This Year's Christmas Gift: FBR Group
Friedman, Billings, Ramsey Group (NYSE: FBR) is a Virginia based financial services company structured as a REIT; part investment bank, part asset manager, part principal trader, and part mortgage banker. They've fallen prey to the credit market upheaval. Sound familiar?
FBR is the typical sob story in the recent credit market upheaval; a former highflying financial in the post-crash low interest rate environment falls hard as things go wrong. From 2002-2004 FBR rode high with strong results investing in agency mortgage backed securities (MBS put out by Freddie Mac, Fannie Mae, and Ginnie Mae) as well as its niche investment bank– FBR’s I-bank ranks (then and now) as the #1 IPO underwriter for firms under $1 Billion in market cap. They earned over $2.00 a share in 2004 and the walls came crashing down in 2005. They began struggling with bad results from non-agency MBS investments as the yield curve inverted in 2005, followed by an involvement in originating, underwriting and securitizing sub-prime mortgages right before the party ended in late 2006. They've lost over $600 million since. Remember Bud Fox being carried out of the trading room crying at the end of Wall Street? That's approximately how FBR's management felt following 2006. Everything had gone wrong.
All their woes combined to form a "lollapalooza" effect, as Charlie Munger would say; lots of things going bad at the same time. FBR Group's stock, which once hit $30 a share in 2004- a market cap of over $4.5b- is now sitting at a mere $2.75; a reverse 10-bagger in Lynch phrenology. They have completed 2 offerings of their Capital Markets unit, one a private placement, one a public offering (Nasdaq: FBCM). FBR Group, the REIT, is left with $33m FBCM shares at today's prices worth about $320 million. As a 52% owner, they consolidate FBR Capital Markets for accounting purposes, and the 48% minority interest is subtracted from earnings to get to Net Income, likewise with book value.
But What's Left?
FBR has been cleaning out the garage all year. From Q2 to Q3, FBR sold off $5.8 billion in MBS, and paid down the financing that backed it, resulting in a deleveraging from a 13:1 asset to equity ratio, to 7:1 in the 3Q. They took losses of about $53 million on the sales. Their exposure to any MBS investments made in the past has been reduced to $470 million from over $6.5 billion. First NLC, their ill-fated sub-prime mortgage banking operation, has been recapitalized, and 80% of it sold off to a private equity interest. This leaves FBR with a small portion of FNLC's equity (20%) and no remaining downside exposure except $12 million in equity. They have exited the subprime mortgage origination business. What's left is $3.2 billion of mostly securitized whole loans, backed by non-recourse financing. Non-recourse financing means that the lenders cannot go after FBR besides the collateral posted (in this case the mortgage loans). As such, they have no real economic exposure left there, although if the loans were to be written down FBR could take a hit, but total the exposure there is under $100 million. Those loans have already been heavily written down as it stands.
Santa, Bring me Something Cheap!
The thesis surrounding FBR Group really could not be simpler. The value here reminds me of when Warren Buffett made a comment about the judge who said he couldn't "define" obscenity but said: "I know it when I see it."
At first glance, FBR is selling for just under book value. However, we need to get around the GAAP accounting. FBCM is a public company with a current market cap as of 12/11/07 is $640 million, so FBR Group's 33 million shares are worth about $332 million at market. They could sell this portion off tomorrow and net $332 million in cash. Let’s say they did this and stopped consolidating:
FBR Group Market Cap - $470 Million
52% Interest in FBCM - $332 Million
Market Value of Remaining Business- $138 Million
Tangible Equity at REIT Level - $580 million
Equity Attributable to 52% FBCM Interest - $270 Million
Net Tangible Equity at REIT Level - $310 Million
Current Market Value as a % of Tangible Equity - 45%
This means we are paying a whopping $138 million for the rest of FBR Group's business! For $138 million, we get $310 million of tangible common equity net of FBR Cap Markets; thus we are buying FBR at 45% of its book value. The productive assets are cash ($300m) and long term equity investments ($180m), as well as their residual interests in mortgage loans, and the $470 million of MBS left. It's hard to lose any money when we effectively buy $310 million of already heavily written down tangible equity, which is mostly cash, for $138 million. If you want to get really creative, you could short .52 shares of FBCM for every FBR share to create a stub, and basically arbitrage their market values. However, FBCM is almost as cheap as FBR, and the stub wouldn't let you benefit in the whole upside, which I think is big.
As for the ongoing business plan, in the most recent conference call, management stated that they are prepared to take $500 million of their cash and liquid securities and invest it in brand new Agency MBS, getting away from the non-Agency stuff that has plagued them in the recent past. They plan to lever at 8-10x, so they should pick up maybe $4 billion of new MBS. Hopefully, these new investments will fare better than those of recent memory- one good development regarding the credit market problems is that interest rate spreads have gone up. Their current net interest spread (the difference between the % at which they borrow and the yield their MBS) is .42%, but they figure to invest their new cash at a 1% spread. That should an instant $40-$50 million boost to revenues, which in addition to the end of write-downs and possible valuation increases in their existing portfolio creates solid earnings.
FBR owns some earnings of their former wholly owned, now 52%, subsidiary FBR Capital Markets, a thriving business that includes investment banking, research, and asset management. Capital Markets is the largest underwriter of small company IPO's in the U.S., and manages a well respected family of mutual funds. Chuck Akre runs the newly renamed FBR Focus Fund, which has returned 20% yearly in the past 5 years, far outpacing the S&P. FBR Capital Markets' revenue was up 70% year over year in the most recent quarter.
I think they can earn over $100 million in year or 18 months, about $.60/sh. Placing a modest multiple of 12 on that, the shares are worth $7.20. That’s 2.6x the current share price of $2.75. This is a company that once earned $350 million in 2004. With a higher multiple, or modestly higher upside to earnings, we can see that there is big potential in a turnaround.
The Last Words
With all that said, we don't even need to figure out what FBR Group will earn to see the value here. Subprime is gone, and those losing MBS investments have been cut down by 92%. FBR’s leverage has decreased from about 13:1 to 7:1, and liquidity runs high. They’re flush with cash and ready to try for a new future. It might not work out, but we as investors have very little, if any, to lose at this price. $500 million is being reinvested on our behalf in what is a buyer’s credit market. Those who are willing to buy in this awful credit market are at an advantage to those who are trying to sell.
The business takes some figuring out and some digging. In fact, I don’t claim to know exactly what they will earn, or just how well they’ll do in the future. This is not a wonderful business, this is not Wells Fargo; all I know is that FBR has been beaten down badly and mispriced. In addition, the dividend has been set to .20/share as of this year, paid quarterly. Even as they were selling off MBS in hoards, cutting subprime exposure, and generally being decimated, they have paid a dividend; most recently $.05 a share paid in October. Not much, but at $2.75/share that amounts to an annual yield over 7%.
One note of comfort- CEO Eric Billings owns about 4.8% of the company, mostly through super-voting class B shares. LIkewise, President, J. Rock Tonkel owns 1.5 million shares. With these stakes, we see that management isn't just playing with Monopoly money, they are incentivized to act like owners.(note: insider ownership formerly stated much lower, now corrected) Analysts don’t even cover the REIT any more. They’ve been buying back shares and have 27 million shares left to repurchase under the current plan (note: increased to 100mm recently, so now 77 million left to repurchase). FBR Capital Markets is buying back shares too, which increases FBR Group’s proportional ownership.
If FBR interests you, go through some annual reports, and, very importantly, their most recent quarterly reports and conference calls. They’ll provide you with the vital information you need about this year’s developments which have transformed the company. Do your own homework and decide if you like what you see. If you are interested, be patient with FBR, it will take time to come back. Once the write downs are over and the cash invested, we should see some solid positive earnings, and the stock will rise.
NOTE: Myself and another investor are looking into forming an investor group to get in contact with the management of FBR and get some more insight into the company. If you are interested in participating in the group, please contact me via e-mail. Thank you.
Full Disclosure: Author owns a position in FBR. He can be contacted at firstname.lastname@example.org