iStar Financial, Inc. (SFI)

Today’s announcement about SFI having completed a new secured credit facility seems to be the final catalyst to this stock moving again. I purchased preferred shares on the way down and common shares near the November bottom when the company was vigorously defending $1 per share. From what could be gleaned from news sources and market action, SFI was doing many things right, but it would take seeing the SEC filings to get a better handle on what was happening behind the scenes.

During the most recent quarter, SFI repurchased 27 M common shares, retired enough debt at a discount to recognize $323 M worth of gains, and recorded $19 M in gains from the sale of 7 corporate tenant lease assets.

Non-performing loans (NPL) continued to increase (from 19.4% to 27.5%), and guidance indicates that this trend will continue in the near term. However, 97% of SFI’s NPLs are first mortgage or senior loans which gives the company more control and can maximize recovery value.

Turning to FFO (which is essentially net income without depreciation, debt gains, loss reserves, impairments, and depreciation, and after payment of preferred dividends), the 4Q was $12,990,000, or .10 per common share. This is the pot of money from which REITs must distribute a percentage to its shareholders. So assuming the 4Q 2008 FFO as a base, we can make adjustments to gain a sense of where the 1Q 2009 FFO may be.

On the positive side, the number of outstanding shares was reduced from 122 M to 105 M; all other things being equal that will add about .017 per share to the Q1 2009 FFO.

On the negative side, the value of non-performing assets (NPAs) (NPLs and OREO combined) net of reserves increased approximately $850M from the 3Q to the 4Q. This incremental amount is non-accruing and reduces potential earnings, but is largely offset by the reduced interest expense as a result of debt repurchases because the face amount of the debt was something less than the incremental addition to NPLs. Applying SFI’s net finance margin (2%) to the additional NPAs as an estimate of lost net interest income, the annual FFO is reduced by about $17 M – to be conservative, round this to $20 M to account for the lower face amount and assign an incremental reduction of $5 M to 1Q.

This results in a projected FFO for 1Q of about $8 M (given the caveats) which equals about .076 per common share. So, SFI could be FFO positive in 1Q (as they were in 4Q), even assuming a higher proportion of NPAs.

If the depreciation is approximately $25 M, that would lead to GAAP net loss of approximately $17 M, assuming no other adjustments. That still leaves a host of unknowns that could affect profitability (e.g., the effect of debt purchase gains, asset resolutions, loss reserves, and net changes in NPAs).

Debt purchases: It is not unreasonable to assume that SFI will aggressively acquire debt in excess of the offset threshold and thereby show significant income from non-operating activities. Particularly since the debt facility has now closed, it would not be surprising to find that SFI acquires a large amount of debt at very distressed prices as soon as possible. Such an approach would be indicated within the bounds of appropriate liquidity management.

Common share repurchasing: Last year, SFI repurchased 53.1 M shares at an average of $3.26 per share. With shares selling at a discount to the average price paid last year, it is not difficult to envision the repurchasing program expanded to continue purchasing more shares. As Catherine Rice (outgoing CFO) said in the conference call: “We continue to believe that our debt and equity securities remain attractively priced and will when appropriate invest in these securities opportunistically.”

Asset resolution: The $6.2 B difference between the book value and the fair value of SFI debt obligations represents potential unrealized gains. If that gain can continue to be realized through the repurchase of debt at current market prices, NPA’s can resolved at a discount to acquisition prices and the proceeds used to retire debt. SFI has the potential to offload its entire NPA at a discount and repurchase its own debt at a profit. This opportunity would not exist if the unrealized gains in debt were a mere $900 M, as they were at the end of 3Q.

In sum, when the crises are largely resolved, a substantially delivered SFI will be able to earn a 15% return on equity of about $2.5 B with moderate and sustainable debt levels. This will likely result in about $375 M per year in earnings. These reflect typical results for a well-run operation such as SFI.

With no further common share purchases, the 105 M outstanding shares would earn $3.57 of which SFI has pledged to distribute 100% of the taxable income. If they buy more shares while still inexpensive, there would be more available per share (93.7 M would be $4 per share; 75 M would be $5 per share).

In addition, the book value of SFI give shareholders a great deal of protection. Without counting debt discounts, the book value is more than $22 per share. If SFI could untangle the unrealized gains available in its debt, the book value could rise to more than $80 per share. Still, if in the process of resolving NPAs, SFI could realize as little as 20% of the currently unrealized gains, that could push the book value over $30 per share.