This article was updated on 8/13/04. Redwood's insider ownership is 32% of shares, not 60% as originally reported. Thanks to a reader for pointing it out. Remember to check the proxy statement for the difference between shares outstanding and float.
Real estate investment trust (REIT) Redwood Trust (NYSE:RWT), a company that acts like the Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) of jumbo real estate loans and securities, issued its second-quarter press release, its 10-Q, and its 8-K on Thursday. It's refreshing to get all of the company information and the reporting information at the same time. Normally the 10-Q lags the press release (this was the case when I wrote about Secure Computing's warning a few weeks ago), making one wonder whether analysts get info before us common folk. As you will see, Redwood is very shareholder-focused.
Redwood Trust reported that GAAP earnings rose 113% to $2.58 per share as compared with the second quarter of 2003. What? There's hyper-growth in jumbo real estate loans and mortgage-backed securities? Before you get too excited, be aware that the press release seeks to temper your enthusiasm for your own good.
GAAP earnings require special ways of accounting for gains and losses from asset sales, hedging, and fluctuating market values of assets and liabilities. So, Redwood also reports "core earnings" that give investors an idea of how the company performed as an ongoing concern. This is reminiscent of Berkshire Hathaway's (NYSE:BRK.A) Warren Buffett describing the value of "look-through earnings" or Overstock.com (NASDAQ:OSTK) CEO Patrick Byrne advising shareholders about how to use its 200% GAAP revenue increase. Kudos to Redwood's George Bull and his team for what I believe Bill Mann would consider an excellent press release.
The company also mentioned that it is finding opportunities to make new investments. In fact, it increased its equity capital investment by 50% over the previous quarter and raised an additional $47 million of equity capital in May. Understand that insiders own 32% of the shares outstanding, so they have no interest in letting dilution get out of hand. Thus, I take this as a good sign that the company can continue to grow via wise capital allocation.
But is Redwood an attractive investment at $55.60? Sorry, folks, but I have to go with the when-in-doubt business school answer (and I've used it many times): It depends.
Because Redwood is a REIT, it must return all of its REIT taxable income to shareholders as dividends in order to skip paying corporate income taxes. That creates substantial savings for everyone, especially shareholders, as the dividends are not taxed twice. The current dividend rate is $2.68 per share, or 5%. The regular dividend grew 3% over last year (note that Redwood has been issuing special dividends to meet its REIT requirements). So, at today's prices, an 8% return is what one might expect.
A more attractive scenario might be found if we factor in some additional considerations. First, given the special dividends and the outlook for growth, could Redwood increase its dividend at a higher rate? It's possible. But its interest rate spreads have been shrinking. So Redwood would have to do more deals through smaller spreads to continue to grow core earnings. Management has clearly stated it will grow carefully and has a good track record handling the ever-increasing amount of deals required.
Second, the company seeks to deal with credit risk rather than interest rate risk or liquidity risk. It does this by buying and selling securities at proper prices to compensate for the latter risks. Think about it this way. The likelihood of someone defaulting on a loan greater than $333,700 is pretty small -- they are not borrowing money because they have to but because it makes sense economically. The company reported a loss rate of less than 0.01% on its portfolio. Redwood's people know how to play the game well and create its competitive advantage in this commodity industry. That's worth a great deal.
There's also one intangible. Investors will be standing alongside Wally Weitz. Wally is a great fund manager who graciously discussed Redwood Trust with me over breakfast in a cafe near his office in Omaha almost 6 years ago. He may not remember me, but he sure believes in Redwood Trust, as he owns 14.2% of the outstanding shares.
With good opportunities, shareholder-focused management, and a team known for its execution, I have to believe Redwood can offer more than 8% returns. I would say 10% to 12% returns are more likely, especially if the company gets back to a price/core equity level of 2 (it is currently 1.71).
Be sure to look into the company's direct stock purchase plan, where you get a 2% discount and can reinvest dividends in stock, also at a 2% discount. I told you it was shareholder-focused!
You may find faster-growing companies in sexier industries. But this is a company that I believe will live up to its name and, like those great trees, stand the test of time.
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Fool contributor David Meier does not own any of the stocks mentioned.
