|Shares Out. (in M):||15||P/E||0||0|
|Market Cap (in $M):||86||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
OAKS is a nanocap with relatively low liquidity and may be most appropriate for smaller funds and personal trading accounts. In a world starved for yield and asset valuations that are full or on the high side of fair value, we are happy to own a security yielding 12%-13% that is trading at about 75% of readily acertainably fair market value with a call option on a potential acquisition of the company in a rapidly consolidating sector. With a potential takeout price of 88% of book value (a 17% premium to today’s price) and a 12.5% yield, which amount to a total return of 29% over the next 12 months, we feel that this security provides an attractive risk-adjusted return.
OAKS is a small hybrid mortgage REIT and mortgage operating company that came to market in March 2013 following several years of strong performance of mortgage REITs. The company invests in a wide variety of agency and credit-oriented investments in residential and multi-family loans and securities, including agency fixed rates, agency hybrid ARMS, multi-family CMBS, non-agency legacy securities, new-issue non-agencies, residential whole loans and mortgage servicing rights. The company is externally managed by Oak Circle Capital, which is led by a veteran team that has been together for 12+ years. XL Investments, a subsidiary of the large insurance company XL Group plc (XL: NYSE), sponsored the launch of the company in 2012 and is still the largest shareholder of OAKS with 36% ownership of the company and a 30% owner of the external manager.
OAKS went public shortly before Bernanke triggered the “Taper Tantrum” in the spring of 2013. The entire sector has been trading down and been quite volatile since then as the market has been trying to digest the shift in the interest rate cycle. As a small player in the sector, OAKS fell victim to the general downdraft and investor distaste for the sector and has traded down with the rest of the sector and at this point largely left for dead.
I. Attractive acquisition candidate of a sub-scale operator (which is unlikely to achieve scale) in a rapidly consolidating industry
Since the Taper Tantrum in the spring of 2013, the entire mortgage REIT sector has traded very poorly. Since then, the capital markets have been pretty much shut down for any company in the sector looking to raise equity. As a result, the companies that went public before or around that time with a plan to raise additional capital in the future to achieve economies of scale were unable to reach sufficient scale to leverage their operating costs. The confluence of various factors, namely mortgage REITs trading at depressed valuations, small mortgage REITs unable to achieve scale in their business, the perceived shift in the interest rate cycle, have spurred consolidation and strategic initiatives in the sector.
The mortgage REIT industry has been experiencing consolidation over the last few years, the pace of which has accelerated dramatically in 2016. Here are the list of recent transactions:
1. Apollo Commercial Real Estate Finance, Inc. (ARI) acquisition of Apollo Residential Mortgage, Inc. (AMTG) announced February 2016.
2. Annaly (NLY) acquisition of Hatteras (HTS) in April 2016.
3. ARMOUR Residential (ARR) acquisition of its affiliated non-agency mortgage REIT Javelin Mortgage Investment (JMI) in April 2016
4. ZAIS Finanicial (ZFC) announcement of strategic alternatives and merger in April 2016
5. Annaly (NLY) acquisition of its affiliated commercial mortgage REIT CreXus in May 2013.
This is a significant number of acquisitions in the space considering that there are only 22 companies in the residential mortgage REIT space. All of the acquisitions except one were at least partially motivated by the inability of the target company to attain scale in the business. In the current market environment, most of the mortgage REITs are arguably at sufficient operating scale except two: OAKS and EARN, with OAKS being the only entity trading under $100 million in market cap. Moreover, OAKS has been trading way below book value for quite a long time and at a lower valuation than most of the other peers in the space.
As a sub-scale platform, OAKS has a very high expense ratios. Expenses totaled approximately 9% of quarter-end capital on an annualized basis. This is 4%-7% higher than the other companies in the space. Given the low valuation ascribed to the company by the market, OAKS has no way to raise additional capital to leverage its operating costs. If OAKS were to raise equity capital at its current valuation at 75% of below book value in a dilutive offering (which we believe is highly unlikely) the market would severely punish the stock, driving the stock price down much further. We feel the management is well aware of this dynamic and would not try to raise capital below book value. The only way to reduce the expense ratio is to rationalize expenses, which the company has been doing. It recently announced in its quarterly press release that it expects annualized cost savings of about $2 million from shutting down the prime jumbo loan aggregation business and an additional $2million from ongoing simplification of the investment strategy going forward.
Given the dynamics in the sector where there are subscale operators in the space trading at depressed valuations (far below book value) and pressure from restive shareholders to maximize shareholder value, we believe that it’s likely one of the other players in the sector will acquire OAKS if the company continues to trade at these valuation levels. With much of the sector trading closer to book value, it makes sense for the other players in the sector to purchase OAKS at discount to book value rather than buy mortgage securities for their own portfolio at fair market value. The acquisitions in 2016 so far have been done around 87%-89% of book value. At a midpoint of those acquisition prices, OAKS shareholders have about 17% upside in addition to the 12%-13% current yield.
Because OAKS has a market value of only $87 million, just about any of the other players in the space could easily acquire the company. There is little integration risk in the acquisition since OAKS has no employees (it’s externally managed) and the assets are mostly liquid and similar to the assets owned by all the competitors. Although any competitor could acquire the company, we believe the likely acquirors are:
Annaly (NLY): As the largest player in the space trading close to book value, NLY has ample capacity to acquire and integrate OAKS. Any acquisition at high 80s of book value would be accretive. NLY previously already acquired CreXus, its commercial mortgage REIT affiliate in 2013 and Hatteras more recently in 2016.
American Capital Agency Corp (AGNC): AGNC recently announced an internalization transaction on July 1, 2016 to become a self-managed REIT. We believe this transaction could serve as a catalyst for acquisition and expansion of the business. AGNC’s chief investment officer, Gary Kain, has stated in the past that they have purchased shares of other mortgage REITs for for their own portfolio when they were trading below book value. As the second largest REIT and trading close to book value, AGNC has ample capacity to acquire and integrate OAKS. Any acquisition at high 80s of book value would be accretive.
Two Harbors Investment Corp (TWO): Although less likely than the other two above, TWO has been opportunitic in making investments in the sector. As the third largest REIT, TWO has ample capacity to acquire and integrate OAKS. Any acquisition at high 80s of book value would be accretive.
If a transaction does not occur in the near term, we think it’s possibly that an activist could step in to force a sale or liquidation. Phil Goldstein's Bulldog Investors was an activist investor in another similarly sub-scale mortgage REIT called Javelin Mortgage Investment (JMI) and pressured the company to maximize shareholder value. JMI was eventually acquired in April 2016 and consolidated into its larger affiliated mortgage REIT ARMOUR Residential (ARR). The writing is on the wall as far as sub-scale mortgage REITs are concerned, and we don’t believe OAKS will be able to resist shareholder pressure to engage in a transaction to maximize shareholder value.
II. Positive carry to the tune of 12-13% while waiting for a sale of the company or other strategic transaction.
The management at OAKS has been re-positioning the portfolio in a more conservative manner over the last year. OAKS has been shifting away from non-agency credit assets more into agency assets, including in the most recent quarter. The company generated core earnings of $0.21 per quarter, which comfortably covers the dividend of $0.18 per quarter. While it’s unlike to raise the dividend, we feel comfortable that the dividend is pretty secure for next 12-18 months even with a modest rise in rates. In addition, the company has hedges in place to mitigate the impact of volatility in interest rates. A low double digit return in today’s yield-starved environment with a potential takeout call option at a 17% premium in a rapidly consolidating industry is pretty compelling from our vantage point.
III. OAKS is trading at the cheapest valuation in the hybrid mortgage REIT space
Currently, OAKS is trading at the lowest valuation in the hybrid mortgage REIT space on a Price to TBV basis:
Source: JMP Securities
Although some some discount may be warranted for OAKS relative to the rest of the sector, the low valuation, the above-average current yield, and the transition of the portfolio to a more conservative posture provide additional margin of safety in owning the security.
- Credit risk. OAKS owns mostly non-agency securities, so it’s exposed to credit risk. Its portfolio would be be adversely impacted by weak economic conditions. However, the company has been transitioning away from credit to more agency securities as it has been shifting to a more conservative positioning.
- Financing risk. Like all mortgage REITs, OAKS is reliant on short term funding to finance the purchase of its mortgage investment portfolio. Thus, rising short term rates or a hiccup in the short term financing markets could adversely affect its business in times of market stress.
- Interest rate risk. OAKS is exposed the risk of a sharp increase in interest rates as well as the risk of interest rate spreads compressing as it borrows short and lends long. The company has various interest rate hedges to soften the impact of interest rate volatility, and they company has been rebalancing the portfolio away from fixed-rate agency MBSs and more into adjustable rate securities and other less rate sensitive securities.
- No strategic transaction occurs. It’s possible that no strategic transaction occurs. However, given the trends in the sector, we’re comfortable that between activist shareholders targeting the sector and a compelling strategic rationale for consolidation in the sector, there will be a positive catalyst for maximizing shareholder value in the foreseeable future.
- Strategic alternatives for the company
- Activist shareholder initiative