Description
I posted NCEN over a year ago. As I expected, the stock quadrupled from $8.93 to $34 (adjusted for recent stock split). Earnings more than doubled, so the P/E multiple actually didn’t change that much and the stock was still very cheap, at only 5x earnings at the peak.
Since the peak in price, however, insiders have done their best to discredit themselves and have proven that, at best, their judgement is questionable and, more likely, have proven themselves stupid, underhanded and highly dislikeable.
Recent actions, however, have created a fantastic buying opportunity. I expect the stock to double in the next 12 months.
RECENT EVENTS:
1) After doing a road show to institutional investors, touting company prospects, several of the management sold just under 20% of their shares a week later. This sent the stock down about 13% over a couple week period.
2) Despite touting their enormous cash horde, huge cash flow, and a positive outlook for business, NCEN announced a convertible debt deal to raise $300mm, but they couldn’t coherently explain why they needed the money. Since the convert announcement the stock has fallen a further 23%, despite reporting another record for earnings last week. The convertible is struck at $34.80, so it is way out of the money right now. And if you include the calls they bought, the effective conversion price is around $48.
New Century Financial Corporation is a leading nationwide specialty mortgage banking company that, through its subsidiaries, originates, purchases and sells residential mortgage loans secured primarily by first mortgage loans on single-family residences. (Please see my previous write up for background on the NCEN.)
ISSUES:
1) Management are a*holes
2) Treasury rates have started to rise, which will hurt originations, (possibly severely) and whole loan sale prices will come down as the yield curve flattens.
WHAT’S RIGHT:
1) Almost everything about the business is still great. NCEN is estimated to earn $6.00/share this year. The earnings are ALL CASH. Cash flow, due to the cash flow of their residuals, will be about $0.75/share higher than earnings. So cash flow is nearly $7.00/share. The business has very little working capital requirements or cap ex requirements -- so all earnings are free cash flow.
2) Although I hold management in the highest contempt and their treatment of shareholders recently has been despicable and their capital allocation has not been optimal, they have run the business itself perfectly.
NCEN has one of the lowest cost structures in the industry. Low enough that NCEN can make money in almost any environment.
NCEN has grown market share faster than any of their major competitors and are now one of top three originators in America.
NCEN more than doubled their market share in the past year and a half, from 3.6% in ’01 to 6.7% last year to 8.0% this year. So although low rates have helped NCEN considerably, their market share growth is equally responsible for their success.
3) NCEN has bought back about 10% of their shares outstanding (2.4mm pre-split), spending $61mm of their excess cash. After doing a nonsensical convertible deal, and sending the stock down, they intend take advantage of the opportunity they created with their stupidity. They are currently buying back stock aggressively and plan to continue to do so as long as the stock is less than about $40/share.
4) NCEN has spent the past few quarters changing their business model. They have begun to establish a much less volatile earnings base.
They established a loan servicing operation, which has a highly predictable earnings stream
They have started securitizing some of their loan production (as a porfolio lender, not gain on sale), in order to earn a steady stream of interest income. They also keep their enormous cash balance invested in mortgage loans on balance sheet.
Their existing residuals also generate a consistent cash stream and earn a high rate of interest
5) NCEN is currently making about $1.50/share in purely “recurring” earnings of interest and servicing income. Within a year, that number will be over $2.50/share.
The origination business (distinct from the “recurring” earnings streams) will obviously be subject to wide fluctuations, and will make anywhere from $1.50-$5.00/share. This will give NCEN total earnings power of $4.00-$7.50/share, trough to peak, once the recurring earnings are at $2.50/share level next year.
6) I estimate that normalized earnings, assuming higher interest rates and lower whole loan sale prices, with more “normal” origination volumes is about $4.00/share currently, and will be about $5.00/share within a year. A 10x multiple ($40-$50/share) of “normalized” earnings of a company with a 30%-50% ROE is very conservative
The reason for the convert deal is that NCEN will increasingly keep their originations on balance sheet in order to build up a less volatile earnings stream than just selling all their originations for cash. The convert money gives NCEN the capacity to securitize almost $6 billion of loans in order to keep them on balance sheet.
Although selling loans and buying back shares at the current price, at 4x earnings, is a far better use of capital, NCEN is determined to try to please the market with less volatile earnings.
VALUATION:
Stock price: $22.56
Diluted Shares Outstanding: 37.8mm
Equity Value: $852
Net Cash: $280
Enterprise value: $573
Cash/Share: $7.42
Book Value/Share: $12.40
Cash/Share at year end: $10.50
Book Value/Share at year end: $15.50
’03 EPS: $6.00
’04 EPS: $5.00-$7.00
P/E ‘03: 3.8x
P/E ‘04: 3.8x
P/E ’03 (Net of year end cash, and backing out interest income earned on cash): 2.1x
P/E ’04 (Net of year end cash, and backing out interest income earned on cash): 2.1x
P/Year End Book Value: 1.45x
When you consider that the residual run-off generates another $0.75/share in cash (not included in earnings), cash flow is even higher than earnings. So, NCEN is trading at an even lower multiple of actual cash flow.
Another way to look at valuation:
NCEN has two pieces, it's balance sheet and it's current earnings power. NCEN's residual's are a valuable cash producing asset but they are not needed for the on-going business (eg they are not working capital and they could be sold if needed). If you ascribe a conservative value of 75 cents on the dollar to the residuals (they could be sold or re-securitized at that level), and add that to the cash balance, you get approximately $14.70/share. (If you value the residuals at 100% on the dollar, you get approx. $16.50/share.)
If you back the $14.70 in net liquid assets out of the current stock price, you are essentially paying less than $8.00/share for the production franchise and future earnings. Without the interest income generated from the cash and the residuals, NCEN would generate approximately $4.50/share in earnings this year. So, you are paying less than 2x this year’s earnings for the on-going business.
The market believes that, like the prime mortgage market, NCEN’s business will go away almost entirely when rates go up. That is not true. There is no historical evidence of this. The sub prime borrower is not simply refinancing higher cost mortgage debt, but rather taking equity out of their homes, for a host of reasons. Even during the high interest years of the past five years, originations never fell that dramatically. And in 2002 industry production only grew 23%. 2003 is predicted to show barely half that growth. So, while originations will fall in a rising interest rate market, the industry did not experience the explosion of the prime mortgage market and is unlikely to experience the “cliff” that prime mortgages will.
While originations will fall, and could fall dramatically, even as much as 50% in a worst case scenario, NCEN will still make plenty of money. They will be earning about $2.50 from interest and servicing within a year, and then even assuming an enormous 50% fall off in originations AND a major fall in whole loan sale prices to historical lows, NCEN’s origination business would still earn about $1.00/share. In this dire scenario NCEN would still be making about $3.50/share. I think worst case scenario earnings are easily worth more than 13-15x, which would be about $50/share.
The market still refuses to give any credit to NCEN. Despite growing market share, despite record earnings, despite producing an ROE of nearly 50%, despite repurchasing 10% of shares outstanding and continuing to aggressively repurchase stock, and despite a growing portion of earnings coming from “recurring” sources, NCEN still trades at less than 4x earnings and 2x earnings, net of cash. When I posted this stock over a year ago, the numbers were equally compelling, and just like last time I expect the stock to do very well.
Risks:
Mortgage volume will go down when rates go up. That is expected.
Whole loan market. The market for selling sub-prime loans has been and is
volatile. Prices may not stay as high as they are (about 4.0% currently). They have been as high as 5%-6% and have been as low as 3%. However, NCEN's cost to originate is about 2.25%. Even after Long Term Capital blew up in '98, whole loan prices did not get much below 3%. So, with their cost structure they would have made money even when the market was at its all time worst.
TARGET:
Rarely do you get a chance to buy the stock of a company that has a 50% ROE, at less than 4x earnings and 1.5x book. I think NCEN is worth about 10x next year’s “normalized” earnings of about $5.00 = $50.00/share.
DOWNSIDE:
At 1.5x book and 4x earnings, downside is practically zero, in any almost scenario. Given NCEN’s enormous cash position, they have the fire power to take full advantage of any price declines through share repurchases.
CATALYST:
Valuation. 3.8x fully-taxed cash earnings and 2x earnings, net of cash, is unbelievably cheap. Unbelievably cheap.
NCEN is aggressively buying back stock. This will be highly accretive. They could easily buy back another 10%-20% of their stock this year. This would increase earnings/share by 11%-25%.
Eventually rates WILL rise, originations WILL decline, and whole loan sales prices WILL fall. This is expected and more than priced into the stock. But at least then the market will stop “fearing “ these things and start to realize how cheap NCEN is, how NCEN’s business model has changed, and that NCEN can make plenty of money in a higher interest rate environment, just as it has before.
Within a year, NCEN could spin-off their on-balance sheet portfolio into a separately traded REIT. Based on the dividend yields REITS trade at today, a $5bln portfolio would be easily worth the entire current stock price of NCEN.
Catalyst
CATALYST:
Valuation. 3.8x fully-taxed cash earnings and 2x earnings, net of cash, is unbelievably cheap. Unbelievably cheap.
NCEN is aggressively buying back stock. This will be highly accretive. They could easily buy back another 10%-20% of their stock this year. This would increase earnings/share by 11%-25%.
Eventually rates WILL rise, originations WILL decline, and whole loan sales prices WILL fall. This is expected and more than priced into the stock. But at least then the market will stop “fearing “ these things and start to realize how cheap NCEN is, how NCEN’s business model has changed, and that NCEN can make plenty of money in a higher interest rate environment, just as it has before.
Within a year, NCEN could spin-off their on-balance sheet portfolio into a separately traded REIT. Based on the dividend yields REITS trade at today, a $5bln portfolio would be easily worth the entire current stock price of NCEN.