Fremont General Corp FMT
December 16, 2002 - 7:14pm EST by
raf698
2002 2003
Price: 4.29 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 323 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

Fremont General Corporation (FMT: $4.29) is a financial services holding company trading at a PE of 3.56, with steadily increasing profitability and free cash flow, and sizable NOL’s.

Although the PE seems low, based on 1.18 in earnings over the last four quarters, it is even less expensive based on non-proforma earnings, with a PE of 3.30.

However, the ratio that best tells the short-term story is the PE net of NOL’s, which I put at approximately 2.29. This is based on a close of 4.29 divided by the sum of 1.18 net income + 0.69 deferred income tax expense over the last four quarters.

Obviously, there must be some history here, and so it goes that FMT was once in the challenging business of workers’ compensation insurance, which they exited in the fourth quarter of 2001. FMT was writing policies in California, Idaho, Utah, Montana, and Colorado, and has accumulated quite a few NOL’s to carry forward as a result. In fact, things were spiraling out of control, as its combined ratio widened from a horrendous 147.3 in 1999 to a mind-boggling 258.9 in 2000.

At that point, as the press release put it, “The Company made a strategic decision to exit” the workers’ comp. ins. business, and focus on its financial services business, which consists mostly of commercial and consumer real estate lending, bridge loans, and mortgage refinancing.

All is forgiven if other vic members want to stop right here, and rate this a three. I’d give it a three if I stopped here.

Aiming for at least a four, I’d better at least clear up the existing liabilities from that fabulous insurance business. The business was sold, but they are still carrying the run-off book. In July 2002, Fremont executed an agreement with the California Dept. of Insurance that would allow the company to self-administer the run-off of the book and also preserve the net operating loss carryforwards from the workers’ comp. business. According to their filings, their total payment is capped at $92.75 million dollars, of which $53 million is contingent upon statutory surplus and loss adjusments. FMT is obligated to put in $13.25 million for three years, in years 2002-2004, and then in 2005-2008, they may need to contribute another $13.25 million each year, depending on the profitability.

The key phrase in the 10-Q (June 30, 2002) seems to be “the amount of contribution for any one year, including any deferred contingent liability, shall not exceed $13.25 million. The total amount of potential contributions is $92.75 million, of which $53.0 million is contingent.” This stands against a current market cap. of $316 million.

The general response during a conference call regarding inquiries on these numbers was that they are no longer in that business, check the filings for their obligations. I believe that the basic post-mortem on their disastrous insurance business is that they are running off the book, capping their liabilities, and receiving the NOL’s in return.

The NOL’s are currently $276 million, and they are taking them at the rate of about $30 million total the last two quarters, or approximately $0.20 per quarter (based on 75.2M shares outstanding).

Now, for the ongoing operating business. Fremont Invesment & Loan, with over $5 billion in assets, conducts its financial services business through a branch network of insured deposit accounts, a wholesale residential lending division, and a commercial real estate lending division. The commercial division provides first mortgages, the residential lending is a national orginator of sub-prime first mortgage loans.

The earnings over the last seven quarters has been steadily growing, averaging 0.19 per quarter last year, and 0.32 per quarter for the first three quarters of this year. The significant increase is a result of increased levels of net interest income and net gain on the sale of residential real estate loans, offset by a higher provision for loan losses. Net interest margins were an annualized 5.08% for the third quarter.

The lending is dominated by commercial lending ($3.68B commercial vs. $0.43B for residential). Approximately 45% of the commercial real estate loans are bridge loans. 48% of the comercial loans were in California.

For 2002, the interest earning assets average 7.93%, while the interest-bearing liabilities cost 3.16% (as a percent of average interest-earning assets, this would be 2.85%, getting us to the 5.08% net interest margin.)

Essentially, FMT is a bank that has scared investors off with a disastrous insurance operation that is now discontinued. It has a nice asset with its large NOL carryforwards, and seems to be generating fine profits from a straightforward commercial loan portfolio. Given its current profitability, both its common stock and its preferred (yielding 12.25% to maturity), appear to be compelling.

Taking another California commercial lender for a superficial comparison, Greater Bay Bancorp (GBBK), which I claim to know nothing about, is trading at a PE of 8.1, and a price/book ratio of 1.56. FMT, which despite discontinuing its insurance operations, stills shows up on many stock screens as a property-casualty company, and is trading at a PE of 3.5, and a price/book ratio of 0.73.

The obvious conclusion that investors have taken with Fremont is that they will probably mess up again. Another possibility is that they ran a generic and disastrous California workers’ comp. business, and were destroyed along with everyone else, and now they run a commercial real estate lending business, and may deserve a valuation consistent with their ongoing operation, in which case, the stock should probably double.

Catalyst

FMT is trading at a PE net of NOL's of 2.3, and has been unloved since it discontinued its workers' compensation insurance business. Recognition of its capped liabilities, attractive NOL asset, and low valuation will eventually drive this in line with other California commercial lenders.
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    Description

    Fremont General Corporation (FMT: $4.29) is a financial services holding company trading at a PE of 3.56, with steadily increasing profitability and free cash flow, and sizable NOL’s.

    Although the PE seems low, based on 1.18 in earnings over the last four quarters, it is even less expensive based on non-proforma earnings, with a PE of 3.30.

    However, the ratio that best tells the short-term story is the PE net of NOL’s, which I put at approximately 2.29. This is based on a close of 4.29 divided by the sum of 1.18 net income + 0.69 deferred income tax expense over the last four quarters.

    Obviously, there must be some history here, and so it goes that FMT was once in the challenging business of workers’ compensation insurance, which they exited in the fourth quarter of 2001. FMT was writing policies in California, Idaho, Utah, Montana, and Colorado, and has accumulated quite a few NOL’s to carry forward as a result. In fact, things were spiraling out of control, as its combined ratio widened from a horrendous 147.3 in 1999 to a mind-boggling 258.9 in 2000.

    At that point, as the press release put it, “The Company made a strategic decision to exit” the workers’ comp. ins. business, and focus on its financial services business, which consists mostly of commercial and consumer real estate lending, bridge loans, and mortgage refinancing.

    All is forgiven if other vic members want to stop right here, and rate this a three. I’d give it a three if I stopped here.

    Aiming for at least a four, I’d better at least clear up the existing liabilities from that fabulous insurance business. The business was sold, but they are still carrying the run-off book. In July 2002, Fremont executed an agreement with the California Dept. of Insurance that would allow the company to self-administer the run-off of the book and also preserve the net operating loss carryforwards from the workers’ comp. business. According to their filings, their total payment is capped at $92.75 million dollars, of which $53 million is contingent upon statutory surplus and loss adjusments. FMT is obligated to put in $13.25 million for three years, in years 2002-2004, and then in 2005-2008, they may need to contribute another $13.25 million each year, depending on the profitability.

    The key phrase in the 10-Q (June 30, 2002) seems to be “the amount of contribution for any one year, including any deferred contingent liability, shall not exceed $13.25 million. The total amount of potential contributions is $92.75 million, of which $53.0 million is contingent.” This stands against a current market cap. of $316 million.

    The general response during a conference call regarding inquiries on these numbers was that they are no longer in that business, check the filings for their obligations. I believe that the basic post-mortem on their disastrous insurance business is that they are running off the book, capping their liabilities, and receiving the NOL’s in return.

    The NOL’s are currently $276 million, and they are taking them at the rate of about $30 million total the last two quarters, or approximately $0.20 per quarter (based on 75.2M shares outstanding).

    Now, for the ongoing operating business. Fremont Invesment & Loan, with over $5 billion in assets, conducts its financial services business through a branch network of insured deposit accounts, a wholesale residential lending division, and a commercial real estate lending division. The commercial division provides first mortgages, the residential lending is a national orginator of sub-prime first mortgage loans.

    The earnings over the last seven quarters has been steadily growing, averaging 0.19 per quarter last year, and 0.32 per quarter for the first three quarters of this year. The significant increase is a result of increased levels of net interest income and net gain on the sale of residential real estate loans, offset by a higher provision for loan losses. Net interest margins were an annualized 5.08% for the third quarter.

    The lending is dominated by commercial lending ($3.68B commercial vs. $0.43B for residential). Approximately 45% of the commercial real estate loans are bridge loans. 48% of the comercial loans were in California.

    For 2002, the interest earning assets average 7.93%, while the interest-bearing liabilities cost 3.16% (as a percent of average interest-earning assets, this would be 2.85%, getting us to the 5.08% net interest margin.)

    Essentially, FMT is a bank that has scared investors off with a disastrous insurance operation that is now discontinued. It has a nice asset with its large NOL carryforwards, and seems to be generating fine profits from a straightforward commercial loan portfolio. Given its current profitability, both its common stock and its preferred (yielding 12.25% to maturity), appear to be compelling.

    Taking another California commercial lender for a superficial comparison, Greater Bay Bancorp (GBBK), which I claim to know nothing about, is trading at a PE of 8.1, and a price/book ratio of 1.56. FMT, which despite discontinuing its insurance operations, stills shows up on many stock screens as a property-casualty company, and is trading at a PE of 3.5, and a price/book ratio of 0.73.

    The obvious conclusion that investors have taken with Fremont is that they will probably mess up again. Another possibility is that they ran a generic and disastrous California workers’ comp. business, and were destroyed along with everyone else, and now they run a commercial real estate lending business, and may deserve a valuation consistent with their ongoing operation, in which case, the stock should probably double.

    Catalyst

    FMT is trading at a PE net of NOL's of 2.3, and has been unloved since it discontinued its workers' compensation insurance business. Recognition of its capped liabilities, attractive NOL asset, and low valuation will eventually drive this in line with other California commercial lenders.

    Messages


    SubjectYuck!
    Entry12/17/2002 12:34 AM
    Memberjim211
    "Yuck" is not necessarily a bad thing in a value investment. But I couldn't take out a sheet of paper and make up a story that sounded worse. I'm not going to rate the idea without doing work on it, so for now I'll just say yuck again.

    Where I'd be going first on research would be loan quality. Any reassurance you can provide there? California sub prime mortgages...I really don't care what the net interest margin is - I care much more whether they're going to get paid back.

    SubjectReply to jim211
    Entry12/17/2002 10:25 AM
    Memberraf698
    Thanks Jim, I'd rather have a dialogue started than get a rating.

    As far as loan quality goes on the California sub prime mortgages, the residential real estate accounts for only 10% of the outstanding loans. A separate business is their gathering of loans for reselling as securities, by buying pools of mortgages. It doesn't appear to me that they are in the business of extending sub-prime mortgages and holding them on their books.

    Most of their loans are secured commercial loans--3.7 billion vs. 0.4 billion for residential loans.

    As of December 31st, 2001, the average loan size was $5.6 million and the average loan-to-value ratio was 66.5%. Out of 632 commercial loans on the book, 13 were classified s non-accrual (1.94% by dollar amount). In addition, 3 properties were foreclosed on (0.05%) and 7 past due, but on accrual status (0.04%). All-in, about 2% of the loan portfolio are accounted for in these problem areas.

    To come back to your residential sub-prime concerns...at year end, they held 7300 residential loans. Of that amount, 93% were originated in 2001, and the residential real estate portfolio, excluding loans held for sale, was 5.0% of the loan portfolio--which actually represented a decrease from 2000. Since then, it has grown larger, but the only way to get at loan quality figures is to use the 10K numbers from year end.

    California was 40%, but FMT originated loans in 45 different states. The average loan-to-value for loans in portfolio and held for sale was 76.5%.

    FMT carried $195 million in residential loans, but SOLD $2.82 billion in securitized transactions--14 times the amount! If you think this area is a YUCK, short the agencies. However, given that this isn't FMT primary business, and they are simply picking the low-hanging fruit of financing, refinancing, and securitizing, it isn't a big concern for me.

    As for "yuck" not necessarily being a bad thing, well, it usually is a bad thing. But this is a simple story to me...a generic commercial lending bank has a great tax asset and a messy past completely separate from their ongoing business. If FMT's banking operations hadn't been paired in the past with the workers' comp. business, then the stock would be trading higher. I just wish all businesses had a jettisoned past that kept investors from looking at the numbers behind the story.

    Again, thanks for starting a dialogue. I know that most people on this board would rather get three's and a thread going, than win the token prize and watch their stock move away. Or maybe I'm just an odd duck!



    SubjectMore yuck!
    Entry12/17/2002 11:13 AM
    Memberraf698
    Jim,

    You wouldn't be surprised, but yuck is the general response to this story. A colleague of mine showed me this idea, and after two minutes of clicking through bloomberg, my response was yuck. As I researched it, I kept saying "c'mon, something has to be really wrong here to be trading at these levels." I couldn't find it.

    Finally, after I mentioned your humbling reply to a colleague (who doesn't trade stocks), he mentioned that he had asked a friend who manages money for a super wealthy group, and the friend's reply was stay away from that insurance company until you can figure out their reinsurance situation. The tone was similarly dismissive, and so far, that makes it three-for-three on initial reactions, myself included.

    I'd enjoy hearing the thoughts of someone who is more familiar with commercial lending banks, because after the smoke clears, that is what FMT appears to be. If my friend's friend wants to avoid an insurance company, that's understandable, but he obviously spent about two minutes on bloomberg also, and dug no further.

    Like I said, very understandable reaction. The idea still might not be compelling, but I wouldn't recommend shorting a stock at that 2.29 multiple I arrived at. The amazing thing is the apparent disconnect between the implied earnings yield of the common and the yield on the preferred (12.3%). That kind of disconnect between the multiple and the yield usually portends bankruptcy or asbestos liabilities.



    SubjectManagement Ethos
    Entry12/17/2002 03:07 PM
    Membernish697
    Nice writeup.

    Do you have any sense of Management's ethos etc. Looks like they've been around forever.

    What do you make of their restricted stock grants?


    Subjectreply to nish
    Entry12/18/2002 11:08 AM
    Memberraf698
    Thanks for the comment.

    As far as management ethos go, this is always a tough one. They compensate themselves well, and they don't expense their options (they have 1.73 million options outstanding at an average of $13.41). They handle themselves professionally on the conference calls, and like you said, they've been around forever. The chairman/ceo owns 12% of the company, and has been there since 1972. Likewise, other key employees seem to own about 4% in total.

    As for the restricted stock awards, they issued none in 2001. Combining 1999 and 2000, they issued 3.1 million (2.2m in 1999, and .9m in 2000)at a weighted average fair value of approximately $5.30. They have authorization for 11.6 million shares, of which they've used 6.4m shares. It doesn't seem to be an issue right now, but as you imply, it could be if management ethos are a problem. However, on a scenario analysis, they cut back their issuance during their problem periods, and if they are going to be diluting us via this mechanism, it might well be in better times.

    Cold comfort, perhaps, and pure conjecture as to their tendency to not issue restricted stock with a depressed underlying stock. However, my own outlook emphasizes measuring the downside, and FMT's interesting valuation multiples, and the residual cloudiness as to the nature of their business, leads me to believe that there is a disproportionate probability of a positive return. Beyond that, I haven't been overly concerned about some diminishment of the return given possible dilution on the order revealed by past practices, or the scale given their current authorization level.

    Again, thanks for continuing the thread. I wish I had more true insight rather than mere personal opinion to answer your inquiry!


    SubjectShort Interest
    Entry12/18/2002 04:41 PM
    Membernish697
    The shares shorted has increased from 1.7 Million shares in July 2001 to an alltime high of 8.2 Million today (over 10% of shares out). Considering 1/3 of stock is with insiders, that's a very large short position.

    Shorts aren't usually wrong. What do you make of the high level of short interest?

    Good news is the catalyst this creates as shorts get squeezed bigtime if they are wrong and you are right.

    Subjectshorts are comfortable
    Entry12/18/2002 06:41 PM
    Memberraf698
    Nish, I would like this more if I felt that the short interest might prove to be a catalyst, however, to argue against it, I'd state a few points. (I don't mind arguing both sides of my ideas.)

    First, I've got insiders closer to 16%. Second, the short interest really exploded between Jan02 and June02--tripling to its current level, and then has leveled off. The average close was 5.79 for that period, so the shorts aren't exactly sweating it out here. Also, keep in mind that the volume increased in there, so to statistical arb. programs, it probably doesn't look like a problem.

    One of the more interesting features about this company is its impressive daily volumes. That is what leads me to believe that there are some stat arb hedge funds out there that trade this as a part of a pair or something. It's nice to see the fifteen percent range this week, but I wouldn't mind seeing it retrace and attempt to do it again. Given the daily volume in this stock, it seems like it might trade back and forth for quite a while, and that might present some opportunities. At least it isn't one of those trade-by-appointment-only stocks that I seem to get too frequently involved in!

    I'd love to see the short-covering, because I think the short-interest is a bit large given the story and the volume, but it won't be another CTAC. Have you looked at that one...short interest was 65% of float, and when the stock broke back through the average short level, the stock traded nearly its entire float on a gap higher that doubled the stock. That volume was nearly 1.5 times the short interest and 40 times the daily volume. I suppose that would be comparable to an eleven million share day in FMT...nah, that's not going to happen. However, since you brought up the topic, I thought I'd entertain you with the CTAC mention.

    SubjectInsider Ownership
    Entry12/18/2002 11:59 PM
    Membernish697
    16% is senior mgt and directors. All employees (incl. 401(k)) is about 33% per the 10K. FYI. So float is about 2/3 of shares out.

    SubjectThanks
    Entry12/19/2002 01:43 AM
    Memberraf698
    Thanks for the correction Nish, that does make the short interest all the more compelling.

    SubjectFMT Buying back publc debt
    Entry12/31/2002 02:45 PM
    Memberwan161
    I know FMT and think this is a great idea. I own the 7.7 senior notes of 04. The company does not pay cash taxes because any profits generated by the bank subsidiary are offset by the NOLs at the holding company level. The bank pays the tax bill to the holding company, which then uses the cash to buy back the publicly traded bonds in the market. They have repurchased $80 million face year to date through Sept 30, 2002. $32 million of that was in Q3 02 alone. They said on the last conference call that they'll probably retire the remainder of the issue (less than $100mm left) before its March 04 Maturity, then they'll consider raising the dividend on the common.

    Re: the commercial real estate portfolio, even when they do have problem loans, they have had excellent results unoading them in the secondary market at a price of at least 80% of face. Frankly, they have been hitting on all cylinders lately. ROE at the bank has been between 30% and 40% (pretax) for each quarter this year. At the time of the Q3 conf call (around Nov 1), they said October residential loan generation was near a record. They make a bundle originating, then securitizing these residential mortgages, so I expect the numbers in Q4 to continue to be at least as strong as we've seen in recent quarters.

    They have been conservatively building up loan loss reserves and as one friend who is a small bank hedge fund manager told me, they occupy a niche with the type of commercial real estate lending they do, and no one does it better. And this guy had been short the common in the past. Some of his buddies who had been short are throwing in the towel after seeing management consistently deliver great numbers. My friend who used to hate this has finally come to appreciate this management team are obnoxious (listen to their conference calls), but very good.

    I was going to write this one up, but I knew the VIC audience would probably hate it. Good write up, and I have not been focused on VIC in the past month, so I'm sorry I was able to post comments until now.

    SubjectThanks wan
    Entry01/02/2003 01:08 PM
    Memberraf698
    Hi Wan,

    Thanks for the comments. I also thought that it would get a mixed response from VIC, but I was surprised by that first comment it received--that must have confirmed for you its general tone (but at least the poster refrained from rating the idea). That being said, I like the idea more given its response--it helped me understand that for many of those who have dug below the surface, FMT is quite compelling. I just had no idea that it would be dismissed so readily based on a quick read of its superficial attributes.

    Anyway, I appreciate hearing your thoughts. Hopefully, this FMT message board will remain at a trickle as we follow this for the next dozen quarters. Of course, the story isn't that difficult to follow--it just requires reading a 10Q four times a year.

    SubjectQ4 was a BLOWOUT
    Entry03/05/2003 12:49 PM
    Memberwan161
    Howdy, I know I'm talking to myself, but how 'bout those Q4 results? Plus they bought another $5.1mm of the 7.7s of 04 out of the market. The stock is finally starting to show some respect to the great job management has been doing. Once they retire the rest of the 7.7s (or pay off at 3/17/04 maturity), I'd expect them to raise dividend again and/or buy back stock.

    SubjectFMT
    Entry03/13/2003 02:33 PM
    Memberraf698
    Thanks WAN, you know, with the buyback in the bonds, it still amazed me that FMT Pfd was going for 11.5% at the time of the write-up. Anyway...we'll check in with each other each quarter. This is an interesting story still, but it was a lot more interesting before this 40% rally.

    No surprise, they had to write down the whole insurance set-aside...obviously the point of the exercise was to keep the NOLs.

    Strange stock, though, given their earnings dependence on refinancing, you wouldn't expect them to trade inverse to bonds on a big rate increasing day like today.

    Regarding your previous comment that "I was going to write this one up, but I knew
    the VIC audience would probably hate it," I think that it would build character for all of us to see those posts!

    SubjectFMT update
    Entry03/21/2003 11:20 AM
    Memberraf698
    With FMT going from .73 P/Book to 1.19, with refinancings probably going to dramatically slow with the the increase in mortgage rates, and with the price volatility picking up (no doubt due to some shorts covering a bit), I sold about half of my position today.

    I think that this thing trades with decent volatility, and there is plenty of opportunity at these type of levels to probably trade a 1.50 range, but what do I know about that?

    I still like the story, and given the way it is unfolding, there is probably another couple dollars of value, but a lot of the trade from here might well be dominated by the short-covering or lack thereof. The preferred is still quite interesting..., if you like bond yields at 10.2%.

    Anyway, thanks for the ideas and feedback. It was very helpful. Actually, even the negative feedback was useful, as it helped me better understand what people perceived of the stock, and how much that opinioned was informed by the facts or not (some facts, some not).

    SubjectYou sold half you position too
    Entry04/23/2003 02:48 PM
    Memberwan161
    Look at this baby go. We have liftoff! The bird is beginning to move! FMT is at $9.20 today. More than double where it was when you posted the idea.

    And for this you got a rating of 5.1. I really think the rating system stinks here. I have seen well written, well thought out ideas get terrible ratings for no logical reason. I've been on the receiving end of these myself. And even though you end up vindicated over time, it still stinks at thew time you get those crummy ratings from others (some of whom are trying to "paint the tape" when they have competing ideas that week).

    Anyway, kudos again for your great write up.


    SubjectWow and thanks
    Entry04/23/2003 03:44 PM
    Memberraf698
    Thanks Wan,

    A few thoughts, first, the rating isn't that big a deal really, and it is part of the CHARM of vic. I love it when the ratings fly around. Hint: if it is a regurgitation of an OID interview, look for it to be closer to a six! Actually, that first post in the thread made me wake up and realize that this was a real mess on the surface, and that helped me realize that this might be a better idea than I thought. Your later comments about why you liked this, and why you thought vic wouldn't gave it an interesting perspective.

    That said, the volume is massive--who would have thought that it'd take a credit rerating to get this moving? I'm out of everything but the preferred stock, so it shows how little I know. Humbling.

    Finally, I guess my current point-of-view as to the key parameters from here (notwithstanding the short interest) can be found in what I emailed a friend who is hanging on:

    -----
    Hi Chris,

    I look at way too many numbers, and I can't recall any ratios without looking at my notes. I can't remember my conclusions via book value for FMT, but book value is now 5.29. At 9.30, P/B is 1.76.

    In my original writeup, I wrote:

    Taking another California commercial lender for a superficial comparison, Greater Bay Bancorp (GBBK), which I claim to know nothing about, is trading at a PE of 8.1, and a price/book ratio of 1.56. FMT, which despite discontinuing its insurance operations, stills shows up on many stock screens as a property-casualty company, and is trading at a PE of 3.5, and a price/book ratio of 0.73.

    But, I also wrote as the conclusion:

    FMT is trading at a PE net of NOL's of 2.3, and has been unloved since it
    discontinued its workers' compensation insurance business. Recognition of its capped
    liabilities, attractive NOL asset, and low valuation will eventually drive this in line
    with other California commercial lenders.

    So, valuation may be in line for book value, but not for NOL adjusted PE, I'd guess. Anyway, didn't want to make up numbers like I did and then not go back and correct them!

    Cheers,
    Roger

    -------

    Anyway, how do you like that, message inside a message inside a message? Again, thanks for your comments and encouragement.
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