Description

Sunset Financial Resources is a hirsute mortgage REIT trading far below its liquidation value of approximately $9.50-$10. I expect that this value will be realized within 18 months either through management’s review of “strategic alternatives” or following replacement of the board and management via a proxy contest.

ASSET VALUE

Book value per share was $10.17 at 9/30/05. I attribute $8.27 per share to a low risk mortgage securities spread portfolio and $1.90 per share to high-risk commercial loans.

1) Mortgage Securities spread portfolio. SFO owns Hybrid ARMs financed with repos. Since inception in 2004 SFO has used swaps to maintain a duration gap close to zero. The spreads available from this strategy are currently quite low, however SFO’s conservative approach incurred lower recent mark-to-market losses than other mortgage portfolio REITs (NLY, MFA, ANH, and LUM.) I think the current liquidation value of SFO securities should be approximately equal to the values on the 9/30 balance sheet and there is low risk of any significant deterioration.

2) Commercial Loan portfolio. In order to jazz up the return from the low risk and low return securities portfolio, SFO bought some brokered high yield bridge loans that turned out to more like Brooklyn Bridge loans, they sounded great but the collateral proved problematic. Nobody with a half a brain would have made these investments, but apparently nobody with half a brain was working at SFO. In recent months a new lending manager, new CFO, and new CEO were all hired. The company is not making any new loans and is working to maximize recovery from the existing portfolio. The current assets are:

North Carolina Resort Development: Net Book Value = $16.1mm. This is secured by a first line on about 1000 acres of land near Spruce Pine, North Carolina. This bridge loan is sort of a bridge to nowhere since the land isn’t selling nearly fast enough to pay off the loan by maturity, however as a first lien the loan should retain significant value even if the property market declines. SFO has been working with the developer to accelerate sales and hopes to reduce the loan balance beginning in 1Q06.

Hawaii Cemetery Loan: Net Book Value = $0. SFO owns a $5.7mm subordinated loan interest in a foreclosed cemetery. The property cannot be sold until a new operating license is issued and the state is not going to issue a new license pending an examination of a shortfall in the trust fund. SFO has filed suit against the other lenders alleging documentation errors. Any recovery from this asset would increase book value.

Multi-sport Facility: Net book value = $3.5mm. This foreclosed property is under contract for sale at this value pending court approval expected around year-end. SFO is seeking to recover an additional $1.2mm from the original loan guarantor.

Retail Development: Net book Value = $3.5mm

Equestrian Center: Net book value = $3.3mm. This loan was repaid on 10/04/05.

If the sport facility sale closes then SFO will have only $19.6mm invested in commercial mortgage loans ($1.90 per share). Some portion of the impairment charges of $6.9mm ($0.66 per share) may be recovered. The new lending manager has concentrated on workout of the existing loans and intends to present a new commercial lending business plan to the Board of Directors in early 2006.

SFO has a trust preferred issue outstanding that could have a marginal negative impact on sale/liquidation value. It pays a high rate (LIBOR+415) and cannot easily be redeemed prior to 2010.

I think the most likely liquidation value would fall between $9.50 and $10 per share. Best case would be up to $10.50 and worst case would be down to $8.

LIKELIHOOD OF RECEIVING ASSET VALUE

SFO came public in 2004 near the end of the mortgage REIT boom. The offering was poorly received and it’s been straight downhill since then. Share ownership has become concentrated in a limited number of holders who either promote sale/liquidation or who simply own too much to get out. Major holders with most recent filing date:

Hunter Global 14.3% as of 9/30/05
Western Investment 9.7% as of 10/28/05
North Sound Capital 9.5% as of 9/30/05
NWQ 9.2% as of 9/30/05
Talkot 9.2% as of 9/27/05
Delaware Mgmt 8.5% as of 12/31/04
TIAA 7.5% as of 12/31/04

Western Investment has adopted an aggressive posture including an attempt to call a special shareholder meeting to replace the BOD and then filing a lawsuit when the BOD rushed through bylaw changes to make it much more difficult to call a special meeting. If there is no special shareholder meeting then it is extremely likely that there will be a proxy contest at the regular meeting next year. Given the concentration of ownership, it is extremely likely that shareholders would be able to oust the current board and management.

SFO has attempted to forestall shareholder action while also making some changes consistent with the aims of activist shareholders. The CEO, CFO, commercial lending manager, and accountants have all been replaced. On 10/28 Bank of America was hired to pursue strategic alternatives including possible merger/sale. SFO is cleaning up its assets by working out problem loans and not making any new commercial loans. The new CEO’s employment contract has a $100,000 bonus if the company is sold or if the stock trades above book value.

I think management would prefer to stay in business rather than sell or liquidate so I do not have great expectations for the B of A work. However management has only until the next shareholder meeting to present a viable plan. If they demonstrate genuine improvement that rallies the stock then we win. If they have bad ideas then they get booted, the company gets sold/liquidated, and we win.

Catalyst

Sale/Liquidation