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.
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