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Aurizon Mines: Maybe growth is finally on the horizon of Aurizon

Sorry about the title.  That was a terrible rhyme.

I didn’t set off with the intent of writing a long post on Aurizon Mines this morning.  I have other research projects to spend my time on that hold more near term potential.  In particular, I have regional banks to evaluate, mortgage lenders to learn about, and mortgage lending podcasts to listen to and transcribe.

Nevertheless I must have a masochistic side because I am always more fascinated by the times I am wrong and the things that I don’t understand than with what is working and making sense.  And nothing has been wrong or made as little sense to me as the downward spiral of Aurizon Mines.

Over the past 6 months I have (somewhat unintentionally) been swing trading Aurizon Mines.  I hold a core position but around that position I buy more at or just under $5 and I sell what I buy at around $5.75 or $6.  It worked well a couple of times last year, however this year not so much.   The stock stalled out a few weeks ago at $5.50, it didn’t stay there long, and I ended up jumping out of some of my non-core position in the $5.30 range.  After that I sat as a bagholder with the rest, watching the stock tumble below $5.

In the last couple weeks I have been in and out some more, buying at $4.80, getting out at $4.9 before buying back on Thursday at $4.50.  The frequency of my indecision is telling. I clearly don’t know what to think about the stock.

To be honest, I didn’t think Aurizon would get this low.  The company holds $1.31 in cash and would be considered to be one of the lower cost gold producers. It has consistently met targets.  Its not a management disaster like so many gold miners.  These are solid operators.

The Alamos Gold Comparison

I did a comparison a few months ago between Alamos Gold and Aurizon Mines to demonstrate the disconnect.  I think it is instructive to dig up and refresh that analysis now that the Q4 numbers are out:

Instead of focusing on the valuation discrepancy and how the market has it wrong, I want to focus instead on why the market is willing to value Alamos at 2x to 3x the value they are willing to assign to Aurizon.

I think its all about growth and costs.

In the Alamos Q4 report, the company forecast that they would increase production from 153,000 ounces to over 200,000 ounces in 2012.  They also predicted that costs would come in about the same as they did in 2011.

In 2012, the Mulatos Mine is forecast to produce its one millionth ounce of gold. Ongoing exploration success has resulted in a track record of mined reserves being replaced. In 2012, the Company expects production to increase to between 200,000 and 220,000 ounces at a cash operating cost of $365 to $390 per ounce of gold sold ($450 to $475 per ounce of gold sold inclusive of the 5% royalty, assuming a $1,700 gold price). The Company expects that gold produced from the gravity mill, which will process high-grade ore from Escondida, will add a minimum of 67,000 ounces of production in 2012 at a grade of 13.4 g/t Au. Based on bulk sample testing conducted in 2007, the Company believes that there is the potential for higher production from the gravity mill as a result of realizing positive grade reconciliation to the reserve grade.

The high-grade gravity mill has been constructed and is currently undergoing commissioning and is expected to be operational with high-grade production by the end of the first quarter of 2012. The current life of the Escondida zone is approximately three years and exploration efforts in Mexico in 2012 will continue to focus on sourcing additional high-grade mill feed. Metallurgical testing completed in 2011 on higher grade ore from San Carlos demonstrated that it is amenable to gravity processing, potentially doubling the amount of available mill feed. Further optimization and metallurgical studies are underway in order to increase the amount of high grade ore that can be processed through the gravity plant.

On the other hand a look at Aurizon’s Q4 report shows the following outlook:

It is estimated that Casa Berardi will produce approximately 155,000 – 160,000 ounces of gold in 2012 at an average grade of 7.5 grams of gold per tonne. Average daily ore throughput is estimated at 2,000 tonnes per day, similar to 2011. Mine sequencing in 2012 will result in ore grades that are expected to be approximately 6% lower than those achieved in 2011. Approximately 42% of production will come from Zone 113, 41% from the Lower Inter Zone, and the residual 17% from smaller zones and development material.

Assuming a Canadian/U.S. dollar exchange rate at parity, total cash costs per ounce for the year are anticipated to approximate US$600 per ounce in 2012. Onsite mining, milling and administration costs are expected to average $134 per tonne, up approximately 6% from 2011 costs as a result of higher stope preparation costs and smaller stopes.

Flat production.  Higher costs.

$600 costs are not high by most gold mining standards.  With those sort of costs Aurizon would still sit in the top quartile of low cost producers.  I think that in this case Aurizon is guilty by association.  There have been SO MANY gold miners that have began to predict higher costs only to see those costs spiral much higher than was originally anticipated. The market is on guard.

The Sinking Growth Ship

As for the growth, the problem is that the company’s flagship growth project is not inspiring confidence.   I stepped through the news timeline at Joanna in a previous post.  Since Aurizon has made it a habit of updating the street with quarterly reminders of just how shitty the Joanna PEA is going to be, let’s do the same thing here.  Below is the time line of events:

May 12th 2008

Aurizon first commissioned a pre-feasibility study on Joanna.

November 11, 2009

Aurizon finally received that pre-feasibility study and proceed to a full feasibility study.

September 14th 2010

Aurizon notifies shareholders that the original recovery process assumed (called the Albion process) would show lower recoveries and higher costs than first anticipated. Additional metallurgical test work would be done and the study delayed until mid 2011.

August 11, 2011

Aurizon delays the feasibility study for Joanna again, saying: “the projected capital and operating costs appear to be significantly higher than previously anticipated. The increased scope of the project, as a result of the expanded mineral resource base, has increased capital costs, including those associated with an autoclave process. The costs of ore and waste stockpiles, tailings and of materials and equipment have also all been trending higher, along with the gold price.”

January 11, 2012

Another update giving an ETA: Feasibility study work on the Hosco deposit will continue in 2012 with completion of the study anticipated by mid-year. The feasibility study will incorporate a reserve update based on the increased mineral resource estimate announced on June 13, 2011, together with results of metallurgical pilot tests, a geotechnical study, updated capital and operating cost estimates, and other relevant studies.

As I wrote at the time:

Its been almost 4 years since the original pre-feasibility study on Joanna was complete! At this rate they should be mining by 2100.

The time line can now be updated with the latest installment from the Q4 report and the following comment:

While some studies are still in progress, based on its review of information currently available the Company believes that the feasibility study is sufficiently advanced to conclude that the projected capital and unit operating costs will be significantly higher than estimated in the December 2009 Pre-Feasibility Study, due in part to the change in the scope of the project, the expanded mineral resource base, the selection of an autoclave process and a decision to process the ore on site.

I think this is about the 3rd time the company has warned investors not to get their hopes up about Joanna.  Keep in mind that the original numbers for Joanna weren’t exactly thrifty (if I rememver right they were $200M + capital and $700 costs).

If I was going to translate this news-release-speak into plain english it would sound something like this:

It is surprising even us with how shitty this project is turning out to be

But that’s just my interpretation.  I could be wrong.

Takeover talk!

I have found 3 articles (here, here, and here) discussing a post-earnings release interview (or maybe it was on the conference call, I haven’t had a chance to listen yet) done by George Paspalas, the company’s CEO, where he said that the company has been approached by potential suitors and that the company is also looking for companyies they could takeover.

With respect to the potential for an acquisition, Paspalas said the following:

To receive the company’s interest, a target would have to be producing around 120 000 oz/y, and at similar profit margins to Aurizon’s flagship Casa Berardi mine in Quebec.  “We’ve looked hard, I can tell you that,” Paspalas said, speaking in a telephone interview from the firm’s Vancouver headquarters.   “There are a lot of companies out there…that are at a point where they have a pretty good project, but they don’t have any cash – and the shareholders are saying ‘enough’s enough’ in terms of dilution,” commented Paspalas.  “We have five or six opportunities in our grade one category,” he said, adding that one of these could close in the near-term if there weren’t any pitfalls in the technical due diligence or price negotiations process.

He went on to say that they are shifting their focus from looking at acquiring a producing mine to instead acquiring a near-term project.

The one report also said that Aurizon “has itself received informal approaches regarding potential mergers.”

Cautiously Optimistic

I think this is quite good news.  The problem with Aurizon, as I have tried to lay out above, is that the market wants growth and the market isn’t buying Joanna as the vehicle for that growth.  It’s too bad they will have to pay up a good chunk of their cash hoard to acquire a project but the argument could easily be made that the cash is being ignored by the market right now anyways.  If you remember Argonaut Gold, their adventure to double digit share prices began when the company took over Pediment Gold and with that acquisition bought themselves a stable of near term production projects.  A similar acquisition by Aurizon would be a positive.  It would allow the brokerages to start prjecting realistic growth  into the future, and from those higher production numbers they can begin to tag a higher multiple onto the stock.  Then everyone gets excited about the prospects and we all jump on the bandwagon and a couple of fund managers get on BNN and hype the stock and pretty soon you have Argonaut Gold all over again, going from $3 to $10 in a little over a year.

Its a plausible scenario.   If the takeover happens and it looks like its the right takeeover, I will no longer swing trade the stock and instead will begin to hold it for the longer term.  But without the takeover I am just not willing to put too many of my eggs in the Joanna feasibility basket, which is sounding more and more to me like it has a big hole in it.


Jumping into another Mortgage Servicer

On Tuesday the financials broke out and that breat out has continued through the week. A quick look at the KRE shows that the trend has been up since the end of December and that the move this week took them decisively above the July-August levels just before the break down occurred.

Along with the plain vanilla regionals, a number of the mortgage specialists that I have leaned towards are showing strength. Newcastle Investments continues to move higher. PHH Corp is flirting with $15. I’m pleased that these stocks are responding so well; as they continue to do so I will continue to add to my positions.

As it is I have bought the breakout over the last few days by buying a new bank and a new mortgage originator/servicer. On Wednesday I initiated a position in Shore Bancshares.The bank is trading at about 1/2 of book value and looks to be slowly turning around its admittedly elevated delinquent loan book.  And just yesterday I initiated a new position in a recent IPO called Nationstar Mortgage Holdings.

Nationstar Mortgage Holdings

I have been stepping through the Prospectus on Nationstar. It is available here .

I’m pretty excited about the company. I have been looking for another pure play on the mortgage servicing rights thesis. Newcastle is not a bad way to go, and PHH Corp looks good, but Nationstar looks like another cheap alternative to get leverage to an early turn in the US housing market and to the pricing disconnect of mortgage servicing rights.It appears to be trading at about 17x last year’s earnings (ex the MSR adjustments), and I expect that with the growing servicing portfolio (they have grown at a 70% rate for the last 3 years), and with deals like the one they are doing with Newcastle, that those earnings are going to go up substantially.

The company has been privately owned by Fortress Investment Group (another company I want to look at), which is a private equity firm. Fortress is the same firm that is involved with Newcastle.  Apparently someone at Fortress is seeing the same thing I see in the mortgage servicing right business.

Fortress did the IPO of Nationstar at $14 but interestingly will remain a large majority shareholder at 81%. I have no doubt that Fortress made the IPO because of the opportunity they see to capitalize on the mortgage servicing industry.

Newcastle Investments

And since we are speaking about mortgage servicing, yesterday Newcastle also made the predictable announcement that they would raise their dividend from 15 cents to 20 cents for the first quarter.  I find it kinda fascinating how the stock jumps on these dividends increases.  They also left the door open for further increases and further investment into MSR’s.

Kenneth M. Riis, Newcastle’s CEO commented, “I am pleased to announce our second common dividend increase since it was reinstated in the second quarter of 2011. Our ability to increase our dividend is a result of deploying capital at attractive returns and improving our overall operating results. As we complete new investments, we expect our operating results and cash flows to improve further.”

I don’t know if there will be another share offering but I don’t really see any other way for Newcastle to “complete new investments”. Any offering could mean a short term down draft in the shares. But with an investment opportunity like mortgage servicing provides right now, I would argue that raising capital is a good thing over the long run.

Remember that the MSR’s that Newcastle has invested in thus far are expected to return 20% IRR based on the expectation that 20% of those loans will refinance or default every year. That’s the base case. Yet we are in a period where refinancing and defaults could begin to fall substantially, which would drive up the IRR of the servicing. In my opinion the potential for an IRR far beyond the base case is significant.

The current Opportunity in Mortgage Servicing Rights

I’m going to say it again.  MSR’s are a HUGE market disconnect right now.  The disconnect is being brought about by a combination of regulatory changes that have made MSR’s unnattractive from the Tier I capital perspective and from a legacy business of bad loans that many of the banks are stuck with.  The result is that most of the biggest players traditionally in the MSR industry are stepping back and some (Bank of America for example) are getting out completely.  This has left the industry undercapitalized, which has resulted in a collapse of pricing of mortgage servicing rights.  The rights have traditionally traded for 4-6x their coupon; today they are trading at less than 2x.  Newcastle has done its recent deals at around 2x.  And this mispricing has happened at a time when the industry fundamentals for servicing have never been better.  Loan quality is high because standards have become very tight, and with rates so low the potential for significant refinancings has dwindled.

No one else seems to be noticing this. I feel like a loan wolf.  Nevertheless I remain convinced that this is a great opportunity.

In the mean time I will continue to take advantage of the silence and keep adding to Newcastle, to PHH, and now to Nationstar.

Newcastle Investment Dividend Ratio

I’m not much of a dividend investor.  Maybe when I get older I will covet the security of knowing I’m getting 3-4% back from the company every year.  But not now.  Right now that 3-4% doesn’t seem like a lot to me.  I’m certainly not going to be changing my lifestyle any time soon on a 3-4% return.  I’m trying to build capital and to do that I need to have a few home runs, not a bunch of sacrifice flies.  I certainly don’t put in as much work as I do so I can make a couple more points than the rest of the mutal fund / index fund / ETF crowd.  Dividends don’t normally excite me.

When a dividend gets to 10%. like Newcastle’s is, then it starts to pique my interest.  But just barely.   10% still doesn’t cut it.  If the best I can do is 10%, than I still think I should quit and hire an adviser.  That’s my thinking anyways.

So when I bought Newcastle, it was with the understanding that the dividend was a nice feature, but not the reason to buy the company.  The reason to buy the company is because I think the price of the shares are going to go up.

Of course…. Newcastle is a REIT the main driver of the share price is the dividend.  So the two are intertwined and therefore I need to understand the relationship.

As the dividend goes, so goes the stock price

I went back through the last 6 years of Newcastle’s 10-K’s and came up with the following graph that helps illustrate how closely the dividend and stock price are linked.

Here is what I found:

The stock price is clearly linked to the dividend.  In most cases (as you would expect) the stock price leads the dividend.

The stock price usually falls within a broad range of 8x to 12x the dividend.  It depends if times are good or if times are bad.  Right now, times are improving, so perhaps a move to 12x is not out of the question.

I haven’t run the numbers in full on the second MSR deal that Newcastle announced.  Until I do I won’t be able to say what I think the dividend will eventually be.  But to ballpark, based on a sustainable cash flow of 10 cents per share from the first dividend, and given that the second deal is roughly 4x larger than the first, I think that a sustainable dividend in the 80-90 cent range is not unreasonable.  Tacking on a 10x to 12x multiple and we get a share price range of somewhere between $8 and $11.

Week 36: Short-termism

Portfolio Performance

Portfolio Composition



One of the unfortunate realities of being invested in the stock market is that while you have to keep your eye on the longer term problems, you can’t let them cloud your ability to look for short term opportunities.  So while I accept the view that the world could quite possibly go to hell in the medium term (see my post on Greece earlier day for the latest installment), in the short term we’re in another liquidity induced high.  Party on or something of that vein.

Buying the correction

As I wrote about on Tuesday, this week I bought the correction, buying Aurizon, Pan Orient and Golden Minerals (I screwed up the Golden Minerals trade in the practice account I post here and didn’t realize it until I checked this weekend so I will have to buy the stock next week to reconcile the practice account with my actual account.   As I mentioned earlier, I bought a fairly substantial portion in my trading account.  In a couple of my other accounts that I do not track with the RBC Practice account I also bought more Newcastle Investments and Atna Resources.  I’ve been doing work on both of these companies and I think these represent two of the best opportunities for appreciation in the next few months.

Never add to a losing position… except this time

I also bought more Equal Energy when it got down into the $3.80’s.  I am going against my rules with Equal.  Never add to a losing position.  I’m losing on Equal.  But I’m simply of the mind that even with low natural gas prices this is getting ridiculous.  The activist shareholder movement posted a new slide to their presentation that showed just how undervalued Equal is compared to some peers, particularly NAL.  NAL has ok assets but I would not say they are that much better than Equal’s.  Yet NAL trades at a valuation that is more than double of what Equal is at.  Something has to give here.

Back into Leader Energy Services

The other stock that I bought recently (was actually last week that I bought it, not this week, but I haven’t mentioned it yet) was Leader Energy Services.  Leader did a bought deal financing two weeks ago.  They raised about $6M with 8.5M share dilution.  For those that have followed this blog for a while, I owned Leader back in the summer but sold the stock when Europe broke out because I feared (rightfully) that a company in a cyclical business with a lot of debt would have a tough time in that environment.  I wrote up my thoughts on why I originally bought Leader in this post.  I wrote up my thoughts on why I sold Leader in this one.  The basic thesis of why to own the stock is still valid.  With the financing, many of the debt concerns are not.  Given that, and given that the immediate problems in Europe having receded, I decided it was probably the right time to take back a starter position in the stock.

Turning Greeks into Germans

On my ride into work this week, on Tuesday I think, I listened to the Planet Money program, In Greece, How Office Politics Could Take Down Europe.  Its a very interesting podcast, and I recommend it to everyone.

Office politics and Europe have a lot in common.  Office politics are mostly about power struggles between competing elements.  They typically put forces of the status quo against forces of change.  The winners tend not to be those with the best ideas, but those with the most clout.  And in the end the losers of the battle have to either conform to the dicatates of the winners, or get out and find at new place to work.

Such is the case with Germany versus Greece and the rest of the periphery.  Greece is getting closer to that bifurcation where they have to either conform or get out.


The podcast describes the travails of a lone Greek Technocrat, Andreas Georgiou, sent back to Greece by his employers in Brussels to go through the books.  Of course, the books are cooked and the more our technocrat (hero?) delves into them, the more he finds out not only how cooked they are, but also how difficult it is to get the truth out.  Eventually they try to put him in jail for his efforts.

It reminded me of one of those old “one good cops” stories, where it seems like everyone on the force is on the take and how can our hero ever persist?

Unfortunately, he probably can’t.

Debt Crisis Delayed, not Over

What I think the story illustrates is just how deeply rooted the problems in Greece are, and just how hard it is going to be to get those attitudes to change. With the focus centered around the default of Greece and whether there will be private sector involvement or ECB involvement and how much the haircut is going to be and whether the ISDA is going to call it a credit event or not, it seems like we’ve kind of gotten side-blinders on and are thinking that once Europe gets through the default its all good.

Of course its not.  As the podcast pointed out, the basic premise of the EU strategy is that in the future when a country starts misbehaving, so when Greece starts running a big government deficit again or some other misdeed occurs, technocrats will swarm the country and force measures of austerity before it gets out of hand.  Greece and the rest of the EU are essentially to give up their economic sovereignty.

Well, Georgiou is a bit of a canary to that coal mine, and he is facing jail time for his attempt.

It’s the Economy Dummkopf

This is all just another way of stating the basic argument that Michael Lewis made in his Germany piece in Vanity Fair.  This article was a bit of an eye-opener to me; it was the point where I saw for the first time just how intractable the problems in Europe are.  In the article Michael Lewis pointed out the dilemna that the periphery faces:

The Greeks (and probably, eventually, every non-German) must introduce “structural reform,” a euphemism for magically and radically transforming themselves into a people as efficient and productive as the Germans. The first solution is pleasant for Greeks but painful for Germans. The second solution is pleasant for Germans but painful, even suicidal, for Greeks.

For the solution to work (and by solution I do not mean the short term papering over that we are accomplishing with the LTRO, the next bailout tranche or the cohersion of the private sector to accept a 70% cut), the Greeks have to become Germans.

And that is just not going to happen.

As I pointed out in my now clearly ill-timed post about the ineffectiveness of the LTRO, eventually the interpretation of Europe is going to come back to the economy.  When it does, and when the somber assessment that the Greeks are still not German sets in, well then the fact that we’ve shaved some debt off the top is going to matter a bit less.

These guys are done.  And not just Greece.  The whole EU.  Its like a walking dead, being propped up by the printed money of the LTRO.

But that’s fine.  I am in no rush to have the market turn over.  I’m in stocks that I think for the most part will outperform the market significantly in an upcycle.  I just have to not forget that the key to investing, at least right now in these debt-ridden times, is to accept the necessary short-termism, but always with a wary eye on the inevitable long term.

How much can Newcastle Investments make from its MSR deals?

When I started to write this post a couple of days ago, Newcastle had a single $44M investment in mortgage servicing rights.  On Tuesday the company announced a second MSR deal worth significantly more ($170M).  Rather than have to re-write my post from scratch, I am instead going to focus here on the original $44M MSR deal.  I will look at the larger, subsequent deal in another post.

Newcastle and MSR’s

I got interested in MSR’s after having become a regular listener to the Lykken on Lending mortgage lending broadcast.  I have listened to a number of episodes where the mortgage professionals on the program describe the disconnect in the mortgage servicing world right now and the opportunity it has created with mortgage servicing rights.  I invested in both PHH and Newcastle with the hope that that I can capitalize from this disconnect.

I have already written extensively about what a Mortgage Servicing Right is in this previous post.

The first MSR deal

In both their first and second forays into the mortgage servicing rights, Newcastle made a deal with Nationstar. Nationstar is a mortgage servicing company.  The specifics of the deal, as put forth by Newcastle in a recent presentation, are as follows:

  • The deal is for the mortgage servicing right of a pool of mortgages with a $9.9B unpaid balance
  • Nationstar will be the servicer of the loan portfolio and will invest alongside Newcastle, purchasing a 35% interest in the Excess MSR
  • Newcastle will not have any servicing duties, advance obligations or liabilities associated with the portfolio
  • Newcastle received a private letter ruling from the IRS that allows for treatment of an Excess MSR as a good REIT
  • Asset and the income that Newcastle generates from the deal will qualify as REIT income and not be subject to double taxation

The mortgage servicing right for the package of mortgages is, on average, 35 basis points per year of the unpaid balance.  Of that 35 basis points, 6 basis points will go directly to Nationstar to cover the cost of the servicing.  The other 29 basis points will be split between Newcastle and Nationstar 65/35.

It’s a good deal for both companies.  Nationstar participates in a much larger mortgage servicing package than they would have been able to purchase with their own cash.  They also participate in some of the upside of the MSR.  Newcastle gets a high return investment that does not require them to develop any mortgage servicing abilities in house.

The Upside

Newcastle says that they are expecting a baseline return from the investment of 20.9%.  That’s a great number, but what I equally interested in is whether there is upside to that number.

In particular, Newcastle is assuming the following:

  • 30% recapture rate.  This means that Newcastle thinks that Nationstar can recapture 30% of the mortgages that go up for refinancing.  If a mortgage goes up for refinancing and is captured by Nationstar, it remains in the pool.  As Newcastle has suggested rather optimistically on their conference calls a couple of times, if you could recapture 100% of the mortgages that go to refinancing, you would have a perpetual money making machine
  • 20% CPR.  CPR stands for Constant Prepayment Rate.  This term defines the number of mortgages that go up for prepayment short of their term.  There are two reasons a mortgage will be prepayed early.  Either the owner refinances or the owner defaults on the loan

Its worth pointing out that so far the 1 month CPR on the pool of mortgages Newcastle has purchased is 9.7%. The 3 month CPR is 7.3%.  However, you have to expect that the CPR is going to increase rather substantially over the next couple of years.  Why?  Because of the government’s HARP II program, which allows homeowners with upside down mortgages to refinance those mortgages.  Presumably this program is going to garner a lot of interest from folks with high loan to value amounts and you are going to see a refinancing spike.

Newcastle has actually modeled the effect of HARP II assuming a spike in prepayments to 30% for the duration of the program (until December 2013). That 20% number that I mentioned is actually a weighted average over the life of the MSR’s.  Newcastle provided the following chart to show how they are accounting for the spike in refinancings expected due to HARP II.

Newcastle also provided the following HARP II assumptions in the appendix:

Modeling the Baseline

I always find it useful to create my own models, so that I can understand the dynamics at play and see what the cash flow really is.  I started off by trying to match to the baseline assumptions  put together by Newcastle.  That scenario and the assumptions provided by Newcastle in the footnote are below:

My model came up with the following:

 Model Validation

How close is my model to the model that Newcastle is using?  The primary differences between my model and the one Newcastle is using are that my model is done yearly (versus a monthly model completed by Newcastle) and I did not try to break out the increase in CPR due to HARP II, instead just using the weighted average 20% throughout the entire period modeled.

I made a comparison of the cash flow estimated by my model for each of the scenarios that Newcastle illustrated on Slide 8 of their presentation.  My results along with the original Newcastle estimates are shown in the table below.  All amounts are in millions.

Close enough.

What does the model tell us?

The first point illustrated by the model is how much the cash flow changes from year to year.  This is not a fixed return investment.  The cash flow from an MSR is heavily weighted to the front end.  The Year 1 and Year 2 cash flow decrease substantially as you move forward.  While its always good to get paid out quickly, it also means that we have to be careful with respect to what we define as a sustainable dividend based on that cash flow.   I’m not entirely sure whether a REIT like Newcastle has any say in the matter (they may just have to distribute 90% of their cash flow irrespective of how that cash flow stream may decline in the future, I’m not sure, I haven’t done the work to understand the rules of the REIT structure in the US carefully).  But if Newcastle pays out the full $14M+ in the first year, the cash flow stream is going to decline substantially in subsequent years and Newcastle is going to have to find equivalent return investments to sustain that cash flow.

Investments that return 30%+ of capital in the first year don’t exactly grow on trees.

The second point is simply that the dividend hike should be significant.  At even $12M, that is a hike of 12 cents per share, or 20% higher than the current 60 cent dividend.

A closer look at the upside

There are two potential sources of upside on the MSR’s.

  1. If there are fewer homeowners that refinance than the baseline scenario estimates than the cash flow stream goes up
  2. If more of the refinancing homeowners are retained than the baseline scenario estimates than the cash flow stream goes up

Newcastle already looked at the sensitivity to cash flow in their presentation, but they only showed a cumulative cash flow comparison.  I am interested in seeing what the cash flow is in those first couple of years, because that is what is going to influence the dividend in the short term.

Let’s look at the first case.

To pick a rather significant deviation from the base case I am going to assume that the total CPR, so the total number of mortgages in the mortgage pool that refinance, comes in at 8% rather than the 20% weighted average assumed by Newcastle.

If this occurs I get the following cash flow profile.

Note that the ROR increases to about 40%.

What is interesting is that the scenario shows how, as one might expect, the cash flow in later periods is effected much more than the cash flow in the earlier periods.   This makes sense as I am really just adjusting how many of the original borrowers are lost in subsequent years.

So the conclusion that can be drawn is that changes in the CPR affect the later years cash flow, but they do not influence the current year’s cash flow significantly.  While my analysis was done at lower CPR’s, the same can be said if you looked at a much higher CPR.  Assuming that Newcastle is strictly bound to pay out a dividend on this years cash flow, that  dividend would be similar under a wide range of CPR scenarios.  Of course the sustainability of that dividend could fairly widely depending on the actual CPR that occurs.

In the second scenario I am going to assume that the recapture rate ends up being significantly higher than the 35% estimate that Newcastle assumes.  I’m going to assume 55%.

How valid is this? Funny you should ask.  As chance would have it Nationstar is doing an IPO at the moment.  As part of the IPO prospectus the company had the following to say about its recapture rate:

 A key determinant of the profitability of our primary servicing portfolio is the longevity of the servicing cash flows before a loan is repaid or liquidates. Our originations efforts are primarily focused on “re-origination,” which involves actively working with existing borrowers to refinance their mortgage loans. By re-originating loans for existing borrowers, we retain the servicing rights, thereby extending the longevity of the servicing cash flows, which we refer to as “recapture.” We recaptured 35.4% of the loans we service that were refinanced or repaid by the borrower during 2011 and our goal for 2012 is to achieve a recapture rate of over 55%. Because the refinanced loans typically have lower interest rates or lower monthly payments, and, in general, subsequently refinance more slowly and default less frequently, these refinancings also typically improve the overall quality of our primary servicing portfolio.

So its a valid target.  Here are the numbers at 55%:

The cash flow really isn’t that sensitive  to changes in the recapture rate.  The change in cumulative cash flow is about $10M over the 24 year period.  The change in IRR is between 2% and 3%.

What are the assets?

The last thing I looked at were the assets involved in the transaction. Newcastle provided, as a supplement to their mortgage servicing presentation, a summary of the assets that were acquired in the original Newstar deal.

The loan package has a decent but not great average FICO score of 687.  Typically, subprime has been considered to be below 640, whereas FICO scores above 700 are considered to be excellent lending opportunities.  This loan package is somewhere in the middle.

I was a little surprised that full documentation loans only accounted for 52% of the loans in the package.  I also am not sure what to make of the “% Delinquent 30 days but making some payment”.  46% seems to be an awfully big number, but maybe that is not uncommon? On the other hand, the one and three month CPR seems to be quite good, and the high loan to value, meaning that the loans are basically the same value as the house right now, will make it more difficult to refinance in the future.

The bottomline  is that I need to investigate the asset quality further, and to some extent, just watch closely how it plays out.  I’m still learning this whole mortgage business, and so I have more questions than answers right now.  I’ve raised a few questions here, and I will report back when I have some answers.


The bottomline is that Newcastle is getting a high return investment (IRR of 20% on the base case) that is going to pay out the majority of the cash in the first few years.  The investment also has some upside if the refinancing surge predicted to coincide with the HARP II program falls flat.   There is also upside if interest rates rise, making refinancing less attractive to borrowers.

The investment should allow Newcastle to make a substantial dividend increase (one that should increase even more with the announced second MSR deal that has been made).  In the recent past it appears that the stock price of the company has followed the dividend reasonably closely; when the hike to 60 cents was made the stock moved quickly into the $5-$6 range.  A hike to 72 cents is likely based on the first MSR deal alone.  I haven’t worked through the numbers on the second MSR deal but I imagine a substantial hike higher is in the cards.

In my opinion the company has proven themselves extremely shrewd by getting into the MSR business when they did.  I have pointed out in the past that much of the buzz in the mortgage brokerage business right now is around how MSR’s are trading ridiculously cheap and how can one get into the business.  Lykken on Lending, a radio broadcast I have mentioned in the past, has done 4 programs in a row dedicated to understanding the MSR industry.  Every one of those broadcasts (the last of which was so good that I plan to do a short synopsis of tomorrow) reiterated the point that the opportunity in MSR’s right now is unprecendented.  The quality of the loans has never been better, the refinancing surge over the past couple of years makes it likely that those loans will stay on the books for longer, and the prices for MSR’s are trading at extremely low multiples, a disconnect that has been caused by so many of the big banks getting out of the busines (Bank of America, which was previously the largest mortgage servicer, being the most commonly sited example).

Newcastle may not be a 10 bagger, but with a 10% payout right now and a high payout coming, I think it will prove to be a very profitable investment for me.

Buying when you don’t want to

The hardest posts for me to write are the one’s where I have to write that I bought a bunch of stocks on a day where the market was down a lot.  Its tough because I am worried I will be proven wrong.  Its extra tough because I am notoriously early and so I have been wrong many times before.

The market really tanked today and nothing tanked harder than the junior gold and oil stocks.  I had lightened up significantly on the gold stocks last week; I exited Canaco Resource, OceanaGold and a significant portion of Aurizon Mine. Unfortunately I used some of the proceeds to buy Pan Orient Energy, which took it on the chin today.

Nevertheless there is some truth to the old adage that the best time to buy stocks is often when you don’t want to.  Today I didn’t want to buy anything.  I even had half a mind to sell it all and stand away.

But having thought it through, I am having trouble making sense of the idea that this is the start of something big.  I have become a convert to the idea that the LTRO has taken out much of the systemic risk potential. The prices of periphery bonds suggest as much; even after today’s shellacking Italian and Spanish bonds sit near their lows.  The TED spread and Swap spread hardly moved at all and currently sits at 40 and 27 respectively, well of their highs of 60 and 55.  The bank stocks, while hit hard, did not lead the way down in the way they did in August.

It just doesn’t feel to me like it did in August, or in November for that matter, when the fear was palpable.  Yes, we are worried about Greece and what is going to happen.  But the evidence does not suggest that the big players are that worried.  If they were we would see more signals of the stress in the bond market.

Which makes sense.  By this point everyone knows about Greece.  Everyone who had money at risk with Greece should have been able to figure out how to take it off the table.  That yields aren’t rising in the periphery suggests that the real problem, that a Greece default would cause a domino effect, is not in the cards.

What I bought

I’ve had good luck buying Aurizon under $5 in the past and so I did so again today, restoring my full position in the stock.  I also bought more Golden Minerals.  Golden Minerals is a stock I had been tempted to sell when it got to $10, but I got a little greedy and decided against it, only to watch the stock fall back to $6.80 today, which is not too far away from my original purchase price.  The stock is reasonable at these levels; the company has $2 cash on hand per share and a 6Moz gold equivalent resource.

Interestingly, Rick Rule was on BNN yesterday and he had some positive comments on Golden Minerals in this clip (I’m not really sure how to embed video from BNN).

Since last Wednesday its been a swift fall for many gold stocks.  My bet here is that the latecomers have been fleshed out and that with stocks like Aurizon and Golden Minerals approaching their 52 week lows once again, we are close if not at the bottom.

I also added to Pan Orient.  This will be the last time that I add until I see the stock begin to rise again.  For the time being I will sit tight with what I own.