underestimate the power of excess liquidity. WTFC has $2.5 billion of excess liquidity. If the bank redeployed $1.5 billion into assets yielding 5%, it would add $1 after-tax earnings per share. There are additional boosts to earnings power through lower FDIC assessments and the eventual paying of dividends by the FHLB of Chicago.
- Opportunistic acquisitions – In the current environment, Wintrust is able to make opportunistic acquisitions. In the last 12 months, Wintrust has bought five failed banks through FDIC-assisted transactions. Additionally, Wintrust bought a life insurance premium finance operation from AIG in a distressed sale in 2009. The FDIC deals are attractive because they drastically reduce the credit risk of the acquired bank through an FDIC guarantee of the assets, and Wintrust is able to acquire the deposits for either a very low or no premium. Wintrust may also take advantage of the low bank stock environment to purchase a whole bank in an unassisted deal, but there are probably 20 banks in the Chicago area that may be sold through FDIC-assisted deals in the next two years.
- Credit quality is manageable – Wintrust’s credit quality has outperformed its peers through the recession. As early as 2006, Wintrust pulled back from loan growth because they wouldn’t lower the credit underwriting guidelines. This conservatism kept credit quality reasonable.
Conclusion
We bought Wintrust for the Gator Small Cap Portfolio because we thought the valuation was compelling given the organic growth capabilities of the bank. We believe there are several drivers to a higher stock price: continued organic growth, additional low cost acquisitions, Wintrust’s stock rerated higher compared to peers due to higher growth, and bank stocks generally getting rerated higher due to lower credit costs.
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