Newcastle Investment Corp (NCT)

I first came across NCT from one of Wally Weitz letters which highlighted NCT and Redwood Trust (RWT) as potentially good investments (during the mortgage crisis, Wally sold out of NCT). I am starting to look into NCT currently to assess its value as an investment.

From the latest 10-Q (31 March 2010), the adjusted book value per share is $17.83 (GAAP BV per share  is ~ negative $22). The bulk of this difference is explained by the difference between the fair value of assets and liabilities, vs. the GAAP book values for assets and liabilities.  NCT adopted SFAS 157 & 159, which broadly speaking, requires mark-to-market for its assets and liabilities.

The interesting thing is while they are able to get market quotes for most of their assets (which could mean depressed mark-to-market prices currently and hence depressed asset book values), they are unable to do so for their CDO bond liabilities, which are private and untraded, and the reported GAAP book value of those liabilities are close to their face value. NCT showed figures of the CDO bond payables fair values estimated using their internal models that are less than half of the GAAP book values. This could be due to the use of the wide credit spreads in their internal models to reflect today’s economic situation.

It would seem that the GAAP book value figure results in a non-apples-to-apples comparison for assets and liabilities. The adjusted BV would be a more accurate indicator. When the market recovers (many gold buyers would say that ain’t happening) and the spreads tighten, it is likely both the fair values for the assets and liabilities will rise and the adjusted BV figure can be realized (interest rate sensitivity should not be a problem as there should be something close to cash flow matching in place in order to pay the CDO buyers). I do note that NCT has been buying back their CDO debt cheaply which helps to unlock more of their BV (e.g. they bought back $56M of CDO debt for $7.5M, ~$0.13).

Of course the adjusted BV could be suspect as it was calculated using the CDO bond payables fair values provided by the company, and the managers indeed have an incentive to produce low figures for the liabilities from their internal models. To account for this, if we cut the adjusted BV by 40%, i.e. $10.70, assumes that it would trade 0.6x BV, i.e. $6.42, take a 50% margin of safety, i.e. $3.21. NCT closed at $3.06 yesterday after a swift tumble from slightly more than $4 together with the rest of the market (we have the usual euro crisis, long periods of market going up, housing overhang worries, etc.). So this looks like a potentially good investment.

Can the adjusted BV be fully realized at this point? It would be difficult for the management to do so due to a few factors, i) they may not be able to raise the cash required, ii) the CDO bonds payable may not be available to be prepaid. Could some external investor come in with funds to do so? Potentially yes, however the complexity of the CDOs and the need to have in-depth analysis of the assets makes it very unlikely. I am surprised that Fortress Investment Group (the manager of NCT) did not do so. I was even more surprised when I read that FIG sold 1.1M out of ~5M of their shares in NCT during 2009 (NCT was  trading around $0.25 – $3.60). This feels like a red flag especially when the sale is by an institutional investor rather than an individual.

Another thing to note is that the AFFO has turned positive this quarter to be ~$3.36 per share. NCT has also paid the accumulated dividends for its preferred shares, as well as bought back much of its preferred shares through a tender offer. That led the preferred shares (Series B, C, D) to recover much of their value lost in the GFC.

Management has shared that currently their focus is in creating liquidity. I would hope that there should not be too many sacrifices on BV to achieve that!

[Notes: FFO (Funds from Operations) starts with Net Income and adds back depreciation (non-cash, and typically real estate increases in value) and subtracting the gains on the sales of depreciating property (one-time event). AFFO (Adjusted FFO) subtracts the capital expenditures required to maintain the existing portfolio of assets (e.g. repair). The AFFO definition is not standarised and each company may calculate it differently.]


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