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.