“Interested in your opinion re: Newcastle (NYSE:NCT). It is handing out dividends, but constantly raises cash by new share offers. Is this a viable model? … Concerned this is just another pyramid /momentum game.” – Hanns
Well, you’ve got the momentum game down for sure. Newcastle is up a staggering 63% since Jan. 1, neck-and-neck with Apple (NASDAQ:AAPL)! And when you throw in the 10% annualized dividend yield, NCT seems mighty tempting to the untrained eye.
But you’re right to be skeptical. Because to the trained eye, this is indeed a pyramid scheme.
Also known as a Ponzi scheme.
Also known as the world’s worst investment idea.
The shocker to me here is that Newcastle has managed to pull this off on such a large scale. It’s a $1.3 billion company by market cap, with volume of almost 3 million shares a day! This is not some pink-sheet penny stock here, but a legit corporation on the NYSE.
But don’t be fooled, this stock fits the SEC’s textbook definition of a Ponzi scheme. So let’s dissect this diseased specimen to look at some of the putrid cancer inside:
Giving mREITs a Bad Name
For starters, there’s the basic business of Newcastle as a mortgage-paper REIT. I have written on so-called mREITs in the past and called out their problematic nature that lurks behind big yields — namely, that they are at the mercy of the spread between short-term and long-term borrowing rates, and that they use “leverage” or heavy borrowing to amplify returns. That leads to very volatile dividends and the chance of a revenue shock if the portfolio of mortgage paper isn’t managed properly or hedged against.
The story of many mREITs in the last year is one of dwindling distributions and share price. Take one of the biggest, Annaly Capital (NYSE:NLY), which has seen its dividend drop for four consecutive quarters and is off 2% vs. a 16% rally in the Dow Jones over the last 12 months.
But though a money loser and a risky bet, Annaly is a legit outfit. It just so happens that its business is under pressure as the yield spread tightens, and the company is playing with fire using leverage to support its investments and big dividends.
Newcastle is under many of the same pressures. So one would think its business would be moving south too, right?
Wrong. That’s because management has decided to inflate earnings via secondary offerings and mask the balance sheet problems that exist at other mREITs.
Addicted to Secondary Offerings
Look at the earnings and revenue history for Newcastle. Not encouraging, is it?
OK, since 2010, earnings have dwindled and the top line is crashing … but guess what? Since September 2010, the stock is up 200%! And NCT is up over 60% this year alone!
Further signs of shadiness: Accounts receivable have MORE THAN DOUBLED in the past year, from $208 million in June 2011 to $563 million this June. So it’s selling a ton more but magically hasn’t been paid yet? Something doesn’t smell right …
I know that sometimes I am a slave to fundamentals, but that’s too glaring a trend to ignore.
And if you want a real mind-bender, riddle me this: How is it that a company that made a measly $29 million in GAAP income last quarter can afford to pay $34.4 million in dividends?
Another ugly fact: The company has $2.9 billion in long-term debt. That’s twice the market value of the entire company … how can they make debt service on this thin balance sheet?
The answer is simple, really: Investors are suckers, and don’t realize New Castle is generating cash simply by offering more and more stock.
Consider that Newcastle just dumped another 25.3 million shares on the market in late July to raise almost $170 million… and that’s after 20 million shares dumped in May and 16.5 million in April and 25.9 million in September! With 172 million shares outstanding, that means the company has offered up 36% of its total shares in the last year!
The use? A nebulous catch-all the company calls “general corporate purposes.” As in paying the CEO’s salary and paying shareholders dividends in a bid to keep this Ponzi scheme going. The money raised from secondary offerings is paid to existing shareholders, and the cycle will continue until the buyers dry up … and then the share dilution will be massive, the dividends will disappear and investors will be holding the bag as the pyramid scheme falls apart.
The Very Definition of a Ponzi scheme
Think it’s unfair to label this company a pyramid scheme or a Ponzi scheme? Consider this definition from the SEC itself:
“A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.”
Sounds exactly like what Newcastle is doing, no? It’s taking money from new investors via secondary offerings to pay purported returns (dividends) to existing investors.
What makes this doubly damning is that because of buying pressure from those new investors, the shares have soared too.
Now the painful part. This from the SEC on, “Why do Ponzi schemes collapse?”
“With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.”
In short, look out below when those secondary offerings can’t find enough buyers.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.