Another commentary http://www.cross-currents.net/commentary.htm
December 24, 2005
"Another Look At NovaStar"
Well over a year ago, we commenced a series on NovaStar Financial (NYSE-NFI), focusing on naked short selling and the apparent efforts of shorts to destroy the company. After months of subsequently covering the circumstances surrounding the tremendous number of shares that had failed-to-deliver per SEC regulations for NFI and other companies, naked shorting, a complete lack of transparency by self regulatory organizations (SROs), the activities of concerted short pools and journalist biases, we think another look at NFI is quite appropriate.
Short positions in NovaStar Financial (NYSE-NFI) began to build in July 2002, as short interest rose from 0.1% to 3.5% of all issued shares. By October, short interest had exploded to 15% of the company's capitalization and by June of 2003, shares short equaled 26.1% of NovaStar's issued stock. In November 2004, short interest rose to an astounding peak, 45.1% of all authorized and outstanding shares. But as the company declared and paid dividends, those that were short the shares had to pay the dividend to "owners" on the other side of the short sale transaction. Dividends paid in this manner did not necessarily go to the exact same party that actually purchased the shorted shares. In practice, short accounts were debited by their brokers for the amount of the dividend, which was then doled out to longs whose shares had been borrowed for the purpose of shorting. Since those dividends did not actually come from Novastar, they were marked as "PIL," short for "payment in lieu [of the dividend]."
Since July 2002, NovaStar shorts have paid out the amazing total of over $124 million in PIL to those they borrowed the stock from. Exactly three years ago, almost one of every five shares of NFI was shorted. Let's assume a worst scenario for long term bears who received average proceeds of $8 for their short sale. Since that time, they have paid out nearly $18 in PIL for the privilege of remaining short. Thus, they are now in the hole to the tune of at least $9 per shorted share, even if the shares were to go to zero tomorrow. In fact, virtually every share shorted before mid-April 2003 can never hit the profit column. Obviously, shorter term bears have fared relatively better and some are in the profit column after paying dividends of $6.85 over the last year or perhaps are only breakeven after paying out $12.20 over the past two years.
Incredibly, it appears that only those institutions and individuals long the shares really understand NFI's business and those short have perilously underestimated exactly how the company functions. For our part, we're guessing that even if loan production drops to zero tomorrow, there should be sufficient income built in from their current portfolio for NovaStar to pay out another $18 to shareholders over the next two years. After that, the guesses become a lot more muddled but a smaller continuing stream of income seems likely. So, why would anyone remain short? Our best answer: strength in numbers.
At present, 31.1% of NovaStar's shares are short. The authorized capitalization of 30.873 million shares is burdened by an additional 9.614 million shares that have been shorted but in reality, are nevertheless "owned" by those on the other side of the short transaction. Thus, if those long Novastar precisely counted their verifiable ownership, it would total 40.487 million shares. As we stated previously, there cannot be a scintilla of doubt that a smaller piece of any pie must be worth less than a larger piece. In this case, a shareholder vote for any proposition would require that the "owners" of borrowed shares receive a vote equal to at most, 76.25% of a full share. Something is horribly remiss with this situation!
NFI's authorized and outstanding capitalization is corrupted by the presence of additional ownership catalyzed by the absolutely enormous short positions in this company. Bear in mind that at least 150,000 shares have not even been delivered to the accounts of their new owners. NFI has appeared on the Reg. SHO Threshold list for 108 trading days this year. The list details securities where failed deliveries of shorts are at least 0.5% of the outstanding stock. The total of undelivered shares could be well into the millions but no one is talking, not the NYSE, not the DTCC, not the NSCC, nor the SEC. None of the entities responsible for running our markets want you to know the truth. Why?!
Oh, and by the way, shorts will have to fork over yet another $13.5 million in PIL in January. Ironically and amazingly, the hole in short's pockets remains the impetus to short even more shares. At this juncture, the only way for shorts to recoup their PIL and to escape unscathed is to attempt to engineer a continuing price decline, if at all possible - and zero is their goal, no matter the cost to shareholders. If another 5 million shares can be shorted, the effective capitalization of Novastar will reach 45 million shares, 50% more than issued. A smaller piece of the pie must be worth less. Make no mistake, this is a battle between the good guys and the bad guys. But could shorts be committing suicide?
NovaStar ended the third quarter with $6.40 per share of undistributed 2005 taxable income. The company will likely need to pay a special dividend of about $3 per share by September 2006 in order to meet its 2005 payout obligation. And because the first three quarterly dividends in 2006 will be paid from 2005 taxable income, we would expect there to be a very substantial accumulation of undistributed 2006 taxable income by that time. In other words, the odds look good for a sustainable dividend. We believe the good guys are going to win.
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