I saw a preacher on the TV with big diamond rings on his hand
He was begging for some money, he said to send us every penny you can
I guess the good Lord's got a mortgage and a payment on a yacht in the Keys
So we better keep sending our hard earned living to those God fearing folks on TV
-Filthy Rich by Big & Rich
American Church & Mortgage is a church-based REIT with some serious fundamental flaws that have caused significant EPS shrinkage over the years. However, ACMC is a dividend paying REIT, and modeling even the most pessimistic scenarios indicates that ACMC shares are undervalued at $2/share (above recent trading prices). Dividends over the last twelve months have been about $0.36/share, so for $2/share you’re getting an 18% yield. At $1.50 you're getting a 25% yield.
1) EPS and the dividend have declined from $0.66 to $0.30 per share over the last ten years because of conflicts of interest. Myers is the president, treasurer, secretary, and chairman, but he doesn’t take a paycheck from ACMC. Instead he holds positions at Church Loan Advisors (paid an asset management fee as a function of AUM and loan originations) and American Investors Group (paid an underwriting fee when ACMC raises new debt). As a result of this arrangement, Myers’ incentive has been to grow the business from an asset base of $13 million in 1999 to $47 million in ‘08 despite consistent shareholder dilution.
2) ACMC looks cheap compared to book value, but it should be trading at a discount and that discount should grow with the debt to equity ratio. If a closed-end-fund manager was just able to track an index like the S&P which for argument’s sake we expected to return 8% per year by replicating it, but management still paid itself a fee of say 2% AUM, shares should trade at a 25% discount to book value. In the case of ACMC, management has consistently underperformed with earnings and dividends falling every year, and they still take a management fee on top of that. Even if the assets are worth book value (which is in question given the weak economy and ACMC’s reluctance to take writedowns), management is a drag on performance. In terms of liquidation value... impossible scenario.
3) Management should only raise capital under two scenarios. If the dividend yield falls below the rate at which management can safely lend they should issue shares. Debt is a little more complicated. The deal with Church Loan Advisors is that operating expenses will be refunded to ACMC if they exceed 2% of average invested assets or 25% of revenue. Therefore, debt should only be issued if ACMC can borrow for a minimum spread of 2% or 75% of the lending rate. If they lend at 10%, they should not borrow for more than 7.5%. If they lend at 8%, they should not borrow for more than 6%. Historically, borrowing has been at a negative after-fee spread and as a result earnings have decreased as leverage increased. The one who benefits, of course, is Myers. And these are breakeven points, it doesn’t take into account default risk or the fact that they’re chasing the same number of opportunities with more capital. To actually create value, the spread would have to be in excess of these limits.
4) The good news is that there’s a limit to how much management can dilute shareholders by increasing leverage. The company has set a debt to equity limit of 3x compared to around 1x today. However, ACMC is presently covering interest by only about 1.4x. I complied a list of nine other REITs yielding over 10% to get a feel for what interest coverage and debt to equity ratios commonly are. To avoid the effects of recent asset writedowns or poor short-term performance, I looked at 2007 financial statement data. The average interest coverage ratio was 1.9x with a minimum of 1.1x. The average D/E was 9.0x, but excluding one outlier brought it down to 3.1x. So assuming management won’t fuel growth by accepting blatantly negative interest rate spreads, the market should limit access to capital and force management to stop diluting shareholders.
5) I built some scenarios to test the effect of changes in leverage and interest rate spreads. If you’re following along in my excel model, scenario 3 is really my baseline. RoA is 8.5%, interest rates are 7.5%, OpEx is 20% of revenue (below the 25% max explained above), and the company raised $12 million to cover ST-liabilities and maintain the current SE of $20 million. This scenario is almost identical to 2007. In scenarios 2 and 4 I lowered and raised the borrowing rate by 1% respectively, yielding a 23% change in EPS. This shows how sensitive ACMC is to the spread, changing RoA would have the same effect. In scenario 1 I reduced the assets to the point where ACMC only nets $2 million in revenue and I reduced the debt level to keep SE at $20 million. The effect of this was $23.5 million in assets (compared to $47.1 million for baseline) and growth in EPS of 14% from baseline. In scenario 5 I increased debt to the 3x debt/equity limit while holding SE at $20, and grew assets by the same amount. With total assets of $80 million, EPS was down 20%. The scariest thing about this scenario is that the interest coverage ratio was only reduced to 1.2x, indicating that there might be more room than implied above for mgmt to continue slowly diluting shareholders. Scenario 6 looks at ACMC’s ability to grow EPS once leverage hits the ceiling. By doubling assets, liabilities, and SE, we can double the EPS. However, we also use cash…which could only then be raised by selling shares. The net effect is a wash. In conclusion, ACMC is probably more sensitive to short-term changes in the spread, but the long-term effect of leverage is slowly chipping away at the dividend.
Finally, in the absolute worst case scenario #7, I reduced the spread to 0%, and I increased the leverage ratio to 3x. This resulted in EPS of $0.14. So at $1.50, shareholders would earn 9.3% 10 years in the future after earning higher dividends for the next few years if management continues on this path.
6) I also modeled how EPS varies with leverage from $0 to $30 million in increments of $5, and surprisingly it’s linear. At an interest rate of 6.8% (and RoA of 8.5%) EPS isn’t affected by leverage. At interest rates below 6.8% the real spread turns positive and ACMC benefits from leverage. For comparison, series C certificates are set to yield between 6.25 and 7.25% depending on the maturity date. Unfortunately, even at breakeven it’s the shareholders that bear the risk of fluctuating mortgage yields and constant interest expenses.
Conclusion: It looks like at a steady run rate in terms of spread and OpEx will probably resemble 2007, but management will probably continue to leverage ACMC up to the 3x debt/equity limit, reducing earnings by another 20%. With the mortgage portfolio yielding 8.5% and debt costing 7.5%, fully leveraging ACMC would result in EPS (and a dividend) of $0.38/year. Maintaining the current debt/equity of 1.35x (slightly higher than where we are at the end of Q2, but with short term debt coming due), we can narrow the interest rate spread to 0% and still generate $0.36/share on the unleveraged portion of the mortgage portfolio. So if the loans under perform, or short-term refinancing comes at a higher rate, we can put a floor under expected earnings of around what we earned LTM. Again, that represents an 18% yield at $2/share, above where the shares have been trading for the last few weeks. And of course, this ignores the upside scenario where management uses loan repayments and prepayments to de-leverage the business and rebuild a more sustainable ACMC which might actually be a better captive client for Myers’ investment banking business in the long-run.
Disclosure: If you haven't already read my disclaimer on the right of this page, read it now. I own a position in this company, and if shares rise enough, I'll be selling. This is as micro-cap as a micro-cap company gets. It's extremely thinly traded, and if you place a simple market order, you might get filled at a ridiculous price. So please please be very careful! After this, I think I'll go back to analyzing normal-size companies for a while.