DFR

The stock had a great day wednesday despite the tough market. Not hard to understand why -- lots of financials rallied and given that the insiders (including management and the Dart family) own about 28% of the stock and about 20% is sold short (roughly because I'm not sure if my total share count is right given the merger), the stock can fly at any moment.

So after hours the company issues news and overall its fine but there are some issues. First some writeoffs but really these are just recognizing in the income statement what has mostly been reflected on the balance sheet already -- accounting crap but not a big deal. They sold the pinetree CDO, which is the one with their subprime exposure. Since they had completely written off their exposure to the CDO the sale has no impact -- except they may have been receiving management fees and if they sold that too that's a hit to income.

They sold $1.5 bill in RMBS to improve liquidity. hmmm.... Well let's give them the benefit of the doubt and assume they proactively sold them to boost liquidity (as in better safe than sorry) as opposed to the uglier version, which is that the dealers they are getting their repos from changed the terms and made the deal uneconomical. Near term more liquidity is a good thing, but it does hurt the amount of income the portfolio can generate. On the other hand they are constantly reinvesting cash flows (regular monthly payments of P and I plus pre-payments) and over the last few months the spread between what they pay and what they earn has widened -- i.e. more income per dollar of assets.

I'm hoping these two issues offset eachother to some extent -- I'm also assuming they will reinvest the equity from that RMBS sale at reasonable rates of return sometime soon. Leverage is great isn't it? helps on the upside but makes life a little tricky on the downside.

So dilution from the deal, less leverage, sold the pinetree, etc. -- raises the question of what the dividend will be for the next year. They will likely pay out a higher amount than they earn because they didn't pay everything they earned last year. so let's assume they pay out around $1.60 but only earn $1.40. Even on the earned amount that is still almost a 20% yield. With that high a yield plus a 30-40% discount to book value plus the potential to grow the dividend over time (alternative assets, higher money management fees, etc)? that's a great deal in my book.

Some probably wonder why the stock is so cheap -- simple -- too many investors doubt their ability to survive. To them the dividend yield is meaningless. How could that happen? Well for the month of August and September the concern was liquidity but since then everyone has learned the real issue: solvency. Who will remain solvent. Obviously Countrywide wasn't going to remain solvent for long -- that's why they sold out to B of A.

Deerfield uses a lot of leverage, which minimizes the amount of price declines the assets have to suffer before the collateral (equity) is used up. The part I am not sure about is all the different pieces of DFR -- I would think even in a worst case scenario some parts might come into trouble but other parts would survive or be able to bail out the rest. The management company to me is the main savior -- other than the sellers note there is no debt. I would argue that the management company accounts for a significant part of the value of the total company right now.

The key assumption is the accuracy of the asset values used to calculate the book value estimate of 11-12 dollars. how solid are those numbers? right now in fixed income, not much outside of US treasuries are truly solid. One other point DFR made was to say that starting Jan 1 2008 they will be doing fair market value pricing as part of their accounting -- not sure what that means but hopefully they have been doing something close to that already. I have a lot of faith in the deerfield people -- they have an amazing ability to analyze credit risks based on their results during the last credit cycle bust in the 2000-2002 time period. They have a good structure and a great plan. I believe they will get through these issues and thrive in the future.

Oh, if mortgages fall enough in price to endanger DFR, perhaps we should all be shorting all the banks and maybe FNM and FRE too.