Newstar Financial news
December 16, 2007 - 11:01am EST by
dawkins920
2007 2008
Price: 8.20 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 400 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Newstar Financial is a Boston-based middle market lender that has to date relied on the asset-backed market for its financing.  To add to its apparent lack of attraction, it lost significant money in RMBS transactions, which is not its core competency and it is relatively illiquid.  It is also a busted IPO, now trading at less than half of its IPO price from last December.

 

What makes Newstar attractive is that it is both safe and cheap. 

 

Below is the company’s balance sheet at September 30:

Assets:


Cash and cash equivalents

73,420

Restricted cash

119,572

Residual interest in securitization

3,051

Investments in debt securities, available-for-sale

37,636

Loans held-for-sale

117,528

Loans, net

1,933,469

Deferred financing costs, net

15,868

Interest receivable

14,501

Property and equipment, net

1,668

Deferred income taxes, net

11,421

Income tax receivable

12,355

Other assets

10,590



Total assets

2,351,079





Liabilities:


Repurchase agreements

545

Credit facilities

705,401

Term debt

1,165,725

Accrued interest payable

26,629

Accounts payable

643

Income tax payable

—  

Other liabilities

25,042



Total liabilities

1,923,985





Stockholders’ equity:


Common stock, par value $0.01 per share:


Shares authorized: 145,000,000 in 2007 and 2006;


Shares outstanding 36,254,443 in 2007 and 36,257,847 in 2006

363

Additional paid-in capital

476,666

Retained deficit

-48,455

Common stock held in treasury, at cost $0.01 par value; 7,584 shares in 2007

-109

Accumulated other comprehensive loss, net

-1,371



Total stockholders’ equity

427,094



Total liabilities and stockholders’ equity

2,351,079

 

 

 


Since the end of the quarter, the company raised 12.5 million shares of equity at $10 a share, so its current shareholder equity is in excess of $552 million, which suggests that even with the loans they make this quarter that equity to assets is probably in excess of 20%.  Also, it is worth noting that at $8.20 a share, Newstar trades at a market cap of about 400 million including the new shares, which is less than 75 percent of book, virtually all of which is all tangible.

 

To make matters somewhat more favorable, because much of the financing is in collateralized loan obligations, even if there were a problem in some vintage of its book, that problem would effectively be segregated into that CLO.  As recently as last week, Fitch was affirming the ratings on a 2006 vintage Newstar CLO.

 

Newstar has no repos and the management believes that at its current pace of making loans that it will not need to come back to the market for capital until at least next summer.  By slowing down the rate of loan growth, management could probably go longer than that.

 

The vast majority of the loans in Newstar’s book are senior cashflow loans to small businesses.   No loan comprises more than a couple percent of the portfolio and management says that they will in general not lend beyond 3 times ebitda.  In a bad economy that may mean that the company is not adequately reserved. (At September 30th, the reserve for loan losses was 1.62% of loans). 

 

Excluding the issue that the company had with its RMBS portfolio (which is now written down almost to about 3 million dollars), the company is currently run-rating at 7.4 million a quarter or about 16 cents a quarter, including the dilution from the new shares, or 20 cents on the old share count. 

 

Assuming that reserves are adequate and that the company continues grows assets at a relatively modest 5% a quarter, the company could pretty easily be running at about 23 cents a quarter by the end of next year or about  $11.1  million. At current prices that would be below 10 times run-rate earnings with a significant growth trajectory.

 

This assumes the following:

1)      No significant increase in Newstar’s spread despite the fact that their CLOs are evergreen and the funding for the loans that will be added to its books has already been locked up.  Management has said that it recently has seen attractive deals at as wide as libor+600, which would dictate a far wider spread than I am using.

2)      Provisions of 6% of net assets added each quarter.  This works out to 31 million in additional provisioning for next year and would be sufficient to keep reserves in line with assets even if there were 15 million dollars of charge offs on the current book next year, which given the age of the loans seems unlikely.

3)      No increases in SG&A and compensation increasing 2 percent each quarter.  It is worth noting that the infrastructure at Newstar currently includes about 100 lending professionals and the team is significantly underutilized compared to the assets under management.

4)      No increase in fees or asset management income from the Newstar opportunity fund.  This is a very conservative assumption.  There is no reason this stream should not grow.

5)      That the management does not run through their current liquidity by the end of 4th quarter of next year. In other words, I am modeling relatively slow loan growth.

6)      Also note that for simplicity, I have simply backed out going forward equity based compensation that was given at the IPO but is being charged through the income statement.  There is approximately 17 million of such deferred compensation left and it will flow through across the next several years.  Also note, I have used the 125 million equity contribution to reduce interest bearing liabilities.  Obviously, this is also a simplification but should not create a substantial difference.

 

There are no doubt a variety of objections that could be made to any of these assumptions on a standalone basis.  Taken as a whole, I think they form a relatively fair picture of what the company might earn.

 

 

 

  

Dec 08

Sept 08

June 08

March 08

Dec 07

Sept 07

 Net interest income:







 Interest income

        69,786

        66,463

        63,298

        60,284

        57,413

        52,626

 Interest expense

        36,907

        34,808

        32,810

        30,910

        29,102

        28,071


 

 

 

 

 

 

 Net interest income

        32,879

        31,656

        30,488

        29,374

        28,311

        24,555

 Provision for credit losses

          8,395

          7,996

          7,615

          7,252

          6,907

          6,553

 Provision as % of new assets

6%

6%

6%

6%

6%

6%

 Net interest income after provision for credit losses

        24,484

        23,660

        22,873

        22,122

        21,404

        18,002








 Non-interest income:







 Fee income

          3,334

          3,334

          3,334

          3,334

          3,334

          3,334

 Asset management income

          1,471

          1,471

          1,471

          1,471

          1,471

          1,471

 Gain on derivatives

                -  

                -  

                -  

                -  

                -  

             134

 Gain (loss) on sale of loans and debt securities

                -  

                -  

                -  

                -  

                -  

               11

 Loss on investments in debt securities

                -  

                -  

                -   

                -  

                -  

         (1,979)

 Loss on residual interest in securitization

                -  

                -  

                -  

                -  

                -  

       (28,136)

 Other income

             500

             500

             500

             500

             500

          3,317


 

 

 

 

 

 

 Total non-interest income

          5,305

          5,305

          5,305

          5,305

          5,305

       (21,848)

 Operating expenses:







 Compensation and benefits (note I have backed out IPO related compensation)

          8,174

          8,014

          7,856

          7,702

          7,551

        11,169

 Q/O/Q

2%

2%

2%

2%

2%


 Occupancy and equipment

             781

             781

             781

             781

             781

             781

 General and administrative expenses

          2,309

          2,309

          2,309

          2,309

          2,309

          2,309


 

 

 

 

 

 

 Total operating expenses

        11,264

        11,104

        10,946

        10,792

        10,641

        14,259


 

 

 

 

 

 

 Income (loss) before income taxes

        18,525

        17,861

        17,232

        16,634

        16,068

       (18,105)

 Income tax expense (benefit)

          7,410

          7,145

          6,893

          6,654

          6,427

         (7,260)

 Tax Rate

40%

40%

40%

40%

40%

40%


 

 

 

 

 

 

 Net income (loss)

        11,115

        10,717

        10,339

          9,981

          9,641

       (10,845)

 After tax adjustments:







 Extinguishment of corporate debt expense (1)

                -  

                -  

                -  

                -  

                -  

                -  

 IPO related compensation and benefits expense (2)

                -  

                -  

                -  

                -  

                -  

          1,969

 IPO related general and administrative expense (3)

                -  

                -  

                -  

                -  

                -  

                -  

 Loss on assets sold and retained residual interest (4)

                -  

                -  

                -  

                -  

                -  

        16,854

 Net interest income earned on assets sold and retained residual interest (5)

                -  

                -  

                -  

                -  

                -  

            (611)


 

 

 

 

 

 

 Adjusted net income

        11,115

        10,717

        10,339

          9,981

          9,641

          7,367


 

 

 

 

 

 








 Net income (loss) per share:







 Basic

            0.23

            0.22

            0.21

            0.20

            0.20

         (0.300)

 Diluted

            0.23

            0.22

            0.21

            0.20

            0.20

         (0.300)








 Weighted average shares outstanding: (6)







 Basic

 48,753,628

 48,753,628

 48,753,628

 48,753,628

 48,753,628

 36,253,628

 Diluted

 48,753,628

 48,753,628

 48,753,628

 48,753,628

 48,753,628

 36,253,628






  


 Adjusted net income per share:







 Basic

            0.23

            0.22

            0.21

            0.20

            0.20

            0.20

 Diluted

            0.23

            0.22

            0.21

            0.20

            0.20

            0.20








 Adjusted weighted average shares outstanding: (6)







 Basic

 48,753,628

 48,753,628

 48,753,628

 48,753,628

 48,753,628

 36,253,628

 Diluted

 48,900,569

 48,900,569

 48,900,569

 48,900,569

 48,900,569

 36,400,569















 Average Balances:







 Assets

   2,938,368

   2,798,445

   2,665,186

   2,538,273

   2,417,402

   2,302,288

 Growth in assets

5%

5%

5%

5%

5%

5%

 Less: assets sold and residual interest (2)

                -  

                -  

                -  

                -  

                -  

        26,955


 

 

 

 

 

 

 Adjusted assets

   2,938,368

   2,798,445

   2,665,186

   2,538,273

   2,417,402

   2,275,333













  


 Interest bearing liabilities (note assumes equity raise used to reduce liabilities)

   2,271,210

   2,142,004

   2,019,084

   1,902,151

   1,790,921

   1,808,174


6%

6%

6%

6%

-1%

4%

 Less:







 Credit facility funding for assets sold (2)

                -  

                -  

                -  

                -  

                -  

 —  

 Corporate debt

                -  

                -  

                -  

                -  

                -  

 —  


 

 

 

 

 

 

 Adjusted interest bearing liabilities

   2,271,210

   2,142,004

   2,019,084

   1,902,151

   1,790,921

   1,808,174








 Net interest margin, before provision






  

 Yield on interest earning assets

            9.50

            9.50

            9.50

            9.50

            9.50

            9.12

 Cost of funds

            6.50

            6.50

            6.50

            6.50

            6.50

            6.16

 


 

On this basis, Newstar would earn about 86 cents next year (or less than an 8 percent return on equity).  Ironically, this number is not terribly out of line with where the street is currently.  It is also worth pointing out that if their spread were to widen by 50 bps, the company could be run rating at as much as 27 cents per quarter by Q4 of next year.  It is also worth noting that from its road show, the management has targeted a 15 percent ROE, which would suggest that they think eventually they could get to an earnings number in excess of $1.65 an $11 worth of book value if they had unfettered access to capital.

 

There are two obvious concerns with the company which help explain why the stock trades where it does.

 

First, there is a concern that by next summer the company is still unable to get more financing.  While it is possible the CLO market will stay closed this long, it seems unlikely to me that if the loans that the company is writing are reasonable that there will not be some available source of funds.  The management team here comes from the small business lending unit of Fleet bank and was backed prior to the IPO by Ochs-Ziff, which among other prominent backers recently put in more money at $10 a share.  I think that it is unlikely that there will not be an avenue for growth as long as the book of business is.  If it is not through a CLO, it may be through other forms of financing or through its being acquired by a larger organization with better access to financing.  The company is sufficiently small and has sufficiently solvent backers that I think a liquidity crunch is unlikely.

 

The second risk is that cash flow lending winds up being a bad business.  If so, this position could be paired with a variety of companies that lend to small businesses at riskier places in the capital structure (such as ALD or ACAS).  If Newstar experiences serious losses, then folks holding riskier debt or equity pieces are in a lot more trouble.

 

It is also worth point out exactly, how bad the loans would have to be for Newstar to be trading at a premium to book at this time next year.  Assuming that the company could make about 90 cents in a relatively normal environment, the company would have to lose almost $4 per share, or close to $200 million to have a book of around $8 at this time next year.  If recoveries are on the order 50 cents on the dollar, this would work out to something on the order of a 15-20 percent loss on the loans to go bad and I am not giving any value to the deferred tax asset that would arise.  While there are probably environments where this might be possible, it seems highly unlikely and even if it did, Newstar would remain in a highly solvent position.

 

 

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