Tuesday, May 6, 2014

Questions for Radian - How to Prove Clayton Buy Is Not Sofa King Stupid

As expected, Radian announced a lights out operating performance that shows they were on a clear path to earning over $400M. Yay! Balloons! Noise makers!

Scratch the record. Kill the music.

Radian announced it will pay $305M for a business that earned $9M last year. Lets me get out my calculator. Yup that is a little higher than the 6-7x normal PE Radian was on its way to. The yield is also lower than the high teens (mgmt estimate) to arguably 20% ROE that Radian is earnings on it's NIW at it's capital starved subsidiary.

But lets not jump to the conclusion that Radian is buying a 3% yield with a cost of fresh capital in the teens. We can pull up financials from when Clayton was a public company to get an idea of their boom time earnings will be. Surely the next boom can't be too far off. Well the companies peak earnings were $15M in 2003 and it's proforma earnings that year were $9M. Wow that is awful close to last year.

Surely past deal makers saw even more potential in Clayton than our trusty Radian leaders. Nope. Back in the heyday of 2006 the Clayton IPOed for a $125M market cap with about $65M in debt. Then Greenfield took them private in April 2008 at a $135M market cap with $25M in debt. So those valuations seem consistent to each other. They are also both 50-63% of what Radian is paying. Radian's presentation does little to justify such a high price which is why I have composed a few questions that management may wish to ponder:

-In your presentation you describe Clayton as a "Non-capital intensive business" which is fantastic, but aren't you spending $305M of freshly raised capital on it? Or was that broccoli you spent? Or are you just trying to tell us that you value this cash flow stream so highly because it does not have a moat of capital around it?

-In your presentation you describe your purchase of Clayton as having a "Future tax benefit from basis step-up". Should I try to negotiate a higher price for a given bond so that I can depreciate a larger premium? Is this Radian's investment strategy?

In your presentation you state "Acquisition is expected to be breakeven from an accretion/dilution standpoint and modestly accretive excluding the non-cash amortization of intangible assets." Is that for 2014? If yes, analyst estimates have 2015 earnings ex-Clayton growing by 50%. Will Clayton earnings keep pace or is the deal dilutive after year 1?

-This deal could only be considered accretive on a normal basis if Clayton earnings growth is substantially faster than MI earnings growth. Furthermore, Clayton earnings would have to attain a far higher than record level, including boom time GAAP and pro-forma earnings. Radian has also said that they do not know when or how final housing finance reform will shakeout. So, what special insight does Radian have that allows it the vision of such high profits at Clayton?

-Simply, how does Radian see twice as much value as a boom time valuation?

-Given the different lines of business and locations, how much expense reduction can Radian achieve with synergies? How does a cross sell function between deal/servicer products and private mortgage insurance (what are the revenue synergy opportunities)?

-Radian has bought diversification across the mortgage market. An investor can buy the S&P 500 and get diversification across all markets for less than half the cost. That one is not a question.

Well this turned out to be more of a rant (OK a temper tantrum) than a list of questions for management. Maybe this post should have been called "Seeing Red with Radian."

Radian management made some graceful moves in the downturn. They managed the bust better than any other company. But now it seems management is doing anything but a favor for shareholders. Managers use your money to buy things for all types of reasons. It may behoove them to diversify their business so that they have a more steady job. Managing a bigger company surely necessitates paying managers more. Sometimes managers acquiesce to large shareholders who may have their own agenda, like buying more stock in a secondary. Many times experts become so overconfident that they actually become worse at their expertise than lay people.

Even if 1) Radian had no other way to utilize it's tax benefit, 2) we think record profits are sustainable and can grow as fast as PMI profits, 3) we add back a $10M amortization, the current yield on the Radian's Clayton investment would be less than 7.5%. It falls at 6.6% without fudging around for taxes. Radian's average analysts estimate (which this quarter was beat by at least 50% anyway you slice or dice operating earnings) for 2014 is 0.95 and for 2015 of 1.45 per share. If you take the most generous current yield on the Clayton investment and the analyst estimates (which were just beaten). then you have something that looks consistent with management's comment on accretion only applying to 2014. Thereafter it would be sharply dilutive.

The good news for shareholders is that this deal is quite small at approximately 10% of Radian's enterprise value. Far worse is having a management team willing or inept enough to destroy shareholder value. Has noted earlier, Radian reported a lights out earnings performance so these are crosscurrents in the market for RDN stock. The only surprise for this shareholder is management's mistakes.

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