aames financial corporation

New Century Financial Corp. (NEW) Investment Recommendation: I. The Firm and its Market Description The New Century Financial Corporation was founded in 1995 when the company’s founders, Bob Cole, Brad Morrice and Ed Gotschall, decided to start their own non-prime mortgage business. New Century Financial is now a real estate investment trust and is one of the nation’s premier mortgage finance companies, providing mortgage products to borrowers % nationwide through k operating subsidiaries, New its Century Mortgage Corporation and Home123 Corporation.1 Their business works by originating and purchasing primarily first-mortgage loans worldwide, and they focus on lending to individuals whose borrowing needs are generally not fulfilled by traditional financial institutions, because they do not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers.2 In 1997, New Century went public and began trading on the NASDAQ Stock Market. Then, in October of 2004, New Century started trading on the New York Stock Exchange under the symbol “NEW.” As the company has grown, so has recognition of its success. The company was named to FORTUNE Magazine’s list of “FORTUNE’s 100 Fastest Growing Companies” – ranking 12th in 2003 and third in 2004. In 2005, it ranked third on The Wall Street Journal’s “Top Guns” list of the best performing companies and moved from the Russell 2000 Index to the Russell 1000.3 Sell To Close Pricing Closing Price (9/26/06) $42.10 $51.97 $30.22 52 Week High 52 Week Low Profitability & Effectiveness (ttm) ROA ROE Profit Margin Operating Margin 1.66% 21.55% 31.98% 35.42% Market Data Total Assets $26,147,090 Market Cap $2.36 B Avg. Vol (3mo.) 1,541,750 EPS (ttm) 7.64 P/E (ttm) 5.50 Portfolio Data Shares Held 50 Buy Price $44.96 Current Value $2,105 Gain/(Loss) ($144.00) Ann. % Return (6.36%) Purchased on 3/27/06 Stop-Loss Price Sell For Profit $42.00 $75.00 Sector Financial Industry Mortgage Investment Mark Kearns mwk34c@mizzou.edu 1 2 ncen.com reuters.com 3 ncen.com 1 Market Position New Century Financial is competitive within their market, especially, considering that they are only a ten year old company. They rank near the top in EPS Growth, Return on Equity, and have an astounding Dividend Yield of 17.80%. However, their forth place ranking in Market Capitalization is somewhat deceiving because it is very distant, number’s one and two have $45.08 B and $21.5 B, respectively, dwarfing their $2.36 B share. They also are very average in P/E Ratio, Revenue Growth, and Long-Term Growth Rate in comparison with the rest of the industry. NEW VS. INDUSTRY LEADERS Statistic Market Capitalization P/E Ratio (ttm) PEG Ratio (ttm, 5 yr expected) Revenue Growth (Qtrly YoY) EPS Growth (Qtrly YoY) Long-Term Growth Rate (5 yr) Return on Equity (ttm) Long-Term Debt/Equity (mrq) Dividend Yield (annual) Industry Leader NEW FRE 45.08B 2.36B CHC 31.22 5.50 NLY 7.80 0.72 LUM 166.40% 14.80% CRZ 1802.90% 9.50% DRL 26.0% 8.0% LEND 29.21% 21.55% DFC 38.285 11.508 HMB NEW Rank 4 / 31 15 / 31 8 / 31 11 / 31 6 / 31 9 / 31 4 / 31 11 / 31 21.00% 17.80% 3 / 31 II. The Competitive and Economic Environment The Competition New Century Financial has three close competitors within its market: Aames Financial Corporation, Countrywide Financial Corporation, and Pacific Premier Bancorp Inc. All of these companies are located in California and compete for the same mortgages and customer base. Aames Financial provides home mortgage equity loans to homeowners with sub par credit who have trouble getting financing from traditional lenders.4 Countrywide Financial is more of a traditional mortgage company, operating in five segments: Mortgage Banking, Banking, Capital Markets, Insurance, and Global Operations.5 Pacific Premier Bancorp operates as the holding company for Pacific Premier Bank, F.S.B. It offers various loan products, such as commercial business loans, lines of credit, commercial real estate loans, SBA loans, residential home loans, and home equity loans.6 4 5 biz.yahoo.com finance.yahoo.com 6 finance.yahoo.com 2 DIRECT COMPETITOR COMPARISON Market Cap: Employees: Qtrly Rev Growth (yoy): Revenue (ttm): Gross Margin (ttm): EBITDA (ttm): Oper Margins (ttm): Net Income (ttm): EPS (ttm): P/E (ttm): PEG (5 yr expected): P/S (ttm): NEW 2.36B 7,200 14.80% 1.39B 100.00% N/A 35.42% 435.72M 7.637 5.50 0.72 1.68 Pvt1 N/A 2,0631 N/A 339.10M1 N/A N/A N/A 90.70M1 N/A N/A N/A N/A CFC 21.63B 54,456 -42.90% 9.91B 85.10% N/A 18.29% 2.68B 4.314 8.19 0.67 2.16 Industry PPBI 61.84M 354.55M 85 989 -1.70% 39.00% 21.78M 49.40M N/A 90.17% N/A 6.55M 49.66% 36.47% 8.18M 17.32M 1.223 0.61 9.61 9.58 0.30 0.77 2.84 2.17 Pvt1 = Aames Financial Corporation (subsidiary or division) CFC = Countrywide Financial Corp. PPBI = Pacific Premier Bancorp Inc. Industry = Mortgage Investment 1 = As of 2004 New Century Financial has a very impressive Quarterly Revenue Growth in comparison with their closest competitors. This is a sign that they are taking business from competitors and it is causing a growth on their bottom-line. New Century’s EPS is way above the rest and they are keeping expenses lower than that of a majority of their competitors, which you can determine because their Net Income is a higher percentage of Revenue than that of most of their competitors. New Century Financial is lagging behind in P/E and P/S though, and Countrywide Financial has a stronghold on the Market Cap in New Century Financial’s region. This is something that will be a continuing uphill battle for New Century Financial, and could only get worse as the housing industry slows down more and more. The Economy The Mortgage Investment industry has a positive correlation with the economy. The graph below shows this as the Mortgage Investment industry moves in almost perfect correlation with the S&P 500, which is a good indicator of the economy. As the economy is booming, so is the mortgage investment industry, but this also rings true for the other side of the spectrum, if the economy is doing poorly, the mortgage investment industry will see a decline in profitability. A slower economy causes a change in spending habits for consumers, especially when buying big items such as real estate. Also, as the economy slows down, mortgage rates will increase, making it even more unaffordable for more and more consumers. The mortgage banking industry is generally 3 subject to seasonal trends. These seasonal trends reflect the pattern in the national housing market. Home sales typically rise during the spring and summer seasons and decline during the fall and winter seasons. Seasonality has less of an effect on mortgage refinancing activity, which is primarily driven by prevailing mortgage rates. In addition, mortgage delinquency rates typically rise temporarily in the winter months, driven by mortgagor payment patterns.7 III. Valuation of the Firm Stable Dividend Discount Model To valuate the New Century Financial Corporation, I decided to use the Stable Dividend Discount Model because I see New Century as a growing company that will only continue to gain market share, and therefore, increase dividends every year. The Stable Dividend Discount Model is a simple formula that allows us to find the true value of the stock. You take the number of dividends the company paid last year and multiply one plus the growth rate of dividends divided by the return minus the growth rate of dividends. D x (1+G)/(RE -G) D=Dividend Payout G=Growth Rate of Dividends RE= Expected Return To do this, you must first find the return. As discussed in class, my risk-free rate was 4.555%, which is the Ten Year US Treasury rate. Using the historical market return of 7 New Century Financial Corp. Annual Report 4 9% subtracted by the risk-free rate, my equity risk premium is 4.445%. Along with New Century’s beta of .82 given by reuters.com, their expected return is 8.1999%. RE = RF + Beta (Equity Risk Premium) RE = 4.555 + .82(9-4.555) = 8.1999% Now, I had to find the growth rate of the dividends. The Payout Ratio of 88% and ROE of 21.55% were both straight off the key statistics page from finance.yahoo.com G= (1- Payout Ratio) x ROE G = (1-.88) x .2155 =.0259 Plug these numbers into the formula along with the dividend payout of $7.40 from last year. The value of the stock is $95.25 per share higher than its current value. 7.40 x (1 + .0259) / (.0812-.0259) =$137.28 Warren Buffett’s Owner’s Earnings Discount Model Assuming discount rate (k) of Owner Earnings in 2005: Net Income Depreciation Amortization Capital Expenditures Owner Earnings 12.00% $ $ $ $ $ 411,125,000.00 114,990,000.00 (60,530,000.00) 465,585,000.00 2005 465,585,000.0 7.8% 501,900,630.0 $501,900,630.0 2006 $501,900,630.0 7.8% $541,048,879.1 $483,079,356.4 2014 $915,309,200.1 7.8% $986,703,317.7 $355,815,108.0 Prior Year Owner Earnings First Stage Growth Rate (add) Owner Earnings Discounted Value per annum $ $ Simulate for the next 10 years. 5 Sum of present value of owner earnings Residual Value Owner Earnings in year 10 Second Stage Growth Rate (g) (add) Owner Earnings in year 11 Capitalization rate (k-g) Value at end of year 10 Present Value of Residual Intrinsic Value of Company Shares outstanding assuming dilution Intrinsic Value per share $4,251,429,026.9 $ $ $ 986,703,317.7 6.00% 1,045,905,516.8 6.00% 17,431,758,612.59 $5,612,559,739.96 $9,863,988,766.86 56,120,000 $175.77 Both valuation models found numbers that are very high. I think these numbers are skewed because they are based on last year’s numbers. The mortgage industry was in a much better state a year ago than it is today. New Century Financial also increased their dividends by a huge amount last year, which inflates the Dividend Model and making the value extremely high. IV. Firm Financials Financial Statement Analysis Profitability Profit Margin (ttm): Operating Margin (ttm): 31.98% 35.42% Dividend Per-Share 2002 $0.16 2003 $0.43 2004 $2.13 2005 $6.50 Net Income 2002 2003 2004 2005 (in billions) Management Effectiveness Return on Assets (ttm): 1.66% Return on Equity (ttm): 21.55% Income Statement Revenue (ttm): 1.39B Revenue Per Share (ttm): 25.029 Qrtly Revenue Growth (yoy): 14.80% Gross Profit (ttm): 2.44B Net Income (ttm): 435.72M Diluted EPS (ttm): 7.64 Qtrly Earnings Growth (yoy): 11.00% Balance Sheet Total Cash (mrq): Total Cash Per Share (mrq): Total Debt (mrq): Total Debt/Equity (mrq): Current Ratio (mrq): Book Value Per Share (mrq): $179.70 $245.50 $375.60 $416.50 Earnings Per Share 2002 $4.73 2003 $6.32 2004 $8.29 2005 $7.17 Stockholder's Equity 2002 2003 2004 2005 (in millions) 380.85M 6.787 24.61B 11.508 0.75 38.13101 $386.60 $542.00 $1,878.60 $2,109.70 Cash Flow Statement Operating Cash Flow (ttm): 485.35M 6 New Century Financial Corporation has been able to attain a very high profit and operating margin for their business. This is a great sign for their company, showing that the aspects of their business are in fact profitable and growing at the rate of 14.8% quarterly. Management is doing a great job getting Return on Equity, which is a whopping 21.55% for this year. Net Income is on a steady increase over the past four years, as well as Stockholder’s Equity and Dividends Per-Share. Earnings Per Share was down slightly last year, but is still up nearly 52% from 2002. Their Debt to Equity Ratio is a little high, showing that New Century might be too leveraged. This chart was pulled out of New Century Financial’s Annual Report, it explains the change to Bad Debt Allowance that has occurred over the last year. New Century Financial has more than doubled their Allowance for Bad Debts in the last year, which could be a sign that they are starting to take riskier investments. This is not always a bad thing, higher Allowance reduces the chance that a surprise could arise on earnings reports. This amount has already been sat aside so, if a big loss occurs, it doesn’t affect have near the affect that it could have. New Century Financial Corporation has been out-performing the S&P 500 for a majority of the last year. In March, New Century reached an agreement with Greenlight, a direct-to-customer mortgage company. Greenlight is able to increase ownership up to 7 19.6% and their president, David Einhorn, will serve as Class III Director at New Century Financial.8 This agreement caused the stocks surge in that short amount of time. Risks   Existing-home sales declined last month, dropping .5% from July and 12.6% from last year. The median home price fell for the first time since 19959 A mortgage lender tries to borrow cheaply and lend expensively. When short-term interest rates go up while long-term rates go down, the margin spread goes down. When long-term rates go up (regardless of short-term rates), fewer loans are produced and more defaults occur. With the yield curve inverting and long-term rates going up, the potential for problems in New Century's business looms large.10 In December, Federal bank regulators proposed guidance to tighten the lending standards for interest-only mortgages and other exotic loans that have helped fuel the national housing boom.11 MBA said Wednesday that loans entering foreclosure during the second quarter rose 29 percent from the first quarter.12 This is the first sign of mortgage market may be on the verge of cracking, mostly, from taking riskier investments.   Recommendation Upon evaluation of New Century Financial Corporation, I think it is too risky to include in our portfolio. The housing bubble is on the verge of busting, and this stock does not fit into our portfolio standards. It is best that we get out of stock now, before the big fall starts. We have already lost over 6% of our investment, and I think there are better investment opportunities within the market, in much safer industries, for us to invest in. Final recommendation, sell to close. 8 9 thestreet.com The Wall Street Journal 10 thestreet.com 11 thestreet.com 12 biz.yahoo.com 8 Income Statement All numbers in thousands PERIOD ENDING Total Revenue Cost of Revenue Gross Profit Operating Expenses Research Development Selling General and Administrative Non Recurring Others Total Operating Expenses 31-Dec-05 31-Dec-04 31-Dec-03 2,443,098 1,732,567 975,966 277,416 2,443,098 1,732,567 698,550 871,365 140,233 - 684,082 70,250 - 119,440 38,283 - Operating Income or Loss Income from Continuing Operations Total Other Income/Expenses Net Earnings Before Interest And Taxes Interest Expense Income Before Tax Income Tax Expense Minority Interest Net Income From Continuing Ops Non-recurring Events Discontinued Operations Extraordinary Items Effect Of Accounting Changes Other Items 1,431,500 978,235 540,827 1,431,500 988,123 443,377 26,834 416,543 978,235 367,094 611,141 235,570 375,571 540,827 117,575 423,252 177,769 245,483 - - - Net Income Preferred Stock And Other Adjustments Net Income Applicable To Common Shares 416,543 (5,418) $411,125 375,571 $375,571 245,483 $245,483 9 Balance Sheet All numbers in thousands PERIOD ENDING 31-Dec-05 31-Dec-04 31-Dec-03 Assets Current Assets Cash And Cash Equivalents Short Term Investments Net Receivables Inventory Other Current Assets Total Current Assets Long Term Investments Property Plant and Equipment Goodwill Intangible Assets Accumulated Amortization Other Assets Deferred Long Term Asset Charges Total Assets Liabilities Current Liabilities Accounts Payable Short/Current Long Term Debt Other Current Liabilities Total Current Liabilities Long Term Debt Other Liabilities Deferred Long Term Liability Charges Minority Interest Negative Goodwill Total Liabilities Stockholders' Equity Misc Stocks Options Warrants Redeemable Preferred Stock Preferred Stock Common Stock 1,230,420 137,945 24,273,285 86,886 92,980 280,751 44,823 26,147,090 1,296,889 247,048 17,274,459 47,266 12,700 173,582 19,051,944 386,423 215,322 8,170,048 32,258 36,901 93,928 8,934,880 508,163 23,529,227 24,037,390 320,108 16,853,271 17,173,379 170,874 3,311,837 4,910,158 8,392,869 45 557 547 338 10 Retained Earnings Treasury Stock Capital Surplus Other Stockholder Equity Total Stockholder Equity Net Tangible Assets 828,270 1,234,362 46,466 2,109,700 $2,016,720 781,627 (70) 1,108,660 (12,199) 1,878,565 $1,865,865 509,998 (14,163) 52,988 (7,150) 542,011 $542,011 Cash Flow All numbers in thousands PERIOD ENDING Net Income 31-Dec-05 31-Dec-04 31-Dec-03 416,543 375,571 245,483 Operating Activities, Cash Flows Provided By or Used In Depreciation 114,990 Adjustments To Net Income (139,687) Changes In Accounts Receivables Changes In Liabilities Changes In Inventories Changes In Other Operating Activities 157,624 Total Cash Flow From Operating Activities 549,470 56,449 (345,188) 198,587 285,419 (323) (63,602) 12,388 193,946 Investing Activities, Cash Flows Provided By or Used In Capital Expenditures (60,530) (28,977) (22,574) Investments (3,126,707) (8,556,895) (4,761,871) Other Cashflows from Investing Activities (80,573) Total Cash Flows From Investing Activities (3,267,810) (8,585,872) (4,784,445) Financing Activities, Cash Flows Provided By or Used In Dividends Paid (357,882) (26,633) (11,515) Sale Purchase of Stock 93,233 811,755 (81,519) Net Borrowings 2,916,520 8,416,739 4,887,032 Other Cash Flows from Financing Activities (272,662) (337,152) (110,628) Total Cash Flows From Financing Activities Effect Of Exchange Rate Changes Change In Cash and Cash Equivalents 2,379,209 8,864,709 4,683,370 $92,871 ($339,131) $564,256 11