Zais Financial Corporation (ZFC):  A misunderstood and mispriced mortgage REIT.

How would you like to own a company offering a high double-digit dividend yield in today’s yield-starved environment with significant equity upside?  The first question to cross your mind may be what’s wrong with this company?  The short answer is nothing.  In fact, the company is performing exceptionally well in a sector that has been decimated by the rise in interest rates.  The company is run by a well-respected management team that is part of Zais Group, a $5.5 billion investment fund that has been investing in credit assets since 1997.  They are shareholder friendly and significant investors in their own company.  This company is currently on sale for 20% less than readily ascertainable liquidation value.  Meet Zais Finanancial Corp – a relatively new public company that, despite exceptional performance for the past 6 months, is currently trading at the least expensive valuation in its sector. 

For a background on mortgage REITs, please refer to sell-side analyst research and past write-ups on the site.  This write-up will assume background familiarity with the sector and will summarize our differentiated view of the investment opportunity and why this bargain sale will be very short-lived.  (This was used for my application to VIC.  The price has run up a bit since we submitted the writeup for our application, but we feel that ZFC is still a compelling opportunity.)

Investment Highlights

1. ZFC today is unlike ANY of the other mortgage REITs.  When ZFC first became public, it parked the majority of its assets in agency MBSs (with no credit risk) with the intention of gradually shifting the majority of this capital to much higher returning whole loans (which are credit mortgage instruments purchased at a discount to par).  As of August 29, 2013 it reached its intended goal of having 50-60% of its equity allocated to whole loans, with the majority of the balance in attractive non-agency credit (the market didn’t pay any attention to this significant news).  Given its whole loan and non-agency exposure, no other mortgage REIT is as levered to the recovery in the housing market as ZFC.  Importantly, ZFC’s exposure to agency MBSs is minimal and the little it does have is extremely well hedged against interest rate risk with very long dated interest rate swaps.  Simply put, ZFC is the most compelling vehicle to play the housing recovery as rising rates are generally positive for credit assets.  (Housing strength continues, CoreLogic HPI +11.9% in June 2013 compared to June 2012).

2. Strong relative and absolute book value performance.  We readily acknowledge the challenges that most investors (retail as well as institutional) have in assessing intra-quarter book values of mortgage REITs given the volatility in the MBS market over the past several months and with ZFC specifically, as it continued its migration of capital out of agency MBSs and into whole loans.  The company reported a book value of $19.95 as of 6/30/2013, which was only down approximately 7% from 3/31.  Given the volatility in the space with many of its peer mortgage REIT book values down double digits, this performance was quite remarkable.  A part of this decline was a result of ZFC having a sizable (39%) agency asset allocation at the time.  As we noted above, ZFC is now almost entirely a credit vehicle now and should be less exposed to interest rate volatility.

More importantly, since the end of the second quarter we believe ZFC’s book value in a worst case scenario is flat, but our base case is a book value that has increased by 2-3%.  This is primarily by driven by an agency book that is very well hedged, a non-agency portfolio we think is up slightly given the performance of Alt-A, Pay Option, Prime and Subprime indices we track and whole loan performance which correlates with many of the drivers in the non-agency sector. 

3. Valuation.   ZFC is massively mispriced.  Even if we make the conservative assumption that ZFC’s book value is $19.95 (unchanged from 6/30/13), at the current price of $16.63, shares are trading at a very discounted valuation of 81% of book value.  Our model shows this to be one of the lowest valuations in the sector.  We have seen other mortgage REITs trade at this level recently, but primarily because they were holding agency MBSs which were declining in value due to the back up in rates.  And even in these cases, those trough valuations existed only for a very short time.  Given the assets held by ZFC today, we see no reason for the stock to be trading here and do not believe this opportunity to buy shares at a 20% discount to book value will last that long.  The three mortgage REITs that are most comparable are currently trading close to book value: CIM, PMT and MFA.  CIM is the non-agency vehicle for Annaly, is non-current on its quarterly filings and is trading at about 1.0x our estimated book value.  PMT has a similar whole loan strategy but a mortgage origination business as well and trades at about 1.0x our estimated book.  MFA has its assets about evenly split between agencies and non-agencies and trades at about .92x our estimated book.  As a pure-play credit REIT levered to the housing recovery, we believe ZFC should trade at least to book value if not higher.

4. Increasing dividend yield.  Given the challenging environment of the past few months, we’ve seen many mortgage REITs become defensive.  They’ve reduced leverage, sold assets and increased their hedging.  The net result of all of this is that we may see a number of mortgage REITs cutting their dividends in the coming weeks.  ZFC will be doing just the opposite.  We saw ZFC more than double their dividend from $0.22 to $0.45 most recently.  The $0.45 dividend was announced despite having a good portion of capital tied up in a lower yielding agency bucket.  As you can see from the table on p.13 of the company's 6/30 presentation (http://www.zaisfinancial.com/Cache/1001178077.PDF?Y=&O=PDF&D=&fid=1001178077&T=&iid=4347641), the levered Net Interest Margin (NIM) for the whole loan strategy is almost 2x that of the agency NIM.  While we expect to see a slight increase in the third quarter dividend (which will be announced in a few weeks), since the company was still transitioning its portfolio, we expect a much higher dividend from the fourth quarter onwards.  We believe that starting in the fourth quarter of this year, the annual run-rate dividend will be in the range of $2.60- $2.70/share.  That is a 16% yield!

5. Supportive macro-environment.  Given the margin of safety we have at ZFC’s current valuation, the discount to par and the conservative model assumptions used by ZFC, we do not necessarily need a significant improvement in housing for this stock to work.  That said, the economic fundamentals that form the backdrop of ZFC’s business in credit assets are very strong.  Housing price appreciation continues to be strong especially in ZFC’s key markets and the employment figures continue to show increasing strength. As the housing market continues its multi-year recovery, we expect ZFC’s book value to appreciate as credit assets levered to housing become increasingly more valuable.  As much of the company's assets are distressed mortgages purchased at a significant discount to par, the recovery in housing should provide plenty of upside while providing a margin of safety in case our macro outlook proves to be too sanguine.

6. Significant insider buying.  Given the relative difficulty in valuing the assets intra-quarter, one of the strongest signals given to investors that a particular stock is trading at a meaningful discount to book is when we see management buying their own shares.  On September 5, 2013 after the market closed, we witnessed the single most expansive insider buying the sector has seen in recent years.  The insider buying included both senior management and directors of the company including Eric Reimer, James Zinn, Christian Zugel, Marran Ogilvie, Daniel Mudge, the CEO Michael Szymanski and the Chief Investment Officer Brian Hargrave.   While we have seen insider buying at other mortgage REITs recently, the purchases have only been by 1-2 insiders -- not seven!  This is a very strong show of support that should put a floor on the stock.

The most obvious question is why is the stock so cheap?

 Specifically, we think this mispricing is driven by three major factors.

1. Since early May, the entire mortgage REIT sector has undergone a dramatic sell-off, far more than bonds or other bond-like assets.  REM, the most liquid mortgage REIT ETF, has sold off over 20% and some sector leaders like NLY and AGNC have sold off even more over the last few months. There are fears of forced liquidations, deleveraging, a spiraling negative feedback loop that generates further selling. Given the volatility in the space, there has been indiscriminate selling; retail investors have bailed and institutional investors are sitting on the sidelines.  We believe that after a 140 basis point move up in 10 year rates since May, the bond market is discounting much of the Fed’s tapering of its quantitative easing program.
2. ZFC is viewed as just another mortgage REIT with interest rate risk and whose dividend may be at risk.  We know that ZFC is now almost completely credit focused whose dividend is likely to increase in the coming quarters.  Moreover, ZFC is very well hedged against interest rate risk and credit assets typically outperform in a rising interest rate environment.
3. Most investors don’t have the resources to calculate mark-to-market book values; ZFC is one of the more challenging ones given the difficulty in pricing individual whole loans.  Based on our analysis and conversations with management, we are comfortable that the book value QTD has been fairly stable.

What is your total return opportunity?

We look at both the dividend as well as the equity upside.  We think when fully ramped and optimized, ZFC can generate $2.60-$2.70 in dividends, or a 16% dividend yield.  Assuming stabilization in rates, we think over the next 12 months ZFC could trade back to our estimate of current book value ($20.48), up $3.85, about 23% upside from today’s price of $16.63.  Hence, the total return opportunity here is 39% over the next 12 months.

We like ZFC because there are multiple ways to win.  In our total return analysis, we leave out a very significant driver of value – which is the continued appreciation of their credit assets. Given our outlook for a modest improvement in the general economy, continued housing price appreciation (albeit at a more modest pace from this year) and the favorable technical back drop of rapidly shrinking supply of non-agency mortgages available for purchase by investors, we think there is an embedded call option on the continued appreciation of ZFC’s holdings.  To be conservative, we do not include this potential appreciation in our return analysis, but we believe it is very likely. 

In our downside scenario, there is no underlying asset appreciation and the stock continues to trade 81% of book… you still collect a 16% annual dividend at current prices.  That’s a decent carry in this environment.

Risks

- Interest rate risk.  ZFC uses interest rate swaps and other tools to hedge against a rise in interest rates.  More importantly, credit assets should outperform in a rising interest rate environment.

- Credit risk.  Since ZFC owns mostly credit assets, there is the possibility of weakening credit conditions that could reduce the value of the assets.  However, the supply/demand dynamics of depressed supply of new homes and increasing household formation favor a continued housing recovery and price appreciation.  In addition, the supply of non-agency mortgages has been shrinking rapidly over the last few years as there has been very limited new supply.  This dynamic should continue and provide a constructive technical backdrop for these assets as these high yielding instruments appeal to investors.

- Leverage. While there are always risks inherent in a levered credit strategy, ZFC is far less leveraged than the others in the mortgage REIT sector.  ZFZ maintains a leverage of about 2.5x vs 6-10x for its peers.  Moreover, ZFC uses longer dated financing sources for its credit assets to mitigate potential short term liquidity issues.

Catalysts.  We see a number of hard/soft catalysts for ZFC over the coming weeks. 

1. Massive insider buying during the week of 9/3/13.
2. Barclays Financial Services Conference Presentation on 9/9/13. 
3. Dividend increase and announcement at the end of September.
4. Management non-deal road-show to get their story out to the Street.
5. Additional research coverage.
6. Tapering getting priced into mortgages as 10 year approaches 3%.

Disclaimer:  We and our affiliates may be have a position in the securities discussed above and may actively trade our position.  We are under no oligation to update the information discussed above.  This is not meant to be investment advice and should not be relied on as such.   

Catalysts.  We see a number of hard/soft catalysts for ZFC over the coming weeks. 

1. Massive insider buying during the week of 9/3/13.
2. Barclays Financial Services Conference Presentation on 9/9/13. 
3. Dividend increase and announcement at the end of September.
4. Management non-deal road-show to get their story out to the Street.
5. Additional research coverage.
6. Tapering getting priced into mortgages as 10 year approaches 3%.