|Shares Out. (in M):||42||P/E||20.0x||0.0x|
|Market Cap (in $M):||1,200||P/FCF||200.0x||0.0x|
|Net Debt (in $M):||350||EBIT||30||0|
Shares of Altisource Residential (RESI) have soared +89% this year as the company has rapidly grown it’s portfolio of NPLs. RESI now trades at 1.5x book value – a 30-50% premium to it’s peers. Growth has been facilitated by accommodating capital markets which have allowed RESI to sell equity at favorable prices. However, there are very good reasons to be cautious on RESI – particularly when insider interests are widely divergent from equity holders. While the company tells a good story (85bears outlined the Bull case on VIC - I won't rehast here), a careful reading of RESI’s public filings reveal the following:
1) RESI’s accounting is very aggressive and highly questionable. The company’s third quarter reported ‘earnings’ (unaudited) come almost entirely from changes in Level 3 asset values. Changes in Level 3 asset values are at the company’s discretion. In other words, over 90% of RESI’s earnings come from marking up the value of assets on it’s books. Actual realized gains from the sale of NPLs were a miniscule 9.7% of revenue. Rental revenues were less than 0.1% of revenue or $6,000 (appears RESI is renting out 1-2 houses thus far).
2) RESI’s dividends are not supported by operational cash flow (because there isn’t any – see point 1). Dividend payments are facilitated by increasing borrowings and equity issuances. It could be said that RESI is borrowing from Peter to pay Paul. I believe RESI’s ability to increase it’s dividend is dependent on continued capital raises.
3) RESI will face a significant headwind from a huge increase in fees paid to it’s external manager Alitsource Asset Management (AAMC). There is a material step-up in fees paid by RESI to AAMC as annual distributions to unit holders exceed $1.03/share (vs. current annualized run rate of $1/share). These hefty payments imply RESI should trade at a discount, rather than a premium to book value.
4) Non-existant corporate governance & Insider incentives are beyond flawed. Key insider, Chairman Bill Erbey (who is also Chairman of AAMC), has significantly more of his net worth invested in AAMC than in RESI (roughly 10x - ie. $700 mn in AAMC vs. sub $70mn in RESI). Erbey is incented to grow the dividend at RESI as fast as possible to maximize payments to AAMC.
While these are individually concerning, taken together these are alarming. In fact, it almost seems as if RESI was created to be abused. I believe that RESI aggressively reports earnings so that it can pay dividends. Paying dividends allows RESI to pay huge fees to AAMC (payments to AAMC are determined by dividends). AAMC is 28% owned by Altisource Residential’s Chairman Bill Erbey. Effectively RESI is raising money from the capital markets (debt & equity) and paying it to AAMC as fees to enrich insiders, namely Bill Erbey. To make matters worse, dividend distributions of RESI are largely determined by AAMC (because RESI has no management of it’s own). Dividends are a function of earnings (company is attempting to convert to a REIT which will mean that 90% of all earnings must be distributed to shareholders) and it seems earnings are solely at the discretion of AAMC management (outlined in detail below). Thus to maximize their own net worth, ‘management’ is incented to 1) report strong earnings (2) increase the dividend (3) issue debt and stock to facilitate continued payment of stock & dividend as well as continued portfolio growth. Continued portfolio growth allows the company to continue to report high levels of earnings/dividends (almost irrespective of underlying performance – see discussion on accounting below). Taking these steps will maximize the transfer of wealth from RESI holders to AAMC holders. Should investors wake up, I believe there could be 50-60% downside in RESI shares should investors realize that the company should trade at a discount (not a premium) to book value. Let’s examine the company in more detail.
Low Quality ‘Earnings’
While the company actively promotes itself as being an acquirer of NPLs and ultimately a large landlord of single-family housing, virtually none of RESI’s revenue is derived from renting properties. Instead, RESI has simply manufactured earnings by marking up the value of it’s assets using what is known as Level 3 accounting. For the most part, owners of financial assets use market-based inputs (i.e. stock and bond prices) in order to report to shareholders the value of their assets. However, non-performing bank loans don’t have active secondary markets – there is no observable market pricing. As such, management has significant discretion in how it chooses to account for it’s portfolio of NPLs. I believe the company is using a very aggressive method for recognizing income as a substantial majority of the income reported by the company is derived from discount rate accretion. In it’s simplest form, discount rate accretion is applying a discount rate (RESI uses 15%) to the unpaid principal balance of NPLs. In short, as time passes, RESI will recognize income on it’s portfolio of NPLs – not because it is collecting interest payments or rents. Simply because time is passing. Sound bizzare? It is. Note that had RESI never purchased these loans from the banks, nobody would be recognizing income on them. But because RESI purchased them at what it has decided is a discount, RESI is allowed to record income on them based future cash flows RESI projects on a discount rate RESI selects (actually it isn’t RESI selecting anything – it is actually AAMC – RESI has no employees). Pure discretion – here’s an exerpt from RESI’s most recent quarterly earnings:
We generated $17.7 million and $26.0 million of net unrealized gain on mortgage loans for the three and nine months ended September 30, 2013 , respectively, which can be broken down into the following components:
First, we recognized $1.8 million and $3.0 million for the three and nine months ended September 30, 2013 , respectively, in unrealized gains driven by a material change in loan status. During the three and nine months ended September 30, 2013 , we converted 43 and 74 loans to REO status, respectively. Upon conversion of these loans to REO, we marked these properties to the most recent market value (less estimated selling costs in the case of REO held for sale); and
Second, we accreted $15.9 million and $23.0 million in unrealized gains for the three and nine months ended September 30, 2013 , respectively, relating to discounts and expenses which were priced into the acquisitions. These amounts represent the time value of money and servicing expenses incurred as a property proceeds through the foreclosure process. The judgment embedded in this value is the estimated time that it takes to foreclose on a loan in various jurisdictions.
In addition to the $15.9 million of discount rate accretion recorded in the third quarter, it recorded $1.8 million in income from a ‘change in loan status’. After RESI has foreclosed on the loan and taken possession of the home, the company reclassifies the loan to REO (real estate owned). The value of Real Estate Owned is based on broker price estimates. This again allows for (another) upward revision to carrying values and I suspect that RESI uses the broker price opinions which are most favorable to it. Because the company’s stated intention is to hold the properties and rent them out, there is little chance that there will be a realized loss recorded on sale (because RESI is not going to sell them) in the near term.
For those keeping score at home: RESI buys a loan. After 1-67 months, it forecloses on the house. At this point it refurbishes the house and gets an appraisal. Rental cash flow received from property: 0 (actually $6,000). Income recognized? Through 9 months, RESI has recorded $17.9 million in net income. RESI then pays dividends to shareholders. Hmmm….. Why is RESI in such a hurry to recognize income? Where is RESI getting the money to pay dividends?
Imminent Increase in Fees to Manager AAMC
Let’s start with a bit of background. Along with Altisource Asset Management (AAMC), RESI was spun out of Altisource Portfolio Solutions (ASPS) in 2012. RESI is a vehicle for the acquisition of residential real estate NPLs from banks. It operates under an externally managed structure. This means that the company does not directly employ an independent management team to act on behalf of RESI shareholders. Instead, it entirely outsources the management of the entity to Altisource Asset Management (AAMC) which provides management (portfolio acquisition, financing, accounting, investor relations, everything). Most importantly (and concerning) is that AAMC, which derives all of it’s revenue from RESI, provides ‘corporate governance’ to RESI (the above diagram is from RESI’s January 2013 investor deck). In fact, while AAMC has a contractual duty to RESI, RESI’s 10-k specifically notes that AAMC does not have a fiduciary duty to RESI. Corporate governance provided by an entity without a fiduciary duty? That doesn’t smell too good.
What does RESI pay for these services? In addition to reimbursing AAMC for all expenses, RESI pays an exorbitant incentive fee 50% of cash flow (in excess of $1.03/share). To put this in context, this is significantly higher than hedge fund managers who typically take up to 20% of client profits. From the 10-K:
We will pay AAMC an incentive fee, which we refer to as our “incentive management fee,” as follows: (i) 2% of all cash available for distribution by us to our shareholders until the aggregate amount of such cash dividends paid during the quarter divided by the average number of shares of our common stock outstanding during the quarter, which we refer to as the “quarterly per share distribution amount,” exceeds $0.161, then (ii) 15% of all additional cash available for distribution by us to our shareholders until the quarterly per share distribution amount exceeds $0.193, then (iii) 25% of all additional cash available for distribution by us to our shareholders until the quarterly per share distribution amount exceeds $0.257, and thereafter (iv) 50% of all additional cash available for distribution by us to our shareholders (in each case as such amounts may be appropriately adjusted from time to time to take into account the effect of any stock split, reverse stock split or stock dividend). We will distribute the quarterly per share amount after the application of the incentive management fee payable to AAMC.
RESI paid a dividend of $0.10/share in September and declared a $0.25/share dividend earlier this month. Of course, the company’s rental receipts and gains on sales (of REO/loans) don’t support this level of dividend. However, as the company seeks to be classified as a REIT for tax purposes, it is required to pay out 90% of earnings as dividends.
Given the discretion involved in determining earnings, why is RESI seeking to structure itself as a REIT? I highly doubt that RESI would be subject to IRS scrutiny/auditor pressure were it to either 1) use a more conservative means of recognizing income or (2) simply record the loans/REO at cost (without the mark-up). Given that RESI is seeking to expand rapidly, retaining this capital would be helpful in expanding the company’s NPL/real estate portfolio. Why not hold off on converting to a REIT until the portfolio has matured (and there is real income to shield)?
Incentives – who is benefitting Peter’s Payments to Paul?
Why is RESI in such a rush to recognize net income/pay dividends? 1) Payments to AAMC are based on the dividend payments of RESI (see above)! Chairman Bill Erbey owns significantly more stock in AAMC than he does in RESI (Erbey owns over $670 million worth of AAMC but less than $75 million of RESI) (2) Paying a large dividend attracts a particularly sleepy class of investor which tend to value companies based on implied yield.
Though the company has done a questionable job of creating value in my view, in today’s yield starved environment, there are a host of yield hungry fish out there to take the bait. They appear unaware that the dividends received are just the secondary offering proceeds they anteed up being returned to them (which they can then pay tax on!).
In RESI’s presentations, it has presented it’s high P/B valuation as a competitive advantage as it allows it lowers the company’s cost of capital. This is an example of George Soros property of ‘reflexivity’. As long the value of sum is being perceived as being greater than the parts, RESI can issue overvalued stock to increase it’s parts – thus further increasing the sum. This is the biggest risk to the short thesis in my view – if RESI shares remain overvalued, it could eventually issue enough stock to grow into (and potentially beyond) it’s current valuation.
While I believe sell-side ‘analysts’ are well aware of the shenanigans at RESI, they have every incentive to continue to pump the stock as RESI is a huge payer of fees given the ongoing secondary issuances, debt raises, etc.
There is a risk that Erbey begins buying nominal amounts of shares to 'Phil Frost' this thing... see Opko Health
|Entry||12/13/2013 08:24 AM|
I meant to included this but guess I forgot: Given that RESI effectively shares half of it’s earnings power with AAMC and that AAMC has little in the way of assets outside of the RESI management contract, it makes sense to combine the market capitalizations when doing valuation calculations. Adding AAMC’s $2.2 billion market cap to RESI’s $1.2 billion cap gives us a total value for the combined enterprise of $3.4 billion. The combined book value is ~$850 million. Thus, RESI/AAMC is trading at an effective valuation of 4.1x book value.
|Entry||12/13/2013 09:32 AM|
Thanks for the writeup.
One of the key questions seems to be if they are writing up assets beyond FMV. In theory, they could be undershooting, correct? Any way to think about that?
|Entry||12/13/2013 10:12 AM|
Anything is possible. On 3Q conf call mgmt noted that if they marked up the portfolio they purchased in October to their estimate of FMV it would add a further $220 mn to book value. Note that under the accounting they use, this will be recognized as income (over two years) irrespective of actual property/rental performance. This would put the AAMC/RESI combo at 3.2x BV.
|Subject||RE: Rental yield|
|Entry||12/13/2013 12:14 PM|
Using purchase price, I estimate they need to earn ~6.5% net rental yield (7.5-8% gross) to pay the dividend (using properties acquired through October) at the RESI level. Thus giving a 3.3% yield (w/ no excess earnings - using 100% POR). I'm not exactly sure how much needs to be spend to refurbish the properties – American Homes for Rent (AMH) targets sub 25% refurb costs. I’m using a 10% estimate for RESI. Also, the above assumes no vacancy. Including a 6-7% vacancy allowance means they need closer to a 7% net yield.
This doesn’t factor in AAMC’s take though. I think it makes most sense to look at this on a combined basis. Let's assume that RESI is able to deploy another $1 bn in capital (using Octobers secondary proceeds and taking on some additional debt) + $200 mn in refurb costs. Let's further assume that all of this capital ($2.05 bn in total for properties + $200 mn refurb) is put to work at an 8% net rental yield (so 10+% gross). After deducting $48 mn in interest expense and $5 mn in non-property level expenses, this leaves us with $111 million in operating income/CF to equity. Dividing this against the combined market cap (of AAMC & RESI) gets us to a yield of 3.2% (assuming everything is paid out and there are no taxes). Again, this is with no vacancy. A reasonable vacancy assumption brings this sub 3%.
So assuming that these guys are able to 1) double asset base (2) do so at very attractive cap rates and (3) execute extremely well, equity holders might clip 3%.
Thus by shorting RESI and AAMC (I short both because while AAMC is more expensive, I think they are both overvalued and can screw RESI). It is worth noting that under the schematic accounting being used, AAMC/RESI can record higher ‘earnings/dividends’ (again discount rate accretion – RESI/AAMC will just decide what they’ve earned). This is my biggest concern in a market which turns a blind eye to risk: nobody cares about bogus accounting and the market is happy to have their secondary proceeds returned to them as dividends. Shares go up, RESI issues more stock at a big premium and the merry-go-around continues. I don’t think the emperor is wearing any clothes, but the longer the market thinks he is, the better his chance to find some pants (because equity issuances at a huge premium to book are highly accretive to existing shareholders).
Hope this helps.
|Subject||congrats . . . so far|
|Entry||02/21/2014 12:26 PM|
It seems to be playing out in our favor . . .
|Subject||Also tempted by OCN & WAC but..|
|Entry||02/21/2014 03:11 PM|
my understanding of these businesses is not that good. Would LOVE to see a write-up walking me through these two....
|Subject||Author Exit recommendation|
|Entry||03/12/2014 11:52 AM|
Though I continue to believe RESI is a Ponzi scheme (dividends are paid from raising debt or new equity), I've decided to exit. I am more concerned about the reflexive loop - raise capital above book, buy assets, claim to have strong earning (all mark to model), hike dividend. Wash, rinse, repeat. I don't know when this ends.
|Subject||Specifically my mind was changed by|
|Entry||03/12/2014 11:57 AM|
1) another successful capital raise at high price, accretive to BVPS
2) insider buying on dip (Phil Frost method)
3) larger than expected dividend hike
|Subject||Kinda think RESI looks cheap here...|
|Entry||11/13/2014 08:36 AM|
11% yield, 15% discount to (real) book. I don’t think they cut the dividend and they might even raise… any thoughts?
|Subject||Re: Kinda think RESI looks cheap here...|
|Entry||11/13/2014 10:35 AM|
I don't feel as strongly either way at this price but still worth noting:
1. Echo everdeen's comments...it's all mark to erbey model.
2. Erbey capitalized on buying NPL's early on at good prices but the capital has flowed aggresively into the space. Note they are no longer the high bidder all the time.
3. You have a 50% carry to AAMC so you better really like the own to rent model b/c you have to believe the yield here is quite high.
4. You provide fees to OCN, ASPS and AAMC for services provided. Bill has every incentive in the world to keep those fees growing so he will keep raising money at discounts to book. In fact he brought up a convert or secondary on the last call. There won't be a pause moment for Bill in waiting till he has shown he is worthy of a premium to book before raising money.
|Entry||01/13/2015 11:11 AM|
Bought some RESI today. It seems cheap.It may not be able to raise capital for a while. Can't justify it trading a deep discount to the book.
What is the biggest risk here?
|Entry||01/14/2015 10:34 AM|
Other than a downturn in housing, I think the biggest risk is they just take forever monetizing the assets (either as rentals or just selling assets). During this time, you don’t get paid and they spend a lot of $$ on G&A/fees.
Agree it looks cheap. Personally, I’m not sure its cheap enough yet, but getting close…
|Subject||Re: Re: cheap|
|Entry||01/14/2015 11:21 AM|
The easiest solution for the new management is to cut the cord with Owens.
RESI has to pay out their rental revenue to remain their REIT status. So you still get paid while waiting.
|Subject||Re: Re: Re: cheap|
|Entry||01/14/2015 12:10 PM|
yes, but they have hardly any rental revenue yet... all the "revenue" has been unrealized gains