Tuesday, January 30, 2007

A Few Interesting Ideas:

As stated before, value is rare these days- at least by my standards. Below is a list of companies that seem potentially compelling and would be a good place for readers to start researching:

Delta Financial (DFC)- report coming soon(see below)

SFK Pulp Fund (SFK-un.to) - high yield, very low cost operator, limited downside, potential for huge gains from normalization in eastern Canadian fiber costs.

TRX, Inc. (TRXI)- speculative, commands a giant share in travel processing software and has a recurring revenue structure.

Cryptologic (CRYP)- check Value Invesor's Club for investment thesis.

Mills Corp (MLS) - large position by Seth Klarman, havent begun research.

Freddie Mac (FRE)- large position by Pzena, haven't begun research.

Of the above, i hold positions in DFC, SFK, and TRXI. Im currently working on a detailed writeup on Delta Financial to post, although it is taking me longer than expected to get in contact with the management. However, look for this report shortly.

Saturday, January 27, 2007

Delta Financial Corp (DFC):
Price: 10.89
Shares Outstanding: 23.7 million
Market Cap: 260 million

As far as investments go, this is definetely an 8 foot hurdle. But that doesn't take away from the fact it is still a value- here goes.
The Business
Delta Financial Corp. is a subprime lender in the United States, which basically means they make loans to people that typical banks will not due to poor credit or lack of documentation. These loans typically have higher default rates but also have higher interest rates. Delta originates about half of their loan volume themselves, while they buy the rest wholesale (from other brokers). They then in turn either sell these loans, or put them together into a securitization trust and sell it to the public. A securitization trust holds claim to a certain pool of mortgage loans and it pays a certain interest rate from this pool. Once sold to the public, Delta is not responsible for any defaults arising on these loans. They have usually securitzed a majority (85%) of these loans, and they profit from this structure by recieving any excess interest left over after paying the securitization's interest. If there are defaults, the excess interest is first used to make up for the lost capital in the securitization before making its way to Delta. The rest of their loans are sold to other financial institutions, and they profit from the premium they recieve on the loan value.
This business does not require much to run- A warehouse credit facility which provides the capital for the loans made but not yet sold/securitized, 1300 employees, and about 40 million in working capital. Thus, the moat is minimal, although one can make a case that scale and management expertise are important. ( more on this later) The market cap is currently at 250 million, and Enterprise Value is 150 million. (also, later)

The Investment Opportunity
The investment opportunity arises by taking a step back and looking at the true economic reality of this company. This business requires expenses to be made upfront in the form of payroll, administrative, etc., while the income from this shows up over time as the portfolio generates more interest income than it has to pay out to the securitization trusts. I have done my analysis by seperating the company into three parts- Origination business, the portfolio, and excess equity. I assume that instead of securitizing, Delta instead chooses to sell all of its loans to the market. This means the portfolio will slowly dwindle as loans expire and new loans are not added (they're all being sold). The excess equity refers to the capital the company has that it does not need to run the business. These sections are discussed more thoroughly below.

Origination Business
Delta will originate approximately 4 billion in loans this year. 700 million of these loans will be sold (for a premium of about 3.7%), while the rest are packaged into securitizations which will be sold to the public. These loans are able to sell for a premium because the market expects the greater interest from these loans will more than make up for the increased credit risk. Delta in particular has been able to command greater premiums than its competitors because it focuses much more on the quality of their loans, compared to the volume approach of their competitors. 87% of Delta's loans are fixed vs adjustable rate, while their competitors' ratios are often reversed. Delta also publishes many of their underwriting criteria, something their competitors do not. I assume this speaks to the strength of their origination, but the numbers speak for themselves- Delta was able to recieve a 3.7% gross premium on sales while competitor New Century only recieves 1%.

Our first major assumption comes from what premium the company would recieve if they sold the entire portfolio. There is a lot of leeway in this area, depending on what gross premium you want to give for the entire volume of business. Meanwhile, the cost of origination for the company is 2%, and the company has remained focused on continuing to automate and reduce these costs (so far, bringing the cost down from 3% 2 years ago). Also, the company immediately expenses "deferred origination fees" - about 10 million a year of fees it expects to incur over the lifetime of their loan portfolio. Since are assuming loans are immediately sold, this would have to be added to gross premium to get the net gain on sales.

4 billion loan volume
Gross premium - cost of origination + 10 million (DOF) =
3% - 2% + 10 million = 50 million (optimistic)
2.5% -2% + 10 million = 30 million (probable)
2% - 2% + 10 million = 10 million (worst case)

Remeber, the company will actually sell 700 million for a gross premium of 3.7%. So to get an average of 3% for the total volume, this implies a 2.8% premium for the 3.3 billion not already sold. To get the worst case of 2% gross premium, the company would have to recieve 1.6% on the 3.3 billion in loans it does not sell. I believe this is a very unlikely given that 90% of the loans fall under their A-category standards.

Range of Value, using a 10x PE: 100 million to 500 million

The Portfolio
Next, the portfolio. With all expenses covered by the origination business above, and no ongoing expenses from new securitizations, this leaves the portfolio practically free and clear to shareholders. As mentioned previously, Delta is not liable for any defaults that occur in the portfolio, although defaults do lower the interest income they recieve. This year, the portfolio will earn 120 million after provisions for loan losses. This number will lower as the portfolio expires, but management's guidance is that it the current portfolio will earn at least 85 million after tax in income after provisions for the next 2 years.(80 million after discounting) My analysis says that after the first 2 years, the portfolio should generate about 30 million more after tax. ( I did this by looking at the expiration of mortgage portfolio provided in the 10-Q)

Range of Value = 80 million+++

Excess Equity
As mentioned earlier, this business does not require much to run it- just 40 million in working capital and a credit facility which does not use up any capital. So, of their 140 million in shareholders equity at 9/30/2006, 100 million is not needed to run the business. Also, in a liquidated value assumption, you could use the full equity of 140 million because you no longer need the working capital.
Value = 100 million

Overall, we get a sum of value from 280 - 680 million depending on the scenario, with a probable value of about 480 million. This compares with the current market cap of 260 million.

What if "All hell breaks loose", so to speak. After all, we are at the peak of a credit bubble where subprime loans have gone from 5% to 20% of the total underwritten loans over the past decade. Rather than try to say its different this time, I'm going to see what the value is if something dramatic were to occur.

-Origination Business
Contrary to first instinct, the origination business would not be in dire trouble should the economy turn into depression. Loans rarely default after they have just been written, and the company can adjust quickly to a change in market sentiment by raising standards and cutting staff. Volume would probably fall however, and probably gross premiums. Depression scenario though, the business would still maintain positive value.

The portfolio of course cannot go into negative value for the company due to the securitization structure. But it probably would still have positive value too. The company gets paid its excess interest every month, and this money is not liable to pay for any future defaults. So every month until doomsday occurs, you get an additional 4 million in interest.

Also, "Doomsday" for the portfolio means a lot. Nationwide home prices have never fallen since the government has begun recording them, a timespan of over 50 years. And DFC's portfolio is very dispersed across the country, with only 3% in California. See the Fact Sheet link below. But let's assume home prices do fall 10%. DFC's loan to value ratio (ratio of loan amount to the value of property it encumbers) is at 80%. Since DFC rarely gets market price for its property sales due to how quickly it is trying to get rid of the property, they usually sell for a 20% discount to market. This would mean that DFC would only get 72 dollars of capital back for every 80 dollars of a loan made, or 90% of their money back if home prices fell 10% nationwide. In order for the interest income of the portfolio to be wiped out, the default rate would have to go up to 20%, along with the 10% drop in home prices. A highly unlikely scenario.

Given the relative safety at these prices, and the potential for huge and likely upside, I believe DFC makes an attractive investment.

Delta Financial Q3 2006 Fact Sheet

Sunday, January 07, 2007

Time to be Fearful:

It's been quite awhile since my last post. In truth, I wasn't exactly sure where I was heading with this blog. I originally wanted this blog to be focused mostly on investing. But recently, I have been very pessimistic on the future returns available in the market. I will save the detailed economic explanation and my entire outlook for upcoming posts, but for now I will pose this question for active investors to think about. With prices rising and yields falling quickly on all sorts of investments, (think, stocks, junk bonds, real estate) how long will it be until this mass of liquidity starts pouring into corporate investment, and as a result, increases competition and lowers corporate profitability? In 2005, Greenspan said that corporate profitability was at an all time high at about 14%. With PE's on stocks nearing 20, treasuries at 4.7%, and junk bonds not much higher, it seems coroprate investment will be the next victim of yield chasing. Just as stocks and bonds start being priced in for a lower return environment, they risk being hit by increased competive pressures. Already high prices mixed with lower earnings bodes terrible consequences for an investor.

I will try to outline my reasoning in further detail as time goes on, but in terms of investing I will still focus on individual companies. I have recently added two short positions to my portfolio. Interoil (IOC) and Silver Wheaton(SLW). These are not plays on a slower economy. Rather, I have analyzed both stocks and concluded that they are both worth slim to none. The Interoil position was not originally my idea. I urge everyone to sign up at Value Investors Club and read both reports on Interoil. The website is also a good site to check regularly for new ideas. I will post my report about Silver Wheaton shortly.