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Tuesday, February 13, 2007

Calls of Note Part 2

- Stifel is upgrading New Century Financial (NYSE:NEW) to Hold from Sell after the co last week preannounced a slew of bad news including a major accounting issue (under-reserving for losses on early-payment defaults or EPDs), a reacceleration in EPDs (after guiding to stabilization last quarter), and sharply lower 2007 origination guidance(from flat to down 20% y/y as underwriting tightens further to stem the EPD issue).

Firm notes that this was even worse than they had anticipated (they had a Sell on NEW since Q3 2006). With persistently high EPDs forcing further underwriting changes, they are even more concerned about the 2007 outlook. Firm's new EPS estimates are -$1.18 in 4Q06 (from +$1.01) and +$0.38 in 2007 (from +$2.95).

However, since the release, NEW shares have traded off sharply (43%) and now trade at 65% of firm's estimate of tangible book value. While it is difficult to predict exactly where book value will be (given the accounting issues and expected 4Q06 operating loss), they believe the continued sell-off indicates rising investor concerns over liquidity risk. NEW ended 4Q06 with $360mm in cash and has 15 credit lines with over $17B in borrowing capacity that were only about 50% utilized at 3Q06-end.

While the obvious risk is that these lines could get pulled (as the restatement and losses breach covenants), firm's analysis of the agreements suggest that NEW should be OK even as EPDs rise further (4%). They also note that FICC, a smaller, more troubled subprime REIT recently was able to renegotiate its lines (and remain operational) despite breaching several key covenants.

Stifel believes the risk/reward at current levels no longer warrants a Sell rating.

Notablecalls: I think this upgrade will get some attention as Stifel had been negative oN NEW ahead of the blow-up that happened last week. NEW (and other subprime lenders) have been targeted by the remaining (and shrinking!) short community and I suspect Stifel's call will cause some of the remaning short positions to be covered. Also, the call makes sense.

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