|Shares Out. (in M):||18||P/E||0||0|
|Market Cap (in $M):||83||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
|Borrow Cost:||Tight 15-50% cost|
Five Oaks Investment Corp (OAKS) is an externally managed mortgage REIT. The company is structurally challenged and over-valued. We believe fair value is at most $4/share and probably much lower.
1. Book value heading South for the Winter
OAKS just reported 4Q16 earnings and book value is down to $6. Unfortunately OAKS is so late in their reporting that their YE16 reported book value will already be almost three months obsolete. We estimate that current book value for OAKS is approximately $5.50/shr today. Note that many services such as Bloomberg had a false share-count for the last several months and failed to incorporate the special dividend paid largely in shares on 11/17/16.
2. Subscale and likely to stay that way
We estimate that OAKS now has common equity value of approximately $95MM (admittedly a moving target in a volatile rate environment). Operating expenses in 3Q16 were $2.5MM. This is an annualized 10% expense ratio. OAKS could be the greatest MREIT managers ever (which we don’t think) but even the Warren Buffett of MREITs would hemorrhage shareholder value with a 10% expense load. Consider that the MREIT game is largely funding commoditized assets with commoditized funding with (hopefully) a little manager hedging skill thrown on top. Just to break even with this cost structure they need to generate a double digit gross ROCE.
The current dividend costs $10MM/year. As described above, annualized operating expenses are running $10MM/year (which gives credit for cost savings below the $11.7MM expense load for 2016). OAKS preferred funding cash costs $3.5MM per year. To maintain this OAKS must generate $23.5MM/year or a roughly 25% gross return on its common equity. This is probably impossible but to even have hope of covering the burn OAKS would need to take terrifying levels of levered risk. Moreover, at what point do funding counter-parties balk at this structure and either pull lines or demand more onerous terms?
We understand that expenses will decline somewhat going forward as OAKS abandons failed ventures such as its non-agency MBS program. OAKS was attempting to build a differentiated business model including private label MBS ala RWT but that effort seems to have failed leaving behind a plain commodity agency MREIT. This might take the expense ratio down by 0.5-1% but OAKs will still face the tyranny of fixed costs on a woefully subscale equity base. In contrast, NLY had $55MM in 4Q16 G&A on $11.3B of common equity for an annualized expense ratio of 2%.
Why doesn’t OAKS just combine with another manager to escape this trap? Herein lies the pain of an externally managed vehicle. The synergies which an acquirer of OAKS might realize by eliminating the entire management team is unfortunately not in the interests of that very same management team which controls OAKS. Look at what happened last year when NLY purchased HTS. By the time NLY paid off HTS’s external manager, shareholders were left with 85% of book value. And this is your max upside IF OAKS was to hypothetically sell today (which we have no evidence they want to do) before destroying more value.
3. Fair Value is at most $4/share and probably much lower
$4/share is approximately 75% of tangible book value. This is the most we realistically see a strategic buyer paying to acquire these assets, especially given the likely value destruction before OAKS even contemplates a sale. Above that point the fixed transaction costs of a deal and necessity of buying off the external manager make a deal improbable. But again, we have no evidence that OAKS is for sale.
So if you are dying to invest in an MREIT you can buy NLY around book with a 2% expense ratio or OAKS at a 10% expense ratio. Capitalize the present value of that 8% difference and you are looking at a value for OAKS at an absurd discount to today’s price. Let’s realistically cap the discount at 55% because at some price point the pressure for OAKS to sell becomes irresistible even for an externally managed vehicle. That would be a price of around $3.