In my write up on Gramercy (GKK), I briefly mentioned a competitor, Newcastle (NCT). Interestingly, reviewing NCT’s financials is what gave me confidience for making my investment in Gramercy, as Newcastle is kind enough to go in to much further break down of their balance sheet and their recourse vs non-recourse assets and liabilities. Seeing this helped me picture what Gramercy’s non-recourse balance sheet would look like.
For those of you interested in Newcastle (or Gramercy, for that matter), I’d highly suggest reading this series on the stock over at gatorcapital, especially their introductory piece to the company. Go ahead and check it out- I’ll wait here for you.
Now that you’re back- forget about the common. Just throw thoughts of investing in it out the window. Is it cheap at today’s prices??? Probably- but not as cheap as Gramercy, and management’s interest is horribly misaligned with shareholders. Management is highly incentived to grow the common equity base at basically any and all costs- here’s a nice little summary of their history, again at gator capital.
But all of this presented an interesting question to me- if management seems dead set on growing the common equity base at any and all costs, what piece of the capital structure presents the most value?
The answer, of course, is everything above it. Adding common equity makes every other piece of the capital structure safer. Given how conservative NCT’s balance sheet is, it’s hard to see how anything above it has any risk of permenant capital loss in the first place, but the fact that they’re willing to add cushion makes me even more comfortable.
Let’s start by taking a look at just how conservative their balance sheet is, and then we can look at where you can profit from it (here’s a hint: the preferreds!).
If we ignore their non-recourse liabilities and assets, NCT’s balance sheet has total assets of $463.4m, consisting almost exclusively of investments ($255.2m) and cash ($205.2m). On the liability side, the company has recourse liabilities of $284.8m in total. Note that most of the debt and investments consist of repurchase agreements- I honestly don’t know if that makes a difference or not, nor do I care in this case. The margin of safety in the assets is so high that it doesn’t matter. Also, the investments are almost exclusively (~90%) FNMA securities, which given their government backing and triple A rating aren’t likely to be impaired.
Add it all up and you get total equity of $175.5m. Again, almost all of the investments are in 1) cash or 2) government backed securities, so your risk of impairment or investment losses destroying your margin of safety is low. It’s true they could see a loss in value with a swift change in interest rates, but it would take quite an interest rate change to $220m or so in FNMA securities to be impacted enough to make a significant dent in the equity.
Now, not all of that equity belongs to the common. Some of it belongs to the preferred. The company has 2,463,321 shares of 3 different classes of preferred outstanding. Each of them has a liquidation value of $25 per share. In other words, the preferred represent a claim of $61.6m on that equity.
With total equity at $176m (I’m rounding now), the $62m of equity is covered almost 3x over (2.85x to be specific). In other words, they are incredibly secure. It’s almost impossible to envision a scenario where they aren’t getting paid off short of management doing something incredibly stupid, like leveraging themselves up like crazy to make an acquisition. That’s certainly a risk, but I think it’s a small one.
Each class of the preferreds has a different yield. Class B yields 9.75% on par, Class C 8.05%, and Class D 8.375%. Given today’s low interest rates and how well covered these preferreds are, I would think they would trade for at least par.
But they don’t. They trade at big discounts to par. The class C, for example, trade for 83% of par and a 9.7% yield. I think that’s insane. It represents an incredible opportunity to me. You can pick up equity like returns in a bond like instrument secured several times over with these preferreds.
And this situation isn’t like Gramercy, where the company is likely preserving liquidity for a near term sale. Newcastle is current on all its preferred payments and paying a dividend on its common.
That’s pretty much it for my analysis. If you wanted to get really into it, dig through all of their seperate CDO holdings- some of them are massively, massively in the money; some are massively out of the money. Combined, they about equal out on NCT’s consolidated balance sheet. But remember- NCT will never have to inject more equity in the underwater ones, while they can reap the rewards from the profitable ones.
In other words- there’s even more margin of safety here!
But really, it’s not necessary. 3:1 asset coverage for my preferreds is enough. It is nice knowing that CDO equity is there if we need it…. though I doubt we ever will!
Disclosure- Long GKK, long GKK and NCT preferreds.
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