The people who know this company best are cheering to see it turn the corner in a difficult rate environment. Lock in a rising yield while you can.
New Residential Investment (NRZ: $8.01, up 5% so far this week) is rebounding fast as investors finally take a break from reflexive interest rate anxiety to take note of what the company’s 2Q20 results really said. We liked these numbers and expect much better things to come.
For all practical purposes, New Residential has turned the corner. While cutting the dividend 90% to $0.05 was inevitable and prudent in the depths of the COVID crash, management was able to find an extra $0.05 per share for shareholders this quarter. Barring fresh economic shocks, this is almost certainly the payout floor for the foreseeable future.
At this level, New Residential pays 5% a year, which is decent but not spectacular. The real excitement here is our conviction that a $0.10 quarterly dividend here can easily become $0.35 and then $0.50 again once the Fed feels brave enough to raise interest rates again. It won’t happen overnight, but when 2022 or 2023 rolls around, someone who bought in to capture a 5% yield can end up with a much higher annualized rate of return.
After all, we’re looking at a company that has hoarded $1 billion in cash in order to ensure its survival across all market scenarios. Management could deploy that money to buy new mortgages and underwrite new loans that would earn an estimated $0.05 per share in any given quarter. They aren’t doing it yet, but when they feel a little more secure, that windfall is practically assured. Given New Residential’s REIT structure, at least 90% of that additional profit will flow back to shareholders sooner or later. Suddenly a 5% yield turns into 7%, and that’s only the first step in the recovery process.
Earnings were better than we expected. We were looking for $0.30 per share, which is a big comedown from last year’s $0.53 but a little pessimistic compared to reality. New Residential found a way to squeeze $0.34 out of minimal interest margins, which we applaud. That’s practically enough cash to raise the dividend back to $0.35 if management decides it’s time to entice shareholders and support the stock.
The next few quarters will probably be a little bumpy, don’t get us wrong. But we’re cautiously optimistic that New Residential will clear $1.35 per share this year in profit and then up to $1.60 by 2022. By that point, income-oriented investors will have generated at least a 10% return on their investment. That’s not big money for two years’ worth of patience, but it isn’t bad as a baseline for more speculative bets elsewhere. We don’t see the dividend dropping from here. At worst, it stays where it is and you book that 10%, no matter where the stock goes.
While we see the stock climbing from here (and we aren’t alone), this isn’t about buying low with the intention of selling. Our passion about New Residential revolves around the reinflating yield scenario . . . if management ever feels confident enough to double the dividend on a sustainable basis, shareholders will get the equivalent of a typical year’s S&P 500 return without lifting a finger, year after year. That’s a nice place to be, especially when other income opportunities paying even 3% are hard to find.
But we do look for New Residential to rise again. The Mortgage Underwriting business is interesting in a time when lending rates are minimal but an upswing in origination activity keeps fees rolling in. This company makes loans to sell, not to earn interest over the long term. That side of the company brought in $300 million last quarter, tripling in the past year. And interest costs are roughly half what they were a year ago, so the Fed brings relief as well as anxiety.
At a glance, this should be a $10.77 stock just to overcome what is now a 30% discount to a currently depressed book value. Management suspects the loan portfolio, Mortgage Servicing Rights and other assets are easily worth $12.50 per share. Our colleagues on Wall Street agree. We haven’t seen a professional argue that New Residential will stay below $10 lately. If anything, we see their Targets on the rise.
In addition, the company has some assets to the tune of $1.7 billion that are off-balance sheet that they say can bring book to the $14 level.
Admittedly, $10 is cold comfort when you’re talking about a stock that seemed comfortable closer to $18 before the pandemic struck. New Residential deserves a little time in the doghouse after slashing its dividend and spooking long-term shareholders. But here below $8, a move to $10 would feel mighty good.
BMR Take: We raise our Target to $10 and look forward to even better performance once New Residential rebuilds its following. Remember, management loves to raise the dividend. Back in 2013, short-term interest rates were as low as they are now and management found it hard to justify paying more than $0.14 per share. Six months later, they tripled that payout and shareholders cheered to lock in as much as 15% a year in cash for the better part of a decade. Gratification won’t be so instant this time around, but it will come.
The management of this company is by far the best in the Mortgage Servicing space. We believe in them fervently and have confidence that they can bring the company back to where they were in early 2020. Thus the bullish scenario of a $14 stock paying $1.60 a year in 2020 is enticing especially with the stock below $8.
We would also like to remind you that the company has three classes of preferred shares that we also like very much. For those of you that are more conservative investors, the Series A ($21.40), B ($20.03), and C ($18.15) shares are well below their $25 liquidation preference where they should normally trade. They provide an 8.8%-8.9% yield.