Description
Delta Financial is a small sub-prime mortgage originator that has been turned around over the last 12 months, is extremely cheap versus current and projected earnings, and additionally has “the wind at its back” in terms of operating momentum. DLTO stock is at about $1.50, and when reporting their Q4 2001 results on March 1st, 2002, they gave guidance of $0.50 of EPS for 2002. DLTO reported Q1 2002 earnings of $0.14 on May 8th, and at this time they also increased guidance to $0.60 of EPS for 2002, which we suspect is conservative given the turnaround that has taken place at the company and the underlying drivers. The company is therefore now trading at 2.5 times management’s recent 2002 guidance, which may be conservative. A reasonable multiple of 8 times the $0.60 management is currently expecting would result in a stock price of close to $5, but we think the $0.60 will end up being too low for 2002. (Note that these EPS numbers have virtually no tax expense associated with them – DLTO has over $100 mm of NOLs so won’t be paying taxes for a long time.) This is a stock that could and should easily triple over the next year, with upside beyond that based on future earnings growth.
DLTO has completely transformed itself over the last year or so. A year ago, DLTO really was involved in two business, both the origination and the servicing of sub-prime home equity loans. They had a $3.3 billion portfolio of loans which they serviced, in addition to originating $1.5 billion in loans in 1999 and $900 mm in 2000. The company was reliant on non-cash gain-on-sale accounting from securitizations to generate GAAP earnings, and was also subject to unpredictable write-downs on its residuals which negatively impacted earnings. As a result of a high percentage of revenues being generated through non-cash gain-on-sales, the company was a user of cash, even when it was able to generate GAAP EPS. The company had $150 mm of bonds which used $14 mm of cash for interest payments annually, further compounding their cash flow problems. As DLTO’s servicing portfolio aged, the servicing business used more and more cash – both in terms of operating expenses and in terms of servicing advances. So this was a leveraged business, which was generally a user of cash, reliant on non-cash gain on sales to generate positive net income, with unpredictable earnings because the non-cash gains would frequently have to be marked down at a later date.
In late 2000 and early 2001 management began transforming the company, with the objective of building a sub-prime mortgage origination business that could both be cash flow positive and generate positive and predictable earnings. In addition to doing the normal things to cut operating costs, they totally changed the business model and capital structure. In May 2001, they got rid of their servicing business by transferring their $3.3 billion servicing portfolio to Ocwen (the servicing business used cash both in the form of operating expenses and through monthly delinquency and servicing related cash advances to the securitization trusts). In the spring of 2001 they initiated a plan to exchange their $150 mm of notes for $150 mm worth of their residuals and new preferred stock in DLTO. This exchange was eventually successful in August of 2001, through which DLTO eliminated over 90% of the bonds. (A new entity was created to own most of DLTO’s old residuals, which the former bondholders now own.) DLTO also changed its assumptions with respect to calculating the non-cash gain-on-sales in securitizations, with the goal of making the initially booked gain-on-sales smaller and therefore less likely to have to suffer write-downs later on – basically they got more conservative with respect to their gain-on-sale accounting, in order to making their recognized earnings stream more predictable. This resulted in a big write-down to the remaining residuals in Q3 2001. At the end of this restructuring, DLTO had a big reduction in cash interest expense due to eliminating substantially all of their debt. As a result, under the new business model as an originator only, DLTO is able to generate positive earnings while generating smaller non-cash gain-on-sales, which allows the earnings stream to be more predictable. Note that DLTO also generates cash revenues through the net interest spread on loans held in inventory before being sold, through whole loan sales for a cash premium, and through selling servicing rights and IO (interest only) or NIM (net interest margin) certificates as part of its securitizations. The net effect of these changes is that the percentage of DLTO’s total revenue that is from non-cash gain-on-sale from securitizations is a smaller proportion of their total revenue, and total expenses (including both operating and interest expenses) are lower, allowing DLTO to be truly profitable with a predictable and consistent earnings stream.
By the start of Q4 2001, DLTO’s restructuring was complete – the new DLTO is solely involved in the origination of sub-prime loans (through its own retail offices and through a broker network), and then sells those loans (along with the servicing rights) through both securitization and whole-loan sales. In Q4 2001, their first quarter after completing these changes, they reported positive EPS of $0.21 (their first profitable quarter since Q1 2000) – note however that Q4 was helped by the fact that they did not do a securitization in Q3 2001, so their Q4 2001 securitization which was done in October 2001 effectively was selling Q3’s loan originations plus part of Q4’s.
In Q1 2002 they reported EPS of $0.14 per share. Like the Q4 results, the Q1 2002 results were helped by selling more loans in the quarter than they originated in the quarter, since they had loans from the second part of Q4 still available to sell in Q1 2002. However this $0.14 is also net of a $2.1 mm or $0.13 per share write-down on one of their old residuals (this particular residual was valued using one underlying assumption that was different than the others, so with this change DLTO’s residuals are being valued on the same assumptions.) Without this adjustment, Q1 2002 EPS would have been $0.27, which suggests that their $0.60 EPS projection for the full year may be conservative, especially if origination levels grow. In the Q1 they sold $175 mm of loans through securitization and $35 mm whole loan sales – or $210 mm total, versus production of $190 mm. So the incremental $20 mm of loans sold versus production * 6% total gain from securitization is about $1.2 mm of incremental profit or $0.07 per share in the quarter from this issue. So if you take the $0.14 reported EPS, plus the $0.13 write-down, less $0.07 incremental due to loan sale timing – that would be about $0.20 of normalized EPS in the quarter.
Q1 2002 also was the first demonstration of another important element of DLTO’s turnaround plan. Through the debt elimination, elimination of the servicing operation, and running the business leanly, the company had made a lot of progress, but originations were still not doing well. As DLTO went through its problems and restructuring in 2000 and 2001, originations fell from about $1.5 billion in 1999 to $900 mm in 2000 to $600 mm in 2001. In fact originations decreased sequentially each quarter through 2000 and 2001, as DLTO management focused on salvaging the business by restructuring operations, getting rid of the servicing business, getting rid of most of the debt, etc. Maintaining originations was just not a priority when the company was having big problems and the focus of the management team was elsewhere. After this restructuring was complete, DLTO was left with a lean, largely debt-free origination platform, but they need to get their originations growing again to take advantage of this platform. In Q1 2002, DLTO originated $190 mm of loans, which was up substantially from $139 mm in Q4 2001, $147 mm in Q3 2001, $165 mm in Q2 2001, $171 mm in Q1 2001, $185 mm in Q4 2000. Q1’s $190 mm origination represented DLTO’s highest quarterly origination level since Q3 2000. This growth came on the broker side of DLTO’s business, and is at least partially due to the return of the EVP in charge of broker originations in September 2001, who had previously left the company when it looked like DLTO might not make it. DLTO also has almost doubled the number of account reps servicing brokers (increased from 18 to 30) during the last part of 2001, which is apparently starting to make an impact. In their Q1 2002 earnings press release, management indicated that production increased each month during Q1, and that the growth has continued into April. They also secured a new $200 mm warehouse line in May, bringing total committed warehouse capacity to $400 mm, which is double their capacity in Q1 2002, which they say leaves them ample room for anticipated increases in future loan originations. Now that the restructuring is complete and they have their operating costs where they want them to be, the way to grow earnings is through increasing originations, and DLTO has recently demonstrated the start of this process. We believe that if originations continue to improve materially from Q1 2002’s pace, DLTO will likely earn more than the $0.60 EPS they are currently projecting for 2002.
Here’s roughly how we think the basic economics work for DLTO’s income statement on a quarterly basis. This is not intended to be a quarterly projection – this just shows how the economics should work at varying levels of production for DLTO, based on reasonable assumptions. This shows how DLTO can easily due a lot better with increasing originations, especially considering that last quarter’s $190 mm was over 30% higher than the prior quarter sequentially. It doesn’t take much for DLTO to get over $1.00 per share of annual EPS.
Quarterly origination assumption (million): $190 $210 $230
Assumed Securitization (80% of origination) $152 $168 $184
Assumed Whole Loan Sales (20% of origination) $38 $42 $46
Assumes originations are 65% broker channel, 35% retail channel.
Gains on Sale of Mortgage Loans
Cash Gain from Securitizations (4.0%) $6.1 $6.7 $7.4
Non-Cash Gain on Securitizations (2.0%) $3.0 $3.4 $3.7
Servicing Rights Value (0.9%) $1.4 $1.5 $1.7
Less: Securitization Underwriting Costs (0.7%) -$1.1 -$1.2 -$1.3
Whole Loan Sales (4.5%) $1.7 $1.9 $2.1
Total Gain On Sale of Mortgage Loans $11.1 $12.3 $13.5
Interest Income
Interest Income on Loans in Inventory $5.0 $5.0 $5.0
(assumes $180 mm average * 11% rate)
Interest Income on Residuals $0.7 $0.7 $0.7
(assumes 15% return on $18.4 mm balance)
Total Interest Income $5.7 $5.7 $5.7
Origination Fees
Retail Origination Fees (450 basis points) $3.0 $3.3 $3.6
Broker Origination Fees (100 basis points) $1.2 $1.4 $1.5
Less: Yield-Spread Premium to Broker (75 bps) -$0.9 -$1.0 $1.1
Total Origination Fees $3.3 $3.7 $4.0
Total Revenues $20.1 $21.6 $23.1
Payroll Expenses $9.7 $10.0 $10.3
(based on Q1 2002 for $190 mm, increasing at 1/3 the rate of origination growth)
G&A (based on Q1 2002 results) $6.0 $6.0 $6.0
Interest Expense $2.0 $2.0 $2.0
(based on $170 mm on warehouse lines at 3.5%, plus $0.3 mm capital leases, plus $0.2 mm for remaining bonds)
Net Income $2.4 $3.6 $4.8
EPS (based on 16.4 mm shares) $0.15 $0.22 $0.28
Annualized EPS $0.60 $0.88 $1.12
Note that the $190 mm originations gets to about $0.15 EPS under the above simple model, which is lower than the $0.20 normalized EPS I estimated above based on making adjustments to actual reported results last quarter, so this “model” would appear to be conservative.
DLTO’s capital structure consists of $10.8 mm of senior notes (this is the portion of the $150 mm originally issued notes that elected not to participate in the exchange), plus $13.9 mm of preferred stock (issued to former bondholders as part of the debt exchange), plus 16.4 mm diluted shares * $1.50 = $25 mm common equity market cap. So the enterprise value is about $49 mm, for an entity on a pace to originate about $800 mm worth of loans this year. Note that the debt above and the enterprise value calculation exclude warehouse debt which is offset by loans in inventory before they are sold. (Also note that the $13.9 mm of preferred stock will start paying a 10% dividend in 2003 – all else being equal this will reduce EPS pace by $0.08 annually, but the upside leverage with originations is likely to more than cover that.)
We believe that the company has turned the corner in terms of its operating performance, and the next step to truly take DLTO to the next level is to continue to improve the capital structure. We think the company may be open to raising more equity by selling stock at some point, but probably not until they can sell stock at $2.50 to $3.00. The concept is that if DLTO had some extra cash and was viewed as a little more financially stable by the capital markets, that could have multiple benefits that could help the company grow its originations and earnings significantly from here. Having more cash reserves would help their execution on securitizations in a way that could be immediately accretive even considering any dilution current shareholders could suffer. Having more cash reserves will also help them get more warehouse availability to further support growth in originations, which would have a big impact on profitability (the recent 10-K notes how DLTO has in place the infrastructure to expand loan production significantly without adding significant new resources).
New Century (NCEN) is a bigger mortgage originator that followed a similar strategy in 2001 with outstanding results. In Q2 2001, NCEN originated $1.4 billion of loans, generated $0.51 of EPS, and was projecting EPS of $1.45-$1.60 for the full year 2001 (after generating a loss in Q1). In July of 2001 NCEN agreed to sell $15 mm of stock at $10.40 in a private placement done by Friedman, Billings, Ramsey – so they were selling stock at an apparent PE of 7 or so. The rationale was to provide capital to support growth in production and allow the company to time loan sales to increase net interest income. In Q3 2001 NCEN reported $0.81 of EPS on $1.8 billion of production. In October 2001 they sold an additional $38 mm of stock at $11.00 through a public offering, with the proceeds being used to increase the company’s capital base to support expansion of credit facilities and additional growth. In Q4 2001 NCEN reported EPS of $0.94 on $2.0 billion of production, and total EPS for 2001 of $2.28 per share (versus their $1.45-$1.60 estimate only 6 months before, prior to raising this new capital). At this time they also announced expectations for EPS of $3.60-$3.80 for 2002 (about 60% growth from the prior year). Q1 2002 results actually came in at $2.7 billion in production and $1.21 of EPS, at which time they raised their 2002 expectations to $4.35 to $4.55 (about 100% growth from the prior year). During this one year period, NCEN’s quarterly originations increased from $1.4 billion to $2.7 billion, quarterly EPS increased from $0.51 to $1.21, while selling equity at relatively cheap prices that provided them the capital to pursue growth. During this period NCEN’s stock price has gone from around $10 to about $26-27 today. We think that DLTO, now that is has been fixed, is in a position where it may be able to follow a similar strategy, although its difficult to say when this will happen and what the results will be. Management has hinted that they are thinking along these lines, and we think this is the really exciting part of the story. Today we have the opportunity to buy a stock at 2.5 times current earnings, for what could really be a growth company, if DLTO is able to raise some more capital through some strategic selling of equity.
What are the risks? DLTO is still dependant on the securitization market, which can be difficult in times of financial crisis. They also continue to rely on gain-on-sale accounting, although non-cash gain-on-sales are a smaller proportion of total revenues today. In the past DLTO has had some legal problems – in late 1999 they entered into a settlement with the New York Attorney General over complaints of violating various state and federal fair lending laws (described in the 10-K). These legal issues are well known and have apparently been resolved. Changes in interest rates could have an impact on origination levels – however DLTO’s business is not purchase-money, its home equity loans, and mostly fixed rate loans at that (DLTO gets better execution on fixed rate loans in securitizations). As rates start to increase that could actually have a favorable impact on DLTO’s originations as borrowers become more interested in fixed rate loans to lock-in lower rates as rates rise (as opposed to borrower’s higher interest in variable rate loans when they think rates will continue to decline). About 64% of the stock is controlled by the Miller family (Hugh Miller is CEO, Sidney Miller is Chairman). However they seem to have done a good job in keeping any related party transactions to a minimum (only one mentioned in proxy is that company pays premium for Chairman’s $25 mm life insurance policy, but the company will get paid back all of the premiums it has paid if and when the policy pays off). They really seem to run this as an independent company for all of the shareholders (otherwise they could have tried to take the company private at $0.50 a share or something like that last year). We believe CEO Hugh Miller and CFO Rich Blass have done an excellent job in restructuring DLTO and positioning it for growth again, in an industry where many others have failed. The Miller family’s ownership position plus the small size of the company make the float relatively small – yet there are still spurts of liquidity where 25k to 100k shares are traded daily. As the stock price moves up, and if more shares are issued, liquidity will improve over time.
Today DLTO is a $1.50 stock that is projected to do about $0.60 of EPS in 2002 – just based on results currently projected by management for 2002, the stock is probably worth close to $5. Results of the last two quarters have demonstrated that the company has turned itself around. We think its likely that the $0.60 projection by management will prove conservative as DLTO’s originations increase throughout the year, adding more upside to the stock. Additionally, there is potential for even more upside if DLTO is able to sell some equity which could provide the company with more capital in order to get better executions on securitizations and increase the rate of growth of originations (as NCEN has done over the last 12 months), although its hard to judge when that could happen or how that will turn out. While DLTO probably has a fair degree of risk, as a small sub-prime lender dependant on the securitization market, we think the risks are controlled by 1) the turnaround that has already taken place, 2) buying the stock at 2.5 times earnings and the potential for a very easy triple based on current earnings expectations, and 3) the significant upside beyond that based on growth in originations and earnings. This may not be a stock that everybody can get comfortable with, but we think investors who understand specialty finance will find this a very interesting situation.
Catalyst
1) Extremely cheap at $1.50 versus $0.60 earnings currently projected for 2002.
2) Company has been turned around and has positive operating momentum, and the $0.60 is likely to be too low for 2002.
3) Potential for DLTO to become a growth company with additional capital infusion (such as NCEN).