Opinion on  NovaStar Financial Inc. (NOVS)
Of NFI, Private Equity and Recessions

NovaStar Noise: With Novastar (nfi) now 28% (as i write this) to $5.16, you could argue that it is officially a penny stock -- at least it is if the stock stays where it is if and when the company pays its dividend for last year. Stocks fall by the amount of their dividends; a $5 dividend, which is about what the company would now pay based on numbers it has presented, would result in a stock that trades for pennies. Speaking of NovaStar: I'm getting multiple comments on these boards wondering why I only focused on NovaStar, and not New Century. The bigger question should be why I only foucsed on Novastar and not New Century (new), IndyMac (nde), Fremont General (fmt) and a few others. The reason is because at the time NovaStar appeared to have its own set of circumstances that were worthy of reporting, with subprime as the connecting overlay with the rest. I cover specific company's and their issues, not industries. One mortgage company is enough!

Private Equity enquiry: Will be interesting to see how any spread of the subprime malady to prime impacts the ability for some of these private equity deals to get done. Sure they have plenty of cash, but the mantra is to boost the leverage, which requires borrowing from others. Not good if we were to enter a credit crunch, or if credit sources merely become more hesitant.

Recession reality: As always, Irwin Kellner puts things in perspective, this time with his latest missive on the economy. "One thing seems certain," he writes, "The next recession will arrive when it's least expected. Always has, always will."

With NovaStar (nfi), you could say the shorts appear to be right for the wrong reason. Subprime-related issues were always only part of the story, not the whole story or even  the major part of the story. Instead, this was a company  popular with shorts largely because of earnings quality and accounting issues. There have also been simmering IRS issues. And while New Century (new) has garnered attention among subprimers for receiving a knock-at-the-door from the SEC, NovaStar was leading the pack with an "informal inquiry" from the SEC as far back as 2004. The company has disclosed that inquiry in every quarterly and annual filing since; it disappeared in its recently filed 10-K. Company declined comment, citing its past relationship with me. "The 10-K speaks for itself," a spokesman said. A bigger issue, of course, is whether it will have the cash to pay the $5.60 dividend for last year and the $4 expected this year. If it does, the bigger question -- if its stock stays at these levels, and as I've mentioned here previously -- is what happens post payout, since  the stock  falls by the price of the payout.  At last check, NovaStar was trading at $3.55.

Catching up -- odds and ends from my email and elsewhere I meant to post but didn't:

Regarding the growing concern over CDOs and other forms of structured finance: "If the true market prices for these esoteric pieces of paper are below current reported valuations," says one market observer, "then is our financial services industry as profitable as we think it is?! A very disturbing question." Disturbing? How about scary as hell.

NovaStar nonsense: Takeover talk keeps swirling around NovaStar (nfi), probably yet another effort to keep investors from focusing on what really counts, including a continued deterioration in trust data across all vintages. From Stifel Nicolaus: "While weakness in the 2006 vintage is widely expected, NFI data showed losses climbing well above our projections in all vintages from 2004 forward." So much for subprime slime being just a little grime.

Tech wreck, etc: Office Depot's (odp) recent warning of weaker-than-expected sales thanks to its claims a "softening" economy can be seen with rising inventory at Micron (mu) and Solectron (slr) and, as businesses start spending less, preannouncements from the likes of Datalink (dlnk), an infrastructure distributor, and Ruth's Chris (ruth), a chain of high-end steakhouses.  And see the story in the FT about food inflation? The head of Nestle doesn't see food inflation  as a short-term issue, but  part of "structural" changes in his world. So much for this "core inflation is in check" mumbo jumbo. Check, please. 

Crazy Eddie, redux: "I have a research report from Drexel Burnham with a buy rating from 1987," writes a former Drexel broker. "I was in a training program and one of the instructors told us never to sell a real winner. He was using Crazy Eddie as an example. Hilarious."

More from the Comedy Channel -- and the "truth stranger than fiction" department: A month ago Gilford Securities issued a bullish report on Medis Technology (mdtl), the company that makes a fuel cell recharger for mobile phone and other portable devices. Speaking about the Power Pack, analyst Otis Bradley wrote -- and I kid you not: "If Medis is as successful as I believe it will be, this technological 'first' may well be worthy of Nobel Prize consideration." Nobel Prize consideration? Uh, um...that would appear to be more than a mere dollop of delusion. And it's clearly not an original thought: CEO Robert Lifton once told me the same thing. It's one of the many things he once told me. Still waiting to see those orders roll in.

The beat goes on...

From the "now I've seen everything" and "I wouldn't want to be that reporter" departments: Bloomberg ran a story today saying that New York Times columnist Gretchen Morgenson had written that NovaStar (nfi) "may pursue a buyout as it seeks 'strategic alternatives.'" The Bloomberg piece went on to say that Morgenson said that Babson Capital, an existing NovaStar investor, "may add to its stake," and then said that Morgenson didn't say where she got the info.

According to my read, Bloomberg's reporting of her story couldn't be more off the mark.

As it pertains to a buyout, Morgenson's column was cynical, at best, and was interpreting events to date. Morgenson pointed out that last April NovaStar said it was seeking strategic alternatives, and that the stock subsequently rose 50%. "Some investors," Morgenson wrote, "may believe a buyout lies ahead." (Hardly new news.) She then said there were whispers last week that Mass Mutual might put money into NovaStar. (That was last week's rumor du jour advanced by a posting on Briefing.com, whose motto these days might as well be, "All the rumors fit to print.")  She then said, "While NovaStar might appear to be an unlikely takeover target, we all know that anything can happen in mergerland. Still, NovaStar's business is plummeting..."

That's hardly a column that says something new about NovaStar possibly  pursuing a takeover.

The point of Morgenson's column, it appears, was to debunk the likelihood of a takeover and shine a light on Howard Hill, a long-time message board poster on NovaStar and critic of yours truly's NovaStar coverage. Hill joined Babson's portfolio management team in November 2005, according to a Babson press release. Hill, whose commentary was regularly included on a website for NovaStar investors run by an anonymous message board poster, was one of those message board posters who other message board readers viewed as the guru to end all gurus when it came to anything NovaStar. After each earnings report, news event or columns by me, readers would await Hill's commentary, who continuously downplayed risks with subprime mortgage lending and elated securitized loans.

By the time NovaStar imploded, Hill had disappeared -- to Babson, which went on to become a NovaStar investor.

According to one Bloomberg story, which quoted Hill as an expert in subpbprime lending, Hill oversees Babson's investments in NovaStar and other subprime lenders.

The bigger question is whether Babson was aware of Hill's involvement with NovaStar and his NovaStar message board history when it bought into NovaStar, whose share prices have fallen sharply since Babson's entry. I'll ask that question when I call Babson on Monday. Doubt they'll respond.

The beat goes on...

Disclosure: NovaStar has been red-flagged by my columns and blogs for years.

From the "desperate times call for desperate actions" department: Turns out rumors of NovaStar (nfi) doing a deal with MassMutual were on the money with today's announcement that MassMutual and Jefferies are bailing out the subprime lender in a highly complex $150 million transaction.

Cutting through the mumbo-jumbo -- the good news for NovaStar common shareholders: NovaStar isn't filling for bankruptcy anytime soon. The bad news: The nature of this deal, which sounds eerily like a death-spiral financing, suggests just what terrible shape the company is in.

And for those hoping the company will be acquired at some wild premium: It won't be. According to NovaStar, this deal concludes its "process to explore strategic alternatives."

No matter what happens, it appears the common shareholders -- those lured to NovaStar in hopes of big dividends -- are the big losers. With dilution via new shares, the dividend this year will be sharply lower than expected; ditto will the shareholder's stake in the company, which suggest  common holders just got their stake in the company trimmed by as much as half, depending on the ultimate number of shares (via preferreds and rights) that will be outstanding. NovaStar's simultaneous announcement of a 4-for-1 reverse split shows just how badly watered down the common stock will be. (And, as we all know, reverse splits really do little more than make a stock look artificially higher than it really is.)

Furthermore, if this financing doesn't help the company get from here to there, common holders are at the end of a growing line of lenders and creditors who get first dibs on the assets. At this point, for common holders, the stock is an option on the business getting better and being worth something substantially more some day.

As pointed out in previous posts, MassMutual, through its Babson Capital unit, is a large investor in NovaStar at much higher levels. This deal, it would appear, is a last ditch effort to salvage its losses by throwing good money at bad. It's the ultimate subprime loan, I suppose. 

Glad-to-be-back Ramblings:

Dollar dollop: Always great to visit Edinburgh, with one big exception: Thanks to the weak dollar, it keeps getting more expensive.  I've heard all of the arguments about why a weak dollar is supposed to be good (helps exports, of course) but remind me again: Why, should we be happy about a weak dollar?  Why, exactly, does that reflect well on our economy? (Just trying to get through the economics mumbo-jumbo.)

Boo!: The way this market acts, it's like somebody jumped
out and yelled, "Boo." That's why this is, in the absence of a better
definition, the "boo market." Boo markets don't occur when there is
conviction, and anything can come along and spook investors.



More NovaStar nonsense: When we last left NovaStar (nfi), on July 16, its stock was trading at a post--reverse-split price of around $30. The company had just announced a deal with MassMutual (through its Babson unit) and Jefferies for a $150 million bailout. To repeat what I wrote at the time: Reverse splits really do little more than make a stock look artificially high than it really is. What I didn't write, but NovaStar proves so perfectly, is that after the reverse stock the prices often revert back to the mean. Its stock is now $6.80, or $1.80 pre-split. That's the lowest the stock has been in seven years.
From subprime to the sublime: The bigger issue, of course, is how far the subprime slime will extend. This much is sure: The new methodology being used by Moody's to rate securitized Alt-A loans, which goes into effect today, won't help matters.  Moody's specifically notes the changes will cover Option ARMS. For what it's worth, Option Arms are more than a small part of Countrywide's (cfc) portfolio. (This whole mortgage mess makes you wonder whether A-rated and higher mortgage paper was ever A-rated and higher in the first place.)

Finally: Yes, it appears to be true. Somebody using our pal Patrick Byrne's  message board alias, Hannibal, was posting on the Investor Village message boards during Overstock's earnings call..  For more, see Gary Weiss' writeup.

As for the quarter itself: Overstock lowered its loss on lower revenue. )And on that bit of news the stock went up? But I digress...)

Not to worry, because Hannibal's posting during Overstock's conference call suggests that Byrne is as engaged as ever in the company's business. In response to one question from an investor about an estimate of legal costs incurred during the quarter, Byrne responded: "Our legal bills are a couple hundred thousand dollars a quarter, in general, maybe a few hundred thousand."

Turning to President Jason Lindsey, he then said, "Jason, do I have that number right?"

Lindsey: "I think it is a little more than that, but..."

CFO David Chidester then chimed in: "A couple of hundred thousand a month." Well done, boys.

The beat, my friends, goes on...

If Friedman Billings Ramsey analyst Scott Valentin is right, the news goes from bad to worse for NovaStar Financial (nfi)-- no stranger to readers of my column or this blog. In a note to clients today, he reiterated his "underperform" on the subprime lender, saying that he is lowing its price target to zero, reflecting his belief there is a "high likelihood that NFI will be unable to continue operations."

He says "the combination of the recent precedent of companies suspending originations prior to closing and the significant  deterioration in subprime market conditions...would result in no value for equity holders given NFI's excessive leverage and precipitous fall in subprime asset values."

On Friday, NovaStar confirmed media reports that it would stop funding new loans originated by wholesale borkers until August 7, "at which time the suspension wold be evaluated." In the wake of a bailout refinancing, NovaStar's recently did a 1-for-4 reverse stock split, which recently boosted its shares to around $13. The stock has since done nothing but go down; it's currently below $5, down around 26% on the day.

With NovaStar's (nfi) cancellation of its $101 million rights offering, the big question for the subprime lender is: How will it pay $157 million in 2006 dividends, which must be declared by September 17 and paid by year end?  Seems its auditor, Deloitte & Touche, said it wouldn't be able to reissue new financials tied to the offering without noting its uncertainty "of NovaStar's ability to continue as a going concern." Without paying the dividend, NovaStar will be on the hook to the IRS for unpaid taxable income for last year -- not good for a company like NovaStar, which is low on cash relative to its obligations. The company, which is pretty much exiting the lending business, tried to put a positive spin on the news by saying it will spend the bulk of its time managing its current $15 billion securitized loan portfolio while looking for "strategic alternatives" for its loan-servicing portfolio. "Our goal is to preserve and maximize the value of the portfolio through this difficult period for the industry...," said President Lance Anderson. Of course, in early March Anderson was quoted by the Kansas City Star as saying, "I'm bullish on NovaStar, I'm bullish on the industry."

The beat goes on....