NovaStar Owes Investors a Better Explanation
By Herb Greenberg
12/20/2002 14:01
For more months than I care to remember, I've been hearing from short-sellers about NovaStar NFI , a subprime mortgage lender dressed as a real estate investment trust.
It's tempting to tune out another subprime lender. Still, I can't ignore a subprime lender in this environment doing what NovaStar did earlier this week, goosing its dividend by 60% and raising guidance.
It didn't explain either move -- never a good sign. The company says it will disclose how it was able to do that when it releases fourth-quarter earnings in several weeks. NovaStar declined any further explanation at this point.
"We assume that the cause relates to higher income recognition on the company's interest-only residual interests in off-balance-sheet securitizations, not higher origination volumes and gain on sale," high-yield analysts Merrill Ross and Wilkes Graham of Friedman Billings Ramsey wrote in a report to clients. But even they conceded they don't know for sure because the accounting and recording "of earnings on these off-balance-sheet structures is opaque, at best, and we have not recommended the stock because of those concerns."
Starstruck
Yet that appears to be of little concern to yield-hungry investors lured by the company's large dividend, while apparently paying little attention to the amount of earnings that comes from gain-on-sale accounting. Lenders like NovaStar, which securitize loans by packaging them and selling them to a trust, book a noncash gain on the sale of those mortgages. The trust then issues bonds backed by the loans. The hope is to collect enough cash from the mortgages after bad-loan losses to make money on the spread between the mortgage rate and the interest paid on the bonds.
But that takes into account a variety of assumptions, including interest rates, the speed of prepayments and delinquencies. Any variation on one side or the other of assumptions -- as was the case with subprime auto lender AmeriCredit ACF , which was hit with rising delinquencies -- and the company puts itself at risk of having to take a charge against cash that wasn't received.
On that score, it would seem that NovaStar is walking a perilously thin line, because gain on sale is a critical component of its earnings. Consider that for the first nine months, gain on sale, as disclosed on the company's income statement, represented 58% of pretax earnings -- and that's after taking into account a hedging loss. Adding back the loss, the gain on sale was actually higher than pretax earnings.
The more a company depends on gain on sale to pad its earnings, the greater the risk.
What's that worth? Subprime mortgage lender New Century Financial NCEN , which is not structured as a REIT, trades at four times fully taxed earnings. NovaStar, meanwhile, doesn't pay taxes because of its REIT structure.
But a simple crunching of the numbers shows that if it were taxed at a normal corporate tax rate, earnings this year would be $2.85, rather than untaxed expected earnings of $4.35. That would translate into a stock price of $11.40, which is much higher than shorts are counting on. NovaStar's stock, which has been rising in the wake of its dividend/earnings guidance announcement, currently trades at around $31.50. |
