Description

1) 6.5x a persistent stream of earnings, with visibility to 10% earnings growth
2) Dividend yield of 15%
3) Earnings quality: conservatively marked earnings through underreporting of GoS margins (compared to Countrywide, New Century).

Novastar is a mortgage originator and investor in the sub prime space. Novastar is producing a stream of interest income at a run rate of approx $160M a year. With future capital raises, they should be able to grow this stream of income at least 10%. The stock is about 6.5x what is a high quality, persistent stream of earnings. It is 3x book value.

Novastar is trading at a significant discount to its Mortgage REIT peers on a P/E basis and a dividend yield basis, even though it offers substantially more growth than its peers through its origination platform. The stock has been severely discounted by a successful group of vocal shorts led by Herb Greenberg (more on this later).

Novastar securitizes loans and makes sales to bond investors, it retains IO’s, and it has a loan servicing business. The driver of Novastar’s earnings is its mortgage portfolio of IO’s and subordinated retained interests in the loans it securitizes. It ended Q1 with a balance of $404M on its mortgage securities and it is currently growing this portfolio at an annual rate of over 60% (vs 100% growth rates last year). Non-conforming originations are at a $7.5B annual run rate and have increased sequentially for the last 5 quarters. This business is much less interest rate sensitive than the conforming business, and should show moderate growth going forward. Given its reasonable leverage, Novastar is in a position to retain these loans given worsening market pricing.


Novastar could be underreporting its GoS margins. Below is a comparison of subprime GoS:

3/01 6/01 9/01 12/01 3/02 6/02 9/02 12/02 3/03 6/03 9/03 12/03 3/04
CFC 4.7% 4.7% 4.7% 4.7% 4.3% 6.6% 6.3% 5.3% 5.2% 5.7% 4.2% 3.5% 5.6%
NCEN #N/A #N/A 4.6% 4.4% 4.4% 4.8% 4.7% 4.6% 4.1% 4.5% 4.6% 3.8% 3.8%
Option One #N/A #N/A 4.8% 3.8% #N/A 4.1% 4.8% 4.6% 4.4% 4.4% 3.9% 4.1% #N/A
NFI 2.3% 1.9% 1.6% 1.6% 0.9% 3.6% 4.2% 3.6% 2.3% 3.1% 3.1% 2.3% 1.5%

Option One’s numbers include 20% prime business, which has ¼ the margins of sub prime. Novastar’s still the lowest of the bunch. It seems to have underreported the massive profitability of the last year. It shouldn’t matter if the loans are sold for cash upfront or if they are securitized with some retained interest—it should hit the income statement the same way under FAS 125. This means that NFI’s retained interests are likely to perform better than booked on the income statement as they mature.

NFI gets 90% of its income from its portfolio holdings, and unlike other mortgage REITs (with higher multiples), it has an origination platform with which it can significantly grow that portfolio.
Credit performance on securitizations has been steady and CPR assumptions on the securities have proved conservative. The negative duration characteristics of Novastar’s largely IO portfolio should contribute to continued cash out-performance of initial assumptions. Novastar is moving more towards limiting its interest rate risk and matching its funding and has less than 5% of its NII at risk under the current rate movement scenario.

About a third of the stock’s float has been sold short. The bear case of the hedge funds shorting the stock has been made clear by Herb Greenberg articles over the past 16 months at Real Money and now at CBS Marketwatch (you have to paste in the link below):

http://www.marketwatch.com/news/yhoo/story.asp?source=blq/yhoo&siteid=yhoo&dist=yhoo&guid=%7B74E2C2C2%2D16A9%2D4C7C%2DB374%2D17EEB068FF17%7D

The WSJ further knocked the stock down recently with the same arguments. After breaking down the points in Herb’s most recent quarterly critique, it’s hard to find compelling strikes against Novastar. Its Q on Q performance was in line with its peers, and from what mortgage bankers are saying, there is still a healthy demand for its deals. Herb’s point about the curtailed branch expansion should be less of a cause for concern than an example of management’s willingness to only expand profitably.

Insiders have been buying shares and selling puts after the recent negative reports by the WSJ and Herb. There have been about 40k shares bought and in the money puts on 40k shares sold short. This is from three different insiders.

At a normalized level of 1.5% interest spreads on its total portfolio (down from the 2.5% level over the last year), NFI would have to raise capital to grow its portfolio to maintain the current level of earnings. Production data has not slowed in the last year, however, as the sub prime business is much less rate sensitive. Production is shown below:


3/1/2003 6/1/2003 9/1/2003 12/1/2003 3/1/2004 Q2 run rate:
912,599 1,259,546 1,491,476 1,587,357 1,783,119 1,964,760

Assuming a much slower 4% quarterly growth rate in originations and a still elevated level of interest spread this year (at 1.85%) and an average level of total assets at 7.7B, you can get a rough estimate of net at $143M or $5.16/share.

Here’s a conservative discounted expected value table, showing best case and a liquidity crisis scenario:

Div in next End Yr Yld Price Probalbil. EV Stk EV Div Tot EV
12 Mths
Scen 1 2.5 25% 9.7 10% 40.8 4.7 45.5 Scen 2 4.4 15% 29.1 20%
Scen 3 4.9 12% 40.4 40%
Scen 4 5.4 9% 59.3 30%

Catalyst

meeting guidance for Q2 with a third of the float sold short; 10 year stabilizing