Frank Voisin writes about value investing topics at http://www.frankvoisin.com
Manhattan Bridge Capital Inc. (NASDAQ: LOAN) provides short-term, secured loans to real estate investors to fund acquisitions and construction of properties in the New York Metropolitan area.The company has seized upon the recent financial crisis to provide high interest, short-term (usually 1 year or less) loans to businesses that are otherwise having difficulty obtaining financing. This allows the company to charge 12 – 16% interest rates plus additional fees. The company conducts its own due diligence and retains all of its loans, suggesting very little incentive to make poor quality loans. The company trades (as of 11/21) for a market cap of $3.59 million, despite being profitable and having a tangible book value of $8.08 million. Is this discount justified? Let’s investigate.
First, given the nature of the company’s business, it may be reasonable for the market to assign such a discount if, for example, there were concerns about the quality of the loans it had made (which comprise ~82% of its assets). Luckily the company’s financial data is replete with information that allows us to assess the quality of its loan portfolio. We note that, throughout the company’s (short) history, it has never experienced any loan defaults, indicating that management has done a good job of assessing potential borrowers. Additionally, as of the most recent 10-Q (9/30), all of the company’s loans were performing (whereby no borrowers were behind on their payments). Finally, the company does insist on secured loans, which are collateralized by the real estate itself as well as personal guarantees from the principals of businesses receiving the loans. Thus, if a client defaults, actual losses should be significantly lower than the value of the loan.
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Despite the foregoing, there may be some reasons for concern. First, since the company is engaged in short-term bridge financing, its loans are predominantly interest-only, with a balloon principal payment at the end of the term. This type of financing is more affordable on an interim cash flow basis than a loan where the principal is amortized over the period. This translates to increased credit risk, as a greater amount of capital is at risk over the term of the loan. This is by no means anomalous in the bridge loan market and losses can be effectively mitigated by increased collateral demands and strong risk analysis, both of which appear to be the case here. However, when losses do hit, they will be larger as a result of this loan structure.
The second potential concern is that the company does not reserve for losses. Usually financial institutions take reserves in each period for losses that may only be sustained on an irregular basis. This removes the lumpiness of the losses from the financial statements and atones for the fact that the riskiness of loans are ever present and should be accounted for in this manner. By not making reserves for loan losses, management is implying that the risk of loss is zero. On an ex post basis this has proven correct, but on an ex ante basis this is certainly not the case. This knife cuts both ways. As the company inevitably does incur defaults, it will appear to be less profitable than its underlying operations actually are because its lack of loss reserve will lead to immediate recognition, making losses as a portion of the total loan portfolio appear (undeservedly) astronomical.
The third potential concern relates to the last point: what is the effect of zero reserves on management incentives? If you pretend that the potential for losses is zero, and thus make no reserves for losses, then you have every incentive to avoid recognizing losses. As noted above, the company has extended loans in the past. The company states the following:
The Company generally grants loans for a term of one year. In certain situations the Company and its borrowers have mutually agreed to the extension of the loans as a result of the downturn in the economy and the real estate industry in the New York metropolitan area. …
Prior to the Company granting an extension of any loan, it reevaluates the underlying collateral. At September 30, 2011, the Company’s short-term and long term loans include loans in the amount of $524,700 and $1,750,200, originally due in 2009 and 2010, respectively. In all instances the borrowers are currently paying their interest and, generally, the Company receives a fee in connection with the extension of the loans.
The value of these loans approximates 26% of the company’s loan portfolio. If these borrowers were unable to repay the principle when their loans came due, then they would likely be considered of lower credit quality than when the loans were first extended (under the belief that repayment would be made within one year). It is management’s discretion to call the loan at the end of the term and force the borrower into default, but with an incentive to not recognize losses, how likely is this to occur? Instead, it is conceivable that management has retained lower credit quality borrowers in the portfolio (and now comprising a large portion of the portfolio) rather than dealing with the issue earlier and forcing default. In the meantime, the commercial real estate market has weakened further, reducing the value of the collateral. I do not pass judgment as to whether this is definitely the case, but the concern that this might be the case certainly could go to explain the company’s significant discount to its loan portfolio.
The final cause for concern with the loan portfolio relates to concentration, both geographic and customer. On a geographic basis, the company’s loan portfolio is completely concentrated in the New York Metropolitan area, which leaves it highly exposed to to the potential for a downturn in this single market. Additionally, the company appears to have significant customer concentration, as noted in its 10-Q (emphasis added):
At September 30, 2011, the Company has made loans to four borrowers in the aggregate amount of $1,205,000. One individual holds at least a fifty percent interest in each of the borrowers. The Company also has made loans to six borrowers in the aggregate amount of $1,310,000. One individual holds a fifty percent interest in each of the borrowers. The Company also has made loans to four borrowers in the aggregate amount of $1,400,000. One individual holds at least a fifty percent interest in each of the borrowers. All individuals have no relationship to any of the officers or directors of the Company.
Thus, three individuals own at least 50% interest in 14 companies that LOAN has extended $3.915 million worth of credit, or ~46% of the total loan portfolio. As they say, owe the bank $100,000 and the bank owns you; owe the bank $100 million and you own the bank. This type of concentration creates potential risks that don’t exist in a more widely diversified customer base, and so this is a cause for concern that might help justify the discount.
Beyond the loan portfolio, what other risks might exist that justify the discount? One is related to corporate governance. At the last annual meeting, the company put forward the following issue to a vote (emphasis added):
The Board has authorized, subject to shareholder approval, the grant 1,000,000 restricted shares of Common Stock (the “Restricted Shares”) to Assaf Ran, the Company’s President and Chief Executive Officer, pursuant to an agreement a copy of which is included in this proxy statement as Appendix B (the “Restricted Shares Agreement”). Under the terms of the Restricted Shares Agreement, Mr. Ran has agreed to the termination and cancellation of 210,000 options with exercise prices above $1.50 per share that he currently holds and further agreed that he will not exercise an additional 280,000 options with exercise prices below $1.50 per share. If Mr. Ran exercises any of 280,000 options that are not being terminated and cancelled, he will forfeit approximately 3.5 Restricted Shares for each such option exercised. Under the Restricted Shares Agreement Mr. Ran may not sell, convey, transfer, pledge, encumber or otherwise dispose of the Restricted Shares until the earliest to occur of the following: (i) June 30, 2026, with respect to 1/3 of the Restricted Shares, June 30, 2027 with respect to an additional 1/3 of the Restricted Shares and June 30, 2028 with respect to the final 1/3 of the Restricted Shares; (ii) the date on which Mr. Ran’s employment is terminated by the Company for any reason other than for “Cause” (i.e., misconduct that is materially injurious to the Company monetarily or otherwise, including engaging in any conduct that constitutes a felony under federal, state or local law);or (iii) the date on which Mr. Ran’s employment is terminated on account of (A) his death; (B) his disability, …
The short story is that the company’s President and CEO will forfeit 490,000 options in exchange for 1,000,000 restricted shares that do not begin to vest until 2026 (but he is able to vote these shares). The Board suggests that this is the best manner of more closely aligning Mr. Ran’s interest with that of the company and its shareholders.
There are a few reasons to be concerned here, and these are best summarized by a letter written by Capstone Equities Capital Management and G Asset Management (which combined own 5.5% of the company) to the members of LOAN’s Compensation Committee, found here. Capstone correctly notes that Mr. Ran owns 50% of the company and so his interests should already be closely aligned to those of other shareholders. Furthermore, Capstone notes that the grant is in no way connected to Mr. Ran’s performance (unlike the options, which at least required the shares to have achieved values above various strike prices), and so it seems to be less shareholder friendly than the board claimed. Nevertheless and quite expectedly given Mr. Ran’s ownership stake, the vote passed in Mr. Ran’s favour. Given Mr. Ran’s control and the board’s unwillingness to accept Capstone’s compelling logic, it would appear that LOAN is not operating in favour of minority shareholders which also goes a long way toward explaining the market’s seemingly discounted valuation.
It is worth noting that the same letter provides some evidence (in Exhibit A) to further support the idea that the company makes conservative loans.
What do you think of LOAN? Is the current discount justified on the facts, or is there a compelling value opportunity?
Author Disclosure: No position
Frank Voisin writes about value investing topics at http://www.frankvoisin.com