Description

Introduction

Before explaining why we believe that Bimini Capital Management is an intriguing investment with multi-bagger potential over the next few years, we would like to share the following caveats:

(1)   We are not experts on how to manage a levered mortgage portfolio

(2)   We do not pretend to know where the curve is going over the next few months or years.

(3)   We would appreciate any feedback from the VIC community who might have greater insight into (esp. point number (1) because this opportunity is massive if the company can avoid being the proverbial 6-foot tall man who drowns in 4-foot tall water on average.

In summary, we find Bimini Capital Management (BCM) intriguing because it is a tiny company ($30M market cap) with effective control over a much larger and growing entity (Orchid Island Capital) which it earns a relatively sizeable and growing management fee on.  Assuming normalize historical spreads and leverage over time, we think BCM currently trades at a 15%+ after tax free cash flow yield which can CAGR at nearly a 20% rate over the coming decade. To our surprise, by making normalized assumptions, Bimini Capital Management might utilize most (if not all) of its $270M+ NOL. Management, which owns 40% of BCM, seem to appreciate the importance of not being cavalier in their portfolio management responsibilities and are playing the “long game” to utilize the NOL as markets permit. Applying a range of assumptions, we think that the probabilistic fair value of the shares are worth $10+ per share today (v. $2.30 share price) even after factoring in a 33% chance of this company drowning in shoulder high water.

What is Bimini Capital Management?

Bimini Capital Management (BCM) is a holding company with two principal operating subsidiaries: Bimini Advisors and Royal Palm Capital.  Bimini Advisors manages a residential mortgage-backed securities (MBS) portfolio for a mortgage REIT named Orchid Island Capital (OIC) and receives fees for providing these services.  Royal Palm Capital maintains a MBS portfolio for the benefit of BCM. Both OIC and BMC leverage their equity with borrowed funds to invest in portfolios of predominantly federally insured Agency MBS.  The portfolios seem quite “plain vanilla” for the space. Although BCM is legally structured as a corporation and Orchid Island Capital is a mREIT, the underlying businesses are quite similar and they are effectively controlled by the same management teams based in the same office.  A key point of distinction is BCM, unlike OIC, is not an mREIT. They have no requirement to distribute management fees and interest accrued. Intuitively, this should afford BCM management greater ability to weather difficult conditions as well as flexibility to increase leverage.

Why is BCM a compelling investment opportunity?

ü  BCM is not only an asset manager of its own internal pool of capital, but also serves as an outside asset manager.  It has two sources of value creation. This differentiates it from many traditional mREITs.

ü  Due to OIC’s growth (via share issuance) in 2017, the advisory fees earned by BCM have increased materially.  This should continue to translate into material growth in normalized earnings power for BCM.

ü  This normalized earnings power was “hidden” in the past few quarters due to changes in the tax code in Q417 and a significant flattening of the yield curve so far in 2018.

ü  Due to historic mistakes stemming back from the acquisition of an Asset Backed Lender in late 2005, BCM has a massive (NOL) carryforward of roughly $270 million.  Most of these NOLs expire by 2029, but some go into the 2030s. Our understanding is that BCM will be shielded from taxes into the early 2030s assuming they don’t utilize the existing NOLs before then.   

ü  Playing around with key modeling variables including (a) spread (b) leverage (c) issuance at Orchid and (d) growth in SG&A leaves a wide range of outcomes but, assuming normalized spread and leverage and arguably conservative estimates in issuance, we come to a discounted fair value of roughly $15.50. More aggressive issuance at Orchid (or even some at BCM when share price justifies it) can result in a share price that is more than double this fair estimate of value.

ü  The management team which controls both BCM and OIC is incentivized to ‘shift profitability’ to BCM since they own roughly 40% of BCM’s shares and this entity has a “tax shield” that will ultimately expire.  At a minimum, they are incentivized to protect BCM because a $15 share price is worth roughly $75 million dollars in value to them.

History of Bimini Capital Management

Origins of Company: Founded in December 2003, BCM had raised roughly $140 million through private placements by early 2004.  In September of 2004, it completed its IPO in which it raised another roughly $75 million in net proceeds.  Another capital raise of $67 million occurred at the end of 2004. As a business which leverages its balance sheet to invest primarily in residential mortgage related securities issued by Fannie Mae, Freddie Mac and Ginnie Mae, the company was structured to earn the difference between the interest income on its assets and its costs, including the interest expense on the funds it borrows.  This is effectively its business model today as well. BCM was designed to leverage its equity capital between 6x to 12x to enhance its return to shareholders. Due to its material issuances and leverage profile, BCM ended 2004 with roughly $280 million in shareholder’s equity and a portfolio of mortgage related securities and cash of $3.1 billion.

Opteum Financial Services Merger: After earning roughly $20M-$25M in pre-tax earnings in 2004 and 2005, Bimini attempted to grow and “diversify its revenue stream” by merging with a privately held home mortgage lender in a deal costing roughly $60M in late 2005.  The enthusiasm for this (prospectively accretive) transaction must have been meaningful since they renamed the entire company Opteum, Inc in 2006.

https://www.businesswire.com/news/home/20051103005975/en/Merger-Bimini-Mortgage-Management-Opteum-Financial-Services

Nevertheless, the Opteum merger could not have been more poorly timed considering the impending decline in the broader housing and financial markets.  Not only did the core historic Bimini business struggle, but the acquired business imploded. Operations in the private home mortgage lending business were discontinued and, by 2007, the company was renamed Bimini Capital Management.  Although the core mREIT business did lose $113M (EBIT) between 2006 and 2008, it lost roughly $20M if you include the years prior and year after this period. Considering they entered this period with a $3B portfolio, the portfolio managers arguably managed this difficult period reasonably well. In contrast, the historic Opteum business reported over $240M in losses (“Earnings of Discontinued Operations”) from 2006 through 2008.  Bimini Capital Management was delisted by the New York Stock Exchange in 2007.

Summary: Although the promise of early BCM was destroyed by both a material decline in the underlying US housing market and associated financing coupled with an ill-timed merger, the company survived. After years of deleveraging and restructuring, the same management is again focused on building a sustainable and meaningful financial firm.

Origins and Growth of Orchid Island Capital

Origins of Orchid Island Capital (OIC): Formed by Bimini Capital Management in August of 2010, the specialty finance company invests in Agency residential mortgage backed securities via traditional pass-through Agency RMBS and structured Agency RMBS (e.g. CMOs, IOs, IIOs, and POs).  In early 2013, Bimini listed Orchid on the New York Stock Exchange and, through its wholly-owned subsidiary Bimini Advisors, manages its investment portfolio.  Both companies maintain similar business models, identical senior management, and office headquarters. This agency issue to OIC shareholders is actually beneficial to BCM.

Growth of Orchid Island Capital: Since Orchid’s public listing, their management team has managed to issue nearly $600 million of stock at premiums to book value.  We believe that management intentionally kept dividend distributions at higher than sustainable levels to capture a higher price-to-book value multiple than its peers due to capital that was attracted to such high yields. When the shares traded at a premium to book value, management was quick to issue shares resulting in material growth in shareholder’s equity.  To management’s credit, although they have issued roughly $140 million in net stock per year from 2014-2017, they did repurchase roughly $20 million in shares (and didn’t issue any) in 2015 when the shares traded at a material discount to book value. Similarly, management repurchased $8M in shares and hasn’t issued any shares since they have tended to trade at a discount to book value.   

Impact on and Opportunity for Bimini Capital Management

As the external manager of OIC’s investment portfolio, BCM receives a monthly management fee and a pro rata portion of certain overhead costs (as well as certain direct expenses reimbursed).  This monthly management fee is (one-twelfth of) 1.5% of the first $250M of OIC’s equity, 1.25% of OIC’s equity that is greater than $250M and less than or equal to $500M, and 1% of OIC’s equity that exceeds $500M.  Consequently, the growth of equity at OIC results in higher Advisory Services revenue for BCM. Furthermore, as the owner of roughly 1.5 million shares of OIC, BCM also receives OIC’s dividend. The shares are worth roughly $10 million at today’s price and may distribute roughly $1.4M in dividends over the next 12 months. Finally, as BCM covers its (relatively fixed) operating expenses with increased Advisory Service Revenues, BCM accrues profits which grow its own equity that can be reinvested in the core MBS strategy for greater profits by its Royal Palm subsidiary.  Finally, this arrangement is protected not only through the alignment of management between OIC and BCM, but also a “poison pill” where OIC will be required to pay BCM a termination fee equal to 3x the trailing management fee should OIC terminate the management agreement without cause. BCM’s agreement with OIC is protected by management team overlap with potentially aligned loyalty to BCM as well as “poison pill” in place.

What assumptions are necessary for the $15 per share DCF valuation and how do we get there?

Orchid Related Compensation

First we look at the impact of OIC on BCM’s revenue.  We assume that Orchid raises no capital in 2018 but raises $140M per year after that.  We assume $140M because that was the average of the amounts raised in 2014 ($171M), 2015 ($72M), 2016 ($118M), and 2017 ($198M).  We don’t expect a straight line in equity raises but for approximation purposes this might even be low since the company should be working off of higher equity balances from which to issue over time.  For example, from 2015 through 2018, they averaged equity raises of 36% of the prior year’s ending book value. We excluded 2014 to avoid distorting this average higher. Our model effectively assumes a 34% equity raise in 2019 over 2018 ending book value and gradually scaling down to 5% over time.  Assuming the existing management fee terms (perhaps a bit under market) remain in place, this would imply that OID’s management fee to Bimini would rise from roughly $6M in 2018 to over $30M in 2036. In addition, we assume that Orchid’s share of overhead continues to increase at a 6% rate. Total Orchid compensation (seen on the bottom chart) grows from $7.8M in 2018 to $35.3M in 2036.  Total Orchid related compensation grows by 8.8%.

Growth of Royal Palm Subsidiary

Since BCM has achieved enough scale to achieve profitability, increased equity should go into Royal Palm.  We anticipate that Royal Palm will end 2018 with $25M in equity. This figure will be aided by $2M from the recent sale of a historic asset which had been written off to zero (see below).  Assuming an average leverage on Royal Palm assets of 7.5x and a gross yield spread income on the Royal Palm portfolio of 1.75%, Royal Palm’s internally generate cash flow (coupled with cash flow coming from the Orchid relationship) results in a nearly 18% CAGR on Royal Palm equity. Remember, they are not paying out a distribution and they have very little taxes for the next decade (plus).

Orchid Dividend

Assuming OIC pays a $.90/annum dividend (currently at a $.96 rate), this should result in roughly another 1.4M per year in revenue for BCM.

Overall Revenue

Based on these assumptions, assets and revenue should compound at roughly 11%-12% per year.

Cost Structure

We estimate that SG&A grows at 6% per year.  While SG&A growth at 50%-60% might be a bit below a a normalized estimate of costs growing at 60% of assets, we assume that BCM/Orchid has $2M in (unrepeatable) overhead costs. Off of this lower base, we would be assuming 7.6% in overhead cost growth.  This is roughly 65% of asset growth (at OIC and BCM combined). We thought this seemed reasonable.

Operating Profit

Based on the assumptions above, EBIT grows at nearly a 16% rate over time with higher rates of growth (closer to 20%) over the next decade due to the tax protection of the NOL.

Subordinate Note

The company has sub notes that are 3 month Libor + 350bp.  They paid $700k in interest expense over the first 6 months of 2018.  We don’t have a view as to where rates go, but we do generally look at them as great capital vehicle for a company with BCM’s description.  Of note, associated with this Note issuance are some assets which BCM had written off to zero. They just announced a sale of some of them for $2M.

http://www.biminicapital.com/static-files/8b4937e7-c0f8-40b8-834d-30ebdbc18079

Although the company has a buyback which was recently put in place, we don’t anticipate any net dilution or net share buybacks over time.

NOLs

According to the 2017 10k, BCM had federal NOLs of $19.1M and Florida NOLs of $18.5M which will begin to expire in 2028 but (according to management) go into the 2030s.  At the Royal Palm subsidiary, they have a federal NOL carryforwards of $254M and Florida NOLs of $26M. These NOLs begin to expire in 2025 and generally expire by 2029. Our model doesn’t take into account state taxes in Florida but we don’t think that this will be highly meaningful. We do begin to assume some taxes by 2030 and a full, all-in tax rate of 25% in 2031.

Fair Value

Although we don’t apply any terminal multiple, we are adding in discounted (at 8%) cash flow accrued at BCM for a long time.  We did this to illustrate the value of the flywheel of internal capital growth, the outside management agreement, and tax protections of the NOL.

We obviously understand that the model below is likely to be quite inaccurate for any specific period due to the cyclicality of this industry.  Nevertheless, we would suggest building your own models and looking at potential upside should larger issuances at OIC be implemented or even some modest (non-382 impacting) issuances at BCM when it is more appropriately valued.  The upside, while far from our base case, is not unreasonable and results in much higher valuations than we have laid out below.

Model

Another Approach To Valuation

Valuation approaches to the mortgage REIT space range from a multiple on book value, EPS, ROIC, dividend yield, etc.   The unusual nature of BCM makes each of these approaches useful, but all modestly flawed. For example:

·        Much of BCM’s book value is tied to its historic Net Operating Loss.  BCM’s book value per share declines from $4.11 to $.56 if the NOL is excluded.  Obviously, Provision 382 in the Tax Code restricts the usefulness of the NOL should the company be acquired.  It has limited transferability value outside of BCM.

·        Even though BCM has a fairly ‘plain vanilla’ mREIT business model of investing in Agency MBS, BCM is not a mREIT.  It does not have to return capital to investors on a regular basis and isn’t subject to distribution pressures in how it manages its portfolio in the short-term.  As the leverage to the model described above indicates, Bimini shouldn’t be paying dividends until its NOL is fully utilized. Not surprisingly, it makes no distributions and has no dividend yield.

·        Unlike most mREITs which are limited by the returns on their book value of equity to generate cash flow, Bimini has this source of cash flow via outside management agreement with OIC.  As indicated above, this agreement should have a long-life to it and might even be slightly under fair market pricing for the service.

·        In our efforts to think about valuation in a distinct manner from the Discounted Cash Flow provided above, we decided to separate the business into a valuation based on BCM’s book value and then a valuation based on the OIC Agreement.  Although many mREITs trade close to book value or above historically (including OIC), we decided to discount this valuation because of the reliance on the NOL instead of traditional equity. Secondarily, we decided to apply a revenue multiple to the outside management agreement ranging from 2x-7x.  Based on the overlap of management, the ability/tendency to grow book value through issuance in the industry, the “poison pill” arrangement, and NOL protections on any income, we would tend to think that a mid-to-high range of the valuation scale would be appropriate. In summary, as another way to think about BCM, we arrive at a fair value range of $26M to $53M on a Book Value basis (.5x-1.0x) and $16M to $56M on the management agreement (2x-7x).  In summary, this other framework on valuation could be looked at as anywhere from $3.30 per share to $8.50 per share but where we think $5 (.5x BV, 5x Revenue) to $8 (.8x BV and 7x Revenue) is likely a fair range. That being said, this doesn’t take into account the ROIC potential which we highlight in the DCF model above.

Management & Portfolio Management

Although we do not discuss spreads and outlook for the rates market here, we found CEO/PM Robert Cauley to be quite accessible.  Our conversation led us to comfort he is playing “the long game” with BCM and will make adjust so as not to “blow up”. This includes reducing the dividend paid at OIC in light of NIM compression as well as certain comments that he has made in the most recent conference call at Orchid including:

“we think we are pretty well-positioned going forward for what we see as the most likely outcome, which is continued Fed increases and a potential for spike higher longer term rates…If we see long-end rates move higher and/or spreads that these assets trade at move wider, then we have the opportunity to increase the yield on the portfolio. That's kind of the big wildcard here going forward. Everybody is aware of the fact that the curve has been flattening, it's putting compression -- downward pressure on earnings, but what happens on the long-end of the curve is going to be the key driver, whether we can still continue to see more earnings compression or we get some relief in the -- as a result of movement higher, either rates or spreads…I think if you followed us for the last few quarters, we are just taking a view that it's okay to have in this period in time this point of the Fed hiking cycle, we'd rather give up a little bit on the earnings front and guard against sort of at inflation type of surprise that gets long end rates moving quickly. That's the kind of move it can be devastating to portfolios like ours and we'd rather guard against that and maybe soft little bit on the earnings side for a few quarters then be exposed to a windfall decline and the value of our assets”

The commentary about avoiding “devastating” impacts to portfolios is what he stressed in our conversation when he explained the history of the industry.  Specifically, he cited that many of his peers are repeating the mistakes that he (and others) made in the mid 2000s when they tried to offset declining NIM by either not cutting dividend payments, increasing leverage, or entering new businesses.   From our conversation, he clearly seemed to have learned his lesson and has limited interest in repeating the experience.

In terms of cutting the monthly distribution at Orchid from $.14 last year to $.08 today, his (unpopular) actions seem to reflect this resolve.  Furthermore, BCM doesn’t have a distribution requirement and, in theory, has more flexibility in raising leverage because of this.

Other Risks/Issues

·        Legal Changes – while BCM seems to think any liability risk from Opteum and the mid-2000s is behind it, this liability risk was part of the reason for the spin of Orchid into a separate legal entity 5 years ago.

·        Regulatory Changes – perhaps at some point MBS from government sponsored entities does not have the same credit risk protections as they do today.  This brings credit risk back into consideration.

·        Risk of activism at Orchid – due to the poison pill, BCM would receive an equity infusion of ~ 70% of its market cap under such a scenario.  While not ideal, it wouldn’t destroy the opportunity in BCM shares since BCM’s internal equity would nearly double and the NOL would still be in place.

·        Management (and Board) compensation feels a bit high to us, but we do believe (as 40% owners of BCM) that management is aligned with us here

·        There is no straight lines in profitability in the mREIT space as current market conditions would illustrate.  So the biggest concern here is management of the portfolio both in good times and bad times.

Catalyst

A few quarters of normalized cash flow 

Additional growth in equity at Orchid