Description

Thesis

Great Ajax (AJX) is a unique mortgage REIT positioned to capitalize on opportunities in the distressed mortgage market to build Book Value per share and fund a reliable dividend. More importantly from a value investor’s standpoint, the stock trades at a great than 60% discount to Intrinsic Value, as measured by recent market transactions (see below). We view AJX as a long-term compounder that will reward investors both through an attractive current yield (~9%) and capital appreciation.    

Overview

Although structured as a mortgage REIT, Great Ajax’s business is vastly different than its industry peers. A typical mREIT purchases pools of 30 year agency (Fannie and Freddie) mortgages, which they lever to achieve leverage in the 6x-8x context. These businesses are, in essences, a levered bet on the yield curve as they take-advantage of lower borrowing costs at the short-end of the curve (usually) to buy longer duration assets. I would be extremely reticent to buy a typical mREIT.

AJX is the only public company primarily focused on the distressed mortgage market (to our knowledge). The company primarily invests in re-performing loans (RPL) and non-performing loans (NPL) mortgages backed by single family homes. The company also selectively buys mortgages of small mixed-used commercial properties (average loan balance ~$5mn). As part of the company’s unique servicing model (which involves “working out” individual loans to maximize value), AJX also takes ownership of some Real Estate Owned (REO) single family homes.

The company provided the following overview of its portfolio, as of 12/31/2015:

Great Ajax is externally managed by Thetis Asset Management. In a somewhat unusual structure, AJX owns 19.8% of the management company; fees paid to the manager therefore partially accrue back to shareholders. AJX was formed in January 2014 by Aspen Capital, a diversified real estate investment firm. Prior to forming AJX as a separate entity, Aspen Capital had invested $500mn in more than 3,792 residential assets (UPB and REO of $841mn) from 2009 through the end of 2014. Hence, while AJX is a relatively new company, its management has a long and successful track-record in the distressed mortgage market.  

Investment Thesis

AJX’s business enjoys a number of structural advantages that should enable management to consistently build shareholder value: 

• Differentiated market segment. A key element of the Great Ajax story is the company’s focus on acquiring smaller pools of loans—targeting transactions in the range of $1mn to $20mn. For point of comparison, Annaly Capital (NLY)—among the largest and most-well known mortgage REIT’s—ended last year with $78bn of total asset on its balance sheet. Needless to say, the NLY’s of the world do not bother with deals in AJX’s “sweet spot.”

   

  Less market competition enables AJX to command greater discounts to Unpaid Principal Balance (UPB) when it buys pools. Importantly, AJX has acquired 90% of its mortgages through negotiated transactions as opposed to auction, furthering their ability to buy assets on the cheap.  Last year, AJX purchased RPL’s with an average UPB of 76.5%, NPL’s with an average UPB of 61.5% and REO’s with an average market value of 64.7%. In short, AJX’s model enables them to consistently buy assets at a significant discount to fair value. 

   

• Unique sourcing. Through their years in the distressed mortgage market (first at Aspen and now with AJX), management has developed a nationwide network to source deals (e.g. money center, regional and community banks). Management has relayed that they often get calls from banks looking to sell troubled mortgages in the days prior to a bank examination. These deals often require fast closing, are sold on an “all or none” basis and require wide serving capability, which limits the number of potential bidders. AJX therefore often finds itself as the only buyer for highly motivated sellers.

   

  Additionally, AJX often purchase re-performing pool from non-performing FHA, Fannie or Freddie pool auction participants looking for short-term gains. These transactions are one-off in nature, again enabling AJX to negotiate for best price.

   

• Differentiated analysis. Focusing on small transactions gives rise to another unique element of the AJX business—its differentiated and proprietary due diligence. While a typical mREIT focuses on pool level analysis (e.g. grouping loans by characteristics like duration, coupon, term, etc.), AJX conducts loan-by-loan analysis.

   

  AJX has created its own data-driven analytical framework for identifying attractive mortgage markets, including the following factors. Some of the factors management considers in its loan purchase analysis include the following:
  

• Property = Location, LTV, Condition, Age

• Borrower = Credit score, Interest rate, Monthly cash flows, etc.

• Economic/Demographic = Income levels, Neighborhood rents, Lottery ticket sales, 3^rd grade reading levels, Voter participation 

Some of these factors warrant highlighting for emphasis. AJX has statically proven that neighborhoods with a small percent of stores selling lottery tickets as well as those with a high proportion of 3^rd Grade reading levels are strongly correlated with home price appreciation. The company’s databases also accounts for average foreclosure timelines on a county-by-county basis, as well as, in some instances, for individual judges.

Beyond data-driven analysis, AJX also conducts “boots on the ground” research. The company attempts to physically visit each home they consider purchasing the mortgage for and also obtains two unaffiliated broker quotes for these target properties. The complexity and thoroughness of AJX’s due diligence should give investors comfort in management’s ability to consistently purchase quality assets. Of note, the company has never taken a write down of its assets. 

• Captive Servicer. Distressed mortgages requires a fair amount of work for each loan—a “high maintenance” dynamic that limits competition. AJX owns a captive Servicer, Gregory Financing LLC, to maximize returns on each mortgage purchased.

   

  Gregory conducts a probabilistic model of future cash flows for each acquired loan. In basic terms, their main objective is to keep Re-Performing Loans performing, and to turn Non-Performing Loans into RPL’s. The company’s preferred resolution is to modify Sub and Non-Performing Loans to better match the homeowner’s ability to pay. After a period of performance, these loans typically refinance, creating a positive cash flow for AJX as the loan’s UPB is paid-off.

   

  Other resolution methods Gregory facilitates include foreclosure, deed-in-lieu of foreclosure, short sale and rental. In foreclosure, the company will from time-to-time convert properties to REO’s, which Gregory also manages.

   

  Gregory also has the ability to issue new mortgages—underwritten with the same proprietary diligence that AJX uses when purchasing loans. These refinancing provide AJX a pay-off on UPB and the company often keeps these high yielding mortgages on their balance sheet.
  

• Modest leverage, attractive ROE. AJX ended fourth quarter 2015 with leverage of 1.58x. Importantly, AJX generated a return on average equity of 14.3% in 4Q despite this limited use of debt. For the full year, AJX generated an average equity of 11.64% on average leverage of just 1.08x. Management expects to keep debt-to-equity in an (objectively conservative) range of 1:1 to 2:1 over the long-term.

   

  By way of comparison, NLY targets a return on equity of 10% to 12%, but ended last year levered 6.0x. There is no greater testament to AJX’s ability to add-value for shareholders than its high ROE on low leverage.

   

• Consistently building assets. Building Book Value per share is among the biggest drivers of share price appreciation for financial-related stocks like AJX. Since its initial offering in July 2014, management has consistently boosted its asset base:

   

  

   

• Alignment of management incentive. AJX’s fee structure helps align management with shareholders. First, the company pays incentive compensation based on dividends paid, as opposed to Book Value. Incentive comp based on BV or invested assets (often employed to BDC’s) can prompt management to rashly deploy capital and/or inflate asset values. 

   

  Second, management receives a significant percent of compensation in stock. Originally, management received 50% of comp in stock. In October of last year, the Board changed the formula to 25% for the first $1mn in stock and then 50% shares about $1mn. We are obviously not happy about this change, but believe the alignment of interest remains intact.

   

• Attractive long-term financing. AJX finances many of its purchases with a Repo facility at a 65% advance rate. The company then securitizes its RPL’s, selling the senior tranches to leading credit investors such as DoubleLine, and retaining junior and/or equity tranches. This mechanism creates attractive long-term fixed financing for AJX and—more importantly—provides a market valuation of their portfolio (more below).

Valuation

Understanding AJX’s securitizations arguably renders everything else in this write-up superfluous. The valuations implied by the company’s securitization transactions proves AJX trade at such a meaningful discount to Intrinsic Value as to attract even the most skeptical of value investors.

AJX has conducted four securitization transactions since October 2014. Applying these same market-based valuations to AJX’s entire UPB suggests the market value of AJX’s portfolio is significantly higher than its GAAP Book Value.

The company completed its more recent securitization at Senior leverage of 63% and a B1 and B2 Tranche at 5% each. If the company employed that leverage to their entire portfolio, and subtracted the Net Debt Proceeds from the Price paid for their assets, AJX would have an equity-basis in their UPB of only $17.4mn. Then, assuming the company sold its Equity Trust Certificate at 40% of face (in-line with market values), the company would generate proceeds of $78.7mn. Net Equity Proceeds less the company’s Equity Basis would represent the Market Value of AJX’s assets above Book Value, suggesting an Intrinsic Value per Share of $18.76:  

Conclusion

As we outlined above, AJX’s Intrinsic Value per Share of $18.76 (as priced by recent market transactions) is significantly higher than GAAP Book Value per Share of $14.92. Further, AJX currently trades at $11.22 per share, which suggests that investors are essentially buying the stock at a double discount—25% below BV, which is 25% below Intrinsic Value:

While the market may never fully value AJX on its Intrinsic Value, we believe it is reasonable (if not conservative) to assume that AJX should trade at Book Value, which would imply roughly 33% price appreciation. Total return potential would be boosted by the company’s 24 cents per share dividend (nearly 9% dividend yield). Further enhancing returns, AJX is continually buying new mortgage portfolios (during 1Q16 management had already acquired $56mn of UPB in 15 different transactions), further building value.

Disclaimer

We own shares of AJX and reserve the right to buy and/or sell shares without prior notice.  All the information in this report is accurate as of the date of publishing.

Catalyst

Catalysts:

1) Management has discussed a potentially large Joint-Venture that could help build scale and increase awareness of the AJX story.

2) As the business scales, AJX should attract greater sellside attention and/or institutional ownership.

3) Each new securitization validates the Intrinsic Value of AJX's assets.