Description

New Century Financial Corporation is a leading nationwide specialty mortgage banking company that, through its subsidiaries, originates, purchases and sells residential mortgage loans secured primarily by first mortgage loans on single-family residences.

At December 31, 2001, New Century originated loans through 65 retail sales offices operating in 25 states and 36 wholesale sales offices, including 5 regional operations centers, operating in 27 states and employed 1,531 Associates.

This stock and this industry are highly controversial. The company is a sub prime mortgage originator. I know the industry very well and have been involved with it for over 5 years. I have made a lot of money shorting many of the POS's that eventually went bankrupt do to uneconomical business models. The industry problems started with fraudulent accouting related to securization of loans and gain on sale accounting. NCEN was no exception to the problems and I was short this stock about 2 years ago. Now I am long. While I made a little money on the short, I like the stock now as a long much more than I ever liked the short.

What's changed? Everything. The industry has been completely washed out. All weak competitors have gone bankrupt and disappeared -- Amresco, Cityscape, Alliance, United Companies, Conti financial and Southern Pacific to name a few (all of which I was short at some point). While the industry was going through a catharsis, NCEN was also having serious problems, but it managed to avoid bankruptcy and fix it's problems. The most important things NCEN fixed: it lowered its costs of originations, and turned from a cash-burning securitizer of loans to a cash-positive seller of whole loans.

The business right now could not be any better. NCEN has one of the lowest costs to originate in the industry, prices received for loans sold are at 4 year highs, and origination volume sets new records every quarter. NCEN is generating a run-rate of almost $4/share in cash after-tax earnings. The earnings are ALL CASH. No accouting gimmicks, no questionable assumptions, no hidden/contingent liabilities.
The stock still has a fairly heavy short interest. The short sellers do not understand how the business has changed (it took me a while to accept it). They do not understand that the assumptions used for valuing the old residuals on the balance sheet are appropriate (finally!) after millions of dollars of write-offs. They don't seem to understand that the business model now produces an enormous amount of cash. The business has very little working capital requirements and no cap ex requirements -- so all earnings are free cash flow.

NCEN will be debt free by the end of the year. The residuals they have on their balance sheet will mostly run-off over the next four years. The cash produced from the residuals is not needed for working capital or cap ex., it will be free cash flow and it will be tax free, since NCEN has already paid taxes on them.

Valuation:

NCEN is generating approximately $4/share in run-rate earnings (estimate for this year were conservatively set at $3.60-3.80). At $13.50, the stock is at 3.5x earnings. This is extremely cheap. But when you consider that the residual run-off generates another $0.60-$0.80/share in cash (not included in earnings), cash flow is significantly higher than earnings. So, NCEN is trading at an even lower multiple of cash flow.
Book value is approximately $10.

Another way to look at valuation.

NCEN has two pieces, it's balance sheet and it's current earnings power. NCEN's residual's are a valuable cash producing asset but they are not needed for the on-going business (eg they are not working capital and they could be sold if needed). If you ascribe a conservative value of 75 cents on the dollar to the residuals (they could be sold or re-securitized at that level), and back out debt and add cash, you get about $240mm. That equates to approximately $9.50/share. (If you value the residuals at 100% on the dollar, you get approx. $12.50/share.)
If you back the $9.50 in net liquid assets out of the current stock price, you are essentially paying $4.00/share for the production franchise and future earnings. Without the interest income generated from the cash, the interest income from the residuals, and without the interest expense from the debt, NCEN would generate approximately $3/share in earnings. So, you are paying 1.5x run-rate earnings for the on-going business.

Risks:

Mortgage volume may go down if rates go up. Historically there has been little correlation in the sub-prime market between volume and interest rates, but I'm sure volume will go down if rates go up significantly. Fortunately, much of the company's costs are variable; commissions etc.
Whole loan market. The market for selling sub-prime loans has been and is volatile. Prices may not stay as high as they are (about 4.5% currently). They have been as high as 5%-6% and have been as low as 3%. However, NCEN's cost to originate is down to 2.25%. Even after Long Term Capital blew up in '98, whole loan prices did not get much below 3%. So, with their current cost structure they would have made money even when the market was at its all time worst.

Target:
NCEN should trade at higher multiples than conforming mortgage originators, since net margins are much better, it has a higher ROE, and volume is historically much less cyclical. However, I will settle for a conservative multiple of at least at 8x earnings = $32.

Catalyst

Valuation. 3.5x fully-taxed cash earnings is cheap. For a company that will generate greater than a 35% ROE this year, it's incredibly cheap.

NCEN will be net debt free by year end. Cash will start to pile up, book value will grow 40% this year ($10 to $14) and book value will exceed the current price. The high quality book value will provide down-side protection.

Perception will eventually change. People will realize that the current sub-prime market is different than before.