NCT risk/reward is balanced -- don't fall quickly for the multiples-rerating thesis

 Bottom-line, with rates rising, I have a little bit of trouble getting above $7.00 / share in the bull case, and see ~$6.00 / share as my base case. Downside is $4.00 - $4.50.

Background and public thesis

Heavily tied to FIG, Newcastle Investment Corp (NCT) is a fairly straight-forward story: Prior to mid-2012, it was predominantly a vehicle that originates CDOs and invests in different flavors of fixed-income securities ranging from MSRs, MBS, to loans and other non-recourse/recourse debt. The firm took a remarkable strategic shift in 2013: it decided to spin off the MSR arm into a public company named New Residential (NRZ), kept the 5 CDOs and the bulk of debt securities, and actively collapse (i.e. selling the assets, pay off tranches of liabilities, and keep the rest) + rotate the principal equity into senior living facilities. NCT believes that there is a major opportunity in the area as 70% of the industry is controlled by "mom-and-pop" operators. FIG owns a senior housing operator, Holiday Retirement, and the partnership + operation should be (and is) robust. As NCT shifts from ~5-10% equity in senior living to 70-80% targeted, the management telegraphs a path towards material multiples expansion from mREITs 9-13% dividend yield to HCREITs 5-6% dividend yield, propelling 50-100% upside while distributing 8-9% dividend yield on the side. After closing a few secondary offerings and senior facility transactions, NCT is set to spin off a publisher company New Media (NEWM) in 1Q14 (one which it owns 84.6% via bond purchase and subsequently prepackaged bankruptcy) and is set to have ~50% of its equity invested in healthcare by that time.

Meanwhile, despite the compelling thesis, the stock has not performed as suggested. It was range-bound between $5-6 / share since the NRZ spin-off while S&P rallied ~10%. Granted, the mREIT & HCREIT sector sold off ~20%+ in the meantime and NCT out-performed relatively. As I shall show below, investors expecting 50%+ 12 month payoffs may be disappointed and the risk/reward may not be particularly attractive to many. Apart from $0.40 / share of dividends (+7.5%) by YE14, my bull-case is ~25% upside to $7.00 / share and my bear case is ~20% downside to $4.50 / share. My base case is $6.00 / share.

I value NCT on a SOTP basis due to disparate nature of the businesses (debt portfolio, senior facilities, media asset), with key drivers as following:

-       How would the market comp the debt book and senior facilities on a dividend yield basis?

-       How quickly will management rotate equity into senior living assets?

-       What is the media asset NEWM worth on an absolute basis?

The crux of the bull thesis to NCT is the multiples rerating from 8-10 % dividend yield to 5-6%. I believe that the multiples rerating is already underway as NCT held its ground for the past few months while other mREITs and HCREITs trade down. What’s more, this rerating effect may not be as powerful as many would hope given the rising rates environment.

As you may observe above, the median LTM dividend yield for the 6 largest comparable HCREITs in a HIGHER interest rate environment (2003-2006) is around 6.5 to 8%. Furthermore, as you may observe below, the positive relationship between 10-year Treasury rates and HCREIT yield is also evident. With tapering underway, a 4% Treasury yield is a very likely reality in 2014, and with that, HCREIT will be pegged at ~7% dividend yield. In other words, the multiples expansion case for NCT has its fuel rapidly leaking out of the gas tank. Accordingly, the dividend yield picture for mREITs may be even worse. I believe it would be too optimistic to assign anything beyond 6% dividend yield for NCT’s healthcare portions and 10% for the debt portion. Additionally, the rising interest rate will place noticeably burden on NCT’s debt servicing for healthcare facilities, currently financed at ~4.5% rate and levered ~2.5-3x debt / equity.

However, a CDO collapse, a sizable equity raise (20 mm + shares at 1.6x+ book value), and the closing of 70+ senior living facilities can bring the NCT’s invested equity portion in healthcare comfortably to target in 2014 and drive good appreciation in my model. Additionally, it is notable that NCT and FIG’s managements are highly competent and has a vested interest in the company given the management fee, subscription to previous 2^nd offerings, and sizable open-market purchases. Management has also proven its ability to improve profitability of the acquired facilities within the last 3 quarters and no evidence suggest that they cannot continue doing so. With consecutive growth in occupancy towards the 87% range, revenue / bed and operating expense stabilizing, the FFO should be pushing towards the 40 mm / quarter range by mid 2014 (or $ 0.11 / share for potential dividends).

Thought the pre-packaged bankruptcy of gatehouse, NCT was able to amass a 84.6% stake in the new company, soon to be emerged as New Media Investment Corp (NEWM) and be spun-out to NCT shareholders by 1Q14 (Source: http://www.sec.gov/Archives/edgar/data/1579684/000119312513467019/0001193125-13-467019-index.htm). Traditional publishing assets (MNI, AHC, LEE, DJCO, NYT) trade at ~5-7x EV/EBITDA. New Media does not exhibit any qualities superior or inferior to them on a margin or growth basis, hence I expect the similar range applies here as well and yields $0.35 - $0.7 / NCT share. A DCF with conservative assumption gets us to the similar ball-park of $0.35 – 0.60 ($140 – 240 mm). There can potentially be another 30-50 cents of upside if new management stabilize revenue + margins and successfully grow into the advertising business, but that part remains to be seen as most of its peers struggle to do so.

Ultimately, investors should give NCT management the benefit of the doubt as the team navigated through the turbulent waters of 07-08, effectively executed the shift of equity base as we see today, and Fortress is known to be a good partner during good times. I do believe that NCT can put forth satisfactory ~20-30% gains consistently, but expectation towards a rapid capital appreciation should be tampered given the rising rates, associated multiples compression, and execution risk alongside time horizon stretch.