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Friday, October 3, 1997

Cityscape Financial Corp.
(Nasdaq: CTYS)
Phone: 914-592-6677
Price (10/2/97): $10

HOW DID IT FIND TROUBLE?

Cityscape Financial climbed a wall of worry when it reached new highs in January at $32 a share. At the same time, the celebrated money manager Michael Price, who owns a bucketload of the company's stock, announced his bullish stance on the company in the Barron's Roundtable. However, all was not well.

Over the ensuing months a variety of problems afflicted the company. The most serious of these was the move by the United Kingdom to halt what it considered abusive mortgage loan practices by the company. The specific complaint was unduly high prepayment penalties and unduly high profits generated through securitization of the high interest U.K. loans. Since the 25% of the company's business generated in the U.K. accounted for 50% of the company's profits, this was a big deal.

Headlines in Britain such as "We Have a Mortgage From Hell" and "Break Out of the Home Loan Prison Cell" didn't help the company one iota.

Top this off with a continued deterioration in the S&P and Duff & Phelps ratings for Cityscape's bonds and a sprinkling of missed earnings estimates and you have serious trouble.

BUSINESS DESCRIPTION

Cityscape Financial is a consumer finance company specializing in home equity lending. The company targets the debt-ridden consumer who is looking for debt consolidation, home improvement loans, and loans for other purposes.

Cityscape originates, buys, sells, and services the loans, working through a network of independent mortgage brokers and loan correspondents. The company operates in 37 states and the United Kingdom.

Competitors include Aames Financial, FirstPlus Financial Group, Beneficial Corp., Household International, The Money Store, and Associates First Capital Corp., to name a few.

FINANCIAL FACTS

Income Statement
12-month sales: $291.7 million
12-month income: $51 million*
12-month EPS: $1.61*
Profit Margin: 17.5%
Market Cap: $317 million
(*Excludes a one-time charges)

Balance Sheet
Cash: $47.9 million
Current Assets: $966.4 million
Current Liabilities: $742.1 million
Long-term Debt: $300.1 million

Ratios
Price-to-earnings: 6.2
Price-to-sales: 1.1

HOW COULD YOU HAVE SEEN IT COMING?

Over in the Cityscape Financial message board on AOL there has been a bull/bear argument going on since early last fall. For every bull there has been an equally outspoken bear.

That said, at the end of January an investor looking at the $28 stock would have found a YPEG valuation of over $57 based on Zack's earnings estimates and would have been able to read glowing comments in Barron's by one of the renowned value investors of the past decade, Michael Price.

However, an investor aware of the force of the backlash against Cityscape in the U.K. and noting the potential impact on the company's bottom line might well have avoided trouble.

WHERE TO FROM HERE?

The bullish case for these shares is not hard to come by. Michael Price still loves the stock, as do many Wall Street analysts. The U.K. problems and the reduction in the debt ratings of the company are out and are factored into the stock price. The P/E of 6 is well below industry averages.

The company now trades at under 4 times next year's earnings estimates. A YPEG valuation based on EPS estimates of $2.64 and a projected growth rate of 20% put fair value at $52 a share. The PEG is under 0.25. Unlike many of its competitors, the company generates positive free cash flow.

The bearish case is actually less company specific. There is a justifiable fear that the entire specialty loan sector could come under pressure because of the highly competitive nature of the business and the accounting used in the industry.

Many of the companies in the subprime home equity loan industry use gain on sale accounting. This is acceptable under generally accepted accounting principles (GAAP). Under this accounting system, revenues from the current quarter's securitizations are estimated and then given a present value. The present value gain is reported as revenue.

The problem is that the quality of these earnings is only as good as the assumptions for prepayment speed and losses. While it appears that Cityscape's loan loss assumptions are conservative, there may be problems under the surface. According to a recent Oppenheimer report, one of the 1996 loan pools had delinquency and foreclosure rates of 16.3% and 11.6% respectively. This may be a harbinger of earnings revisions to come.

The same Oppenheimer report finds that prepayment speeds are exceeding Cityscape's estimates as well. This leaves the potential for a writedown in the future.

Even though Cityscape appears to be undervalued, especially in relation to its peers, the industry may experience tough times as adjustments are made for aggressive accounting of gains on sales. It should be a wary Fool that latches on to these shares.

- Mark Weaver, MD, MWEAV@aol.com


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