SCM - Rithm Capital: Bargain Hunting Starts Now

2023-11-03 08:30:00 ET

Summary

• Rithm Capital Corp stock has outperformed the S&P 500 since my update in August, supported by an attractive forward dividend yield of 10.8%.
• The upcoming resolution of Rithm's acquisition of Sculptor Capital Management is expected to provide more clarity as the company staked its ambitions in alternative asset management.
• Rithm faces substantial challenges from macro headwinds and tightening financial conditions, but management is diversifying its business to mitigate cyclical risks.
• With RITM priced at an earnings multiple of just above 6x, it's still very attractive. Strong performance in its newer business segment could lift its valuations higher.
• I argue why buyers have returned with conviction, helping RITM to bottom out in October. If you have been waiting to buy more, the bargain hunting starts now.

I last updated Rithm Capital Corp. (RITM) investors in early August, as I anticipated its reasonable valuations and positive buying momentum. Despite that, I also cautioned buyers to be prepared for an "unforeseen pullback." However, it should be capitalized as a buying opportunity for Rithm investors.

Accordingly, RITM has outperformed the S&P 500 ( SP500 ) since my previous update, bolstered by its highly attractive forward dividend yield of 10.8% at the current levels. The upcoming resolution over its acquisition of alternative asset manager, Sculptor Capital Management ((SCM)), should also provide more clarity. However, there's an impending lawsuit filed by ex-Sculptor executives " to prevent Rithm Capital's planned acquisition of the alternative asset manager." As such, investors should pay close attention to a hearing slated for November 9, aimed at "securing a preliminary injunction to block [shareholder's] vote on November 16."

Notwithstanding RITM's market outperformance over the past three months, it has also been affected by broad market headwinds that are mostly out of the company's control. Management presented several challenges: Basel III endgame, commercial real estate writedown, maturing debt in 2024/25, increasing leveraged loan defaults, and headwinds relating to debt refinancing.

As such, the recent tightening of financial conditions has also led to a sharp repricing of risks, hitting RITM, as the market needs to reflect increased execution risks.

Therefore, I believe management's focus on diversifying Rithm from its core residential loans and MSR business is helpful. Moreover, the negative duration in its MSR segment has benefited Rithm, as prepayment speed slowed, given the high mortgage rates. As such, it has "translated into increased earnings and cash flow for the servicing business."

Management also stressed that Rithm is "actively pursuing" another substantial deal that could see its AUM rise to $50B, further boosting its alternative asset manager ambitions.

Fed Chair Jerome Powell and his FOMC indicated another pause in the Fed Funds rate. However, it's still a hawkish pause, as the Fed remains ready to raise rates again if necessary. Despite that, the language could be discerned as more dovish than the previous meeting, as Powell stressed the " risks associated with both overdoing rate increases and allowing inflation to rise excessively are now closer to being in balance." It was a departure from previous meetings when Powell accentuated " the risk of doing too little," giving more confidence that we are likely or already at the peak rates.

While it benefits Rithm's servicing business, it could hurt its origination segment. Furthermore, with interest rates expected to peak, the growth cadence in its interest income could start to normalize. With that in mind, I believe the focus of management in pursuing growth in other fee-based areas outside of its core business is helpful, diversifying its income source from the cyclical macroeconomic challenges. These businesses could provide more stability and even a further uplift for its earnings multiples.

With RITM trading at an EAD multiple of just 6x (well below its 10Y average of 7.2x), the market hasn't re-rated RITM for its progress outside its core business.

RITM dip buyers returned at a crucial moment in early October 2023, helping to defend it from sliding further. As such, the support zone at the $8.85 level has allowed RITM to form a higher low price structure above its previous March 2023 lows.

Despite that, there's a robust resistance zone at the $10.40 level, which could attract selling pressure. However, RITM's increasingly constructive buying sentiment suggest the market is confident about RITM's attractive valuation even as it transforms its business model. In other words, while execution risks have intensified and interest income growth could slow further, they have likely been priced in.

I expect RITM to make another attempt to re-test its August highs ($10.40 level). While we have moved away from the optimal entry zone, I believe the current levels are still conducive for investors to add more shares.

Rating: Maintain Buy.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

We Want To Hear From You

Have constructive commentary to improve our thesis? Spotted a critical gap in our view? Saw something important that we didn't? Agree or disagree? Comment below with the aim of helping everyone in the community to learn better!

For further details see: