Good News at FBR Group

Circle of Competence Blog — Thu, 21 Feb 2008 16:24:28 -0500

As you may have seen, I wrote up an article at the end of last year on FBR Group, a small cap financial stock that had fallen very hard in the past few years as it got involved in the subprime and structured finance mess. My main thesis was that the stock was mispriced, extremely cheap, and available at a substantial margin of safety. As they reported their 4^th quarter results today, my belief in a margin of safety came to fruition as the write downs were aplenty, and total asset value has changed, but the company is doing fine.

FBR Reported huge losses, on a GAAP basis for the quarter and the year. Doesn’t really matter to me- 2007 was a lost year of write downs, sell-offs, and de leveraging. The important thing here is that sub-prime balance sheet exposure is gone, the sub-prime lender is gone and bankrupt, and nearly all of FBR’s assets are of a liquid and high quality nature. They ended the quarter with almost $2b in MBS, with 80% of that brand new agency MBS, all backed by Freddie and Fannie, and the full faith and credit of the US Government. They also have about $300mm in cash ready to deploy, at 8-10x leverage, in more new agency securities. The rest of the stuff on their balance sheet is of generally good quality, mostly AA or better securities. Management's plan is to convert as many assets as possible to conservative agency MBS.

Hold on, there’s more.

FBR, through its incompetent and thorough losses, racked up net operating loss carry forwards of over $600mm! This is a huge tax asset, and net realizable value, according to management, will be about $270mm of that, in cash. They are also going to realize another gain, in cash, of about $70mm in recovery from the bankruptcy proceedings of their defunct sub-prime mortgage lender.

But wait, there’s more.

The credit crunch has created some great opportunities for management to invest in their core strategy of agency MBS. With spreads between borrowing costs and yields on the agency MBS approaching a huge 175 basis points (remember 100 basis points is 1%), return on invested capital will approach 18% with leverage of 10x. The bad credit market is bad for sellers of this toxic waste- but for buyers of the good stuff (i.e. nearly riskless agency bonds), it just gets better and better.

Conclusion

FBR has had a rough go, and I wouldn’t give management any awards in the near future for their shoddy performance since 2004. However, their balance sheet is all cleaned up and ready to rock- they have the capacity to re-leverage their balance sheet, this time with the good stuff, not the toxic waste they bought in the last few years. In the fourth quarter, they bought back shares, and reduced the count to about 152 million shares, down from 174 million at this time last year. When the earnings begin to roll in from the agency strategy, they will propel the stock higher. What’s our downside? They have $3.10 per share of tangible book value, including the recovery from the bankruptcy proceedings. The shares, as of today, are priced under $3.00 a share. Things are looking up for FBR, so let’s hold on and see what happens. Read today's conference call here

At this time of writing, the author had a position in FBR.

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Good News at FBR Group