Rithm Capital Corp (RITM)

[ThSeeker]

Down today, commentary on why:
https://seekingalpha.com/article/4075222-new-residential-investment-corp-deserve-premium

New Residential Investment Corp. Doesn't Deserve Premium
May 22, 2017 9:59 AM ET|

Summary

The stock is currently trading at a 15% premium to its book value.

Yield on the other hand is very attractive at 12%, plus the dividend coverage seems high.

The stock does not deserve premium to book value as the safety of the dividend is exaggerated.

Adjusted Core EPS is just 1 penny higher than the dividend after we take incentive compensation into account.

Macro environment is more unfavorable than favorable.

New Residential Investment Corp. (NYSE:NRZ) currently trades at a sizable premium to its book value. Based on Friday's close of $16.06, the stock's market cap of $4.94 billion is 15% higher than Q1's book value of $4.3 billion, implying that the stock is expensive. On the flipside, the stock is trading at a very attractive yield of 12%, which implies that it's cheap. Which metric tells the right story? After taking a closer look, I believe that the stock does not warrant a premium to book value due to inflated yields and a macro environment that is skewed to the downside.

Earnings inflated

Due to the complexity of the business, investors often look to core earnings as an indicator of a sustainable dividend. By that measure, the yield looks fine as the dividend coverage seems to be ample. The company reported core EPS of $0.54 in Q1, handily outpacing the dividend of $0.48. However, the core EPS does not include incentive compensation to the company's manager, and I think we can agree that incentive compensation is a very real expense. Such compensation amounted to $12.5 million in Q1, or 8% of core earnings ($155 million). If we readjust the core EPS by taking this 8% inflation into account, we get a core EPS of $0.49, which is barely above the dividend of $0.48. So dividend coverage isn't as high as you think.

To make things worse, the company's MSR portfolio is subjected to consistent run-offs. Certainly MSRs have appreciated in value after the election as prepayments fell, but there will still be prepayments in the future. Management's estimate as of Q1 was 9.7%. Since MSRs account for 65% of the company's interest income, there will be a natural decline of income.

Macro Environment Mixed

On the one hand we have impending rate hikes, on the other hand we have potentially higher mortgage rates. While anything could happen, the big jump in mortgage rates has occurred already (i.e. immediately after election), so I don't expect any big upward movements in the future; but we do know that there will be more hikes coming, especially when the market is still hovering around all-time highs. In other words, the company will be more likely to experience earnings compression (higher rates on its $6.3 billion repo agreements) than to experience earnings expansion on its investment portfolio.

Conclusion

Even though New Residential has a very attractive yield and a seemingly good dividend coverage ratio, it does not deserve a high premium to its book value. Core earnings do not include incentive payments which are real expenses; and after we adjust for such payments, the company is just making enough to pay the dividend. Furthermore, unpaid balance on its MSR portfolio is constantly decreasing, so income will naturally decline. Finally, the current macro environment is also more unfavorable than favorable. The bulk of the benefit from lower prepayments have occurred already, but short-term rates have yet to reach their full potential. For the above reasons, I would sit on the sidelines for now.