Deerfield: A Difficult Rebalancing Trade
The following things that I write are more risky than normal, and may be wrong. If you decide to imitate what I have done, you are doing so at your own risk. Please do your own due diligence.
I have bought more Deerfield Triarc [DFR] today @ $9.76. A sharp-eyed reader noted (see the first comment) that DFR must have been past my rebalance point, and wondered why I hadn’t bought more. Truth is, I had been working on the issue for two weeks. Whenever a security falls dramatically (it was close to a second rebalancing sell for me at one point), I do a review. I don’t automatically do rebalancing buys when a company is under stress.
Okay, what gave me confidence to buy? DFR is levered; the main risk here is that they cannot continue to finance the positions that they hold. Point one that gives me comfort is that the financing is likely secure.
Most of it is repo funding on prime mortgage collateral, most of which is floating rate. Though there is a high degree of leverage there, the hedging inherent in managing such funding is a common skill. You could contrast Deerfield and Annaly. The collateral and leverage are similar; the main difference is that Deerfield uses swaps and floors to manage interest rate risk, and Annaly uses longer repo terms (1-3 years) than Deerfield (0-3 months).
The trust preferreds are not putable, and they lever up their alternative assets through CDO structures, which are not callable. The risk there is that the equity and subordinate bonds that they hold could be worthless. Unlikely, but a possible loss somewhere north of $50 million. They also have warehouse lines, where assets are held prior to securitization. I don’t know what might be in their warehouse lines now, but they did recently complete a securitization which freed up $230 million of those lines. (Note: they couldn’t sell the BBB securities.) The lines are capable of financing $375 million, and extend to April of 2008 at minimum.
Point two is that very little of the assets inside DFR’s CDOs are subprime. The total risk to DFR is from the Pinetree CDO, which if they end up writing off the CDO equity, will reduce net worth by $12 million. Not huge.
Point three is that they might not be able to consummate the merger with Deerfield Capital Management [DCM], since DFR has to pony up $145 million. I find it unlikely that they could not get the financing for what is a profitable asset where Debt/Operating Income is around 6. But even if they can’t do the deal, that does not affect DFR, except that they don’t get to purchase an asset manager at a bargain price, which is even more of bargain now, given that the stock price has fallen, and the deal terms (half stock, half cash) don’t adjust.
Point four is might the deal terms adjust? Couldn’t DCM allege a material adverse change, and try to get the terms changed? It’s a little late for that. The DFR shareholders meeting is one week from today. Besides, many of the same problems facing DFR are facing DCM.
Point five is that much of what DCM manages are ABS CDOs. Much of the ABS collateral is subprime residential mortgages. (For more details, here is an S&P report from last year.) Now, aside from about $20 million of investments in the CDOs that they manage, they don’t have any more risk exposure. There is the outside possibility that they could be removed as manager on some of the deals that they manage, but that doesn’t happen often. The current market environment could have a negative impact on their ability to issue more ABS CDOs and other CDOs, but once things clear up, those that are still in the game of issuing CDOs will make much better interest spreads than they made in the last two years.
In summary, why did I buy more?
- The losses look limited, if they occur at all
- The financing seems secure
- Exposure to subprime losses are small, and
- I think the deal goes through.
Could I be wrong on some of these points and lose badly? Yes.
Full disclosure: Long DFR
August 2nd, 200710:28 pm at
HI david: this is a very useful analysis to read. Thanks
August 3rd, 20071:33 am at
Yes, I agree with Paul that was very helpful — thanks David for taking the time to provide a thorough presentation of your analysis and thinking regarding DFR.
As I read through the 10K I was struck by how little they talked about liquidity issues — other than in the risks section. An entire risk management section that mentions leverage once and liquidity zero is somewhat disconcerting in this environment. Somewhere they mention this is DCMs first REIT — made me wonder if this was their first experience with leverage? Its one thing to study other people’s leverage (i.e. be a credit analyst) but its something else entirely to be leveraged yourself.
Some interesting commentary on the origins of the deal in the proxy statement too — DCM starts thinking about selling themselves so DFR starts thinking about switching managers. Next thing you know they are talking to eachother about a deal. Hmmmm….
Thanks again for sharing your perspective. And good luck on your future plans — a big scary step to leave a firm but it sounded to me like you have been ready to go for some time. Nothing wrong with that — very common that people’s interests diverge over time.
Kyle
August 7th, 200711:13 am at
something you don’t address is that the bid for prime mortgage colalteral is fading. so even the the repo collateral relationship seems safe (as the collateral is floating). I think the lessons learned from CFC and AHM is that subprime is not the issues. I was wondering if a liquidity squeeze was part of your consideration.
Thx for the good blog.
August 8th, 20074:09 pm at
I found it very discomforting for the DCM deal to go forward, with $145M cash and 9.6M shares of DFR. Both of these firms have a really closed relationship with each other, which raises the conflict-of-interest flag. John Trutter is both the CEO of DFR and he appeared also as Chief Investment Offer at DCM.
You mentioned in your blog that the debt/oper.inc. is 6 for DCM. Can you tell where you have that info ? Which metrics do you use to evaluate an asset manager is a bargain or not ?
Thank you,
PTran
Point three is that they might not be able to consummate the merger with Deerfield Capital Management [DCM], since DFR has to pony up $145 million. I find it unlikely that they could not get the financing for what is a profitable asset where Debt/Operating Income is around 6. But even if they can’t do the deal, that does not affect DFR, except that they don’t get to purchase an asset manager at a bargain price, which is even more of bargain now, given that the stock price has fallen, and the deal terms (half stock, half cash) don’t adjust.
Point four is might the deal terms adjust? Couldn’t DCM allege a material adverse change, and try to get the terms changed? It’s a little late for that. The DFR shareholders meeting is one week from today. Besides, many of the same problems facing DFR are facing DCM