Description

Newstar Financial is a Boston-based middle market lender that has to date relied on the asset-backed market for its financing.  To add to its apparent lack of attraction, it lost significant money in RMBS transactions, which is not its core competency and it is relatively illiquid.  It is also a busted IPO, now trading at less than half of its IPO price from last December.

What makes Newstar attractive is that it is both safe and cheap. 

Below is the company’s balance sheet at September 30:

Since the end of the quarter, the company raised 12.5 million shares of equity at $10 a share, so its current shareholder equity is in excess of $552 million, which suggests that even with the loans they make this quarter that equity to assets is probably in excess of 20%.  Also, it is worth noting that at $8.20 a share, Newstar trades at a market cap of about 400 million including the new shares, which is less than 75 percent of book, virtually all of which is all tangible.

To make matters somewhat more favorable, because much of the financing is in collateralized loan obligations, even if there were a problem in some vintage of its book, that problem would effectively be segregated into that CLO.  As recently as last week, Fitch was affirming the ratings on a 2006 vintage Newstar CLO.

Newstar has no repos and the management believes that at its current pace of making loans that it will not need to come back to the market for capital until at least next summer.  By slowing down the rate of loan growth, management could probably go longer than that.

The vast majority of the loans in Newstar’s book are senior cashflow loans to small businesses.   No loan comprises more than a couple percent of the portfolio and management says that they will in general not lend beyond 3 times ebitda.  In a bad economy that may mean that the company is not adequately reserved. (At September 30^th, the reserve for loan losses was 1.62% of loans). 

Excluding the issue that the company had with its RMBS portfolio (which is now written down almost to about 3 million dollars), the company is currently run-rating at 7.4 million a quarter or about 16 cents a quarter, including the dilution from the new shares, or 20 cents on the old share count. 

Assuming that reserves are adequate and that the company continues grows assets at a relatively modest 5% a quarter, the company could pretty easily be running at about 23 cents a quarter by the end of next year or about  $11.1  million. At current prices that would be below 10 times run-rate earnings with a significant growth trajectory.

This assumes the following:

1)      No significant increase in Newstar’s spread despite the fact that their CLOs are evergreen and the funding for the loans that will be added to its books has already been locked up.  Management has said that it recently has seen attractive deals at as wide as libor+600, which would dictate a far wider spread than I am using.

2)      Provisions of 6% of net assets added each quarter.  This works out to 31 million in additional provisioning for next year and would be sufficient to keep reserves in line with assets even if there were 15 million dollars of charge offs on the current book next year, which given the age of the loans seems unlikely.

3)      No increases in SG&A and compensation increasing 2 percent each quarter.  It is worth noting that the infrastructure at Newstar currently includes about 100 lending professionals and the team is significantly underutilized compared to the assets under management.

4)      No increase in fees or asset management income from the Newstar opportunity fund.  This is a very conservative assumption.  There is no reason this stream should not grow.

5)      That the management does not run through their current liquidity by the end of 4^th quarter of next year. In other words, I am modeling relatively slow loan growth.

6)      Also note that for simplicity, I have simply backed out going forward equity based compensation that was given at the IPO but is being charged through the income statement.  There is approximately 17 million of such deferred compensation left and it will flow through across the next several years.  Also note, I have used the 125 million equity contribution to reduce interest bearing liabilities.  Obviously, this is also a simplification but should not create a substantial difference.

There are no doubt a variety of objections that could be made to any of these assumptions on a standalone basis.  Taken as a whole, I think they form a relatively fair picture of what the company might earn.

On this basis, Newstar would earn about 86 cents next year (or less than an 8 percent return on equity).  Ironically, this number is not terribly out of line with where the street is currently.  It is also worth pointing out that if their spread were to widen by 50 bps, the company could be run rating at as much as 27 cents per quarter by Q4 of next year.  It is also worth noting that from its road show, the management has targeted a 15 percent ROE, which would suggest that they think eventually they could get to an earnings number in excess of $1.65 an $11 worth of book value if they had unfettered access to capital.

There are two obvious concerns with the company which help explain why the stock trades where it does.

First, there is a concern that by next summer the company is still unable to get more financing.  While it is possible the CLO market will stay closed this long, it seems unlikely to me that if the loans that the company is writing are reasonable that there will not be some available source of funds.  The management team here comes from the small business lending unit of Fleet bank and was backed prior to the IPO by Ochs-Ziff, which among other prominent backers recently put in more money at $10 a share.  I think that it is unlikely that there will not be an avenue for growth as long as the book of business is.  If it is not through a CLO, it may be through other forms of financing or through its being acquired by a larger organization with better access to financing.  The company is sufficiently small and has sufficiently solvent backers that I think a liquidity crunch is unlikely.

The second risk is that cash flow lending winds up being a bad business.  If so, this position could be paired with a variety of companies that lend to small businesses at riskier places in the capital structure (such as ALD or ACAS).  If Newstar experiences serious losses, then folks holding riskier debt or equity pieces are in a lot more trouble.

It is also worth point out exactly, how bad the loans would have to be for Newstar to be trading at a premium to book at this time next year.  Assuming that the company could make about 90 cents in a relatively normal environment, the company would have to lose almost $4 per share, or close to $200 million to have a book of around $8 at this time next year.  If recoveries are on the order 50 cents on the dollar, this would work out to something on the order of a 15-20 percent loss on the loans to go bad and I am not giving any value to the deferred tax asset that would arise.  While there are probably environments where this might be possible, it seems highly unlikely and even if it did, Newstar would remain in a highly solvent position.

Catalyst