At these prices, an equity investment in KFN has simply become a bet that the world is not going to end. In any reasonable scenario (even taking into account a recession, unprecedented illiquidity, and the highly levered investments), far too much downside has already been priced in here. At $3 a share, it's really worth doing a quick bit of math to understand what these pricing levels represent.
There are two interrelated ways to think about valuing this stock: i) Analysis of equity value per share in different default scenarios, and ii) expected dividend yield. (Disregarding ongoing franchise value)
i) At each additional $1 decline in its share price, another ~$150 million of cushion for permanent asset impairment has been priced into the company's market cap (150m shares outstanding). Since they own 83% senior bank debt, of which 94% is first lien, even when defaults occur, historical recovery rates for their blended portfolio are around 70% (based on seniority and securitization of their holdings). Per the loss sensitivity analysis on pg 16 of the 9/15 presentation (available on the investor relations part of the KFN website) note that each $150m decline in equity value implies an expectation that an additional ~6% of their portfolio will be defaulting (assuming normal distribution of those losses )
Starting at the $13 book value of equity from 6/30 (true par value of the portfolio is likely higher) the stock has dropped $10 bucks on its way down to $3, and therefore, ~$1.5 Billion in expected permanent asset impairments is currently priced in. This implies an expectation that over 60% (10*6%) of their entire portfolio will default (again, assuming 70% blended historical recovery rates). So even if you believe this will be the worst recession in history, and therefore that, say, 20-25% default rates are to be expected in the next few years based on the credit class of their holdings (in line with worst seen in 1991 or 2001), this stock should still be trading north of $7 a share.
Realistically, we are indeed in for a bad extended period in the economy, and yes KFN’s holdings are primarily the largest most highly levered LBOs ever done (2006-2007 period), so undoubtedly, this portfolio is going to see some delinquent and defaulting loans. But a) 60% is 2-3x too high by standard of historical crises; b) big companies are far more resilient to defaults (KFN portfolio averages $5.5B in rev and $1.2B of EBITDA which means more diverse revenue streams, access to funding sources, etc). At 6/30, while the broader market was at cumulative defaults of roughly 2%, KFN still had no corporate loans in default or delinquent status. c) the private equity owners of their holdings don’t want these companies to default, and thus may choose to ‘cure’ some cash flow issues with additional equity infusions, and d) the company has already set aside $265 million in various reserves, which according to their loss sensitivity analysis, means they have already reserved for what would be a bad historical scenario where 10% of their portfolio defaults. When credit markets finally recover a bit a $10+ per share equity value or higher would not be out of the question. $6-7 is the absolute minimum it should reasonably trade at while people ponder the severity of this recession.
It is also a crucially important point to understand that book values of assets are being marked at prices that reflect illiquidity, but not necessarily true probability of default. Fear has been a huge factor here, so when new book values come out from Sept, they are likely to fall substantially. What remains important to anyone holding for the intermediate period is the math above – what do we have to believe with regard to overall defaults to justify the level that the market cap is trading at. (Part 2 to follow)
i wouldn't fall in love w/the dividend. it's pretty clear from the market price that it will be cut substantially. delevering is happening to everyone. will it improve or get worse? KFN and a lot of other leveraged companies are under real re-financing threats. if KFN's lines are deemed too risky, they won't get rolled over. the key issue then, is debt coverage, i.e., how vulnerable is debt coverage in a recession? what about a long, severe recession? will cash flow hold-up? or will it decline and eventually fall below covenants?
any of KFN's lenders who know that they will not renew KFN's lines, could share this information with their short friends, who would have the absolute confidence to sell or short KFN's stock into extinction. this is what happened during the first phase of the credit crunch. REPO lenders to Novastar, Luminent, et al, knew their credit lines would not be renewed, and so they shorted these stocks into oblivion, which further exacerbated the situation, by making it impossible for the REITs to raise capital, due to their low stock prices. this could explain KFN's current stock price. there are scoundrels on wall street, and KKR themselves are guilty of having played in the deep end of this pool. there will be blood in 2009, unless things get better soon. management might deem it prudent to cut the dividend now. KFN's shares might even rally when it's cut.
I don't think there is anything very technical to derive from the price action in KFN lately. Basically, the market has no spine at all, and the description of KFN's business model makes too many faces turn green. However, the nature of KFN's funding, in that it is not margin based indicates to me that this is a great bet at this point. I don't know of any company out there that can afford to be as brave as KFN in this environment, solely by the virtue of their CLO funding structure.
That's not totally accurate. Although I think mgmt would rather hold onto the cash to pay off the Ways. loan, a buy back would be quite accretive. Remember, mgmt owns 12% of outstanding so it benefits them greatly to reduce the float.
By eliminating the divided you take away a compelling reason to buyback stock. In addition -- and it's been posted on this board a few times -- KKR's disincentive for a stock buyback. I'm convinced we'll see divy elimination. Hopefully management can take those savings and take full advantage of the current historically high credit spreads.
One thing's for certain, the market does not believe that KFN will survive. We'll see.