Quest Capital Corp (QC)

(All data from quarterly June 30 2009)

Quest capital is a mortgage finance company in Canada. They focus on short-term (less than 2 years) mortgage lending, and therefore do not have significant exposure to interest rate risk. The investment thesis for this company is quite simple; the company was hit quite hard by the credit-crisis and is now trying to monetize its loan portfolio. They have stopped issuing new loans. The share price is trading at less than a reasonable estimate of what the company will be able to recover through its monetization efforts.

The market cap of QC is $170M or $1.12 per share with 151M shares outstanding. It appears as though this price is much too low; the shares are trading at 55% of adjusted book value.

The company has paid down all its debt and is working on the repayment of its preferred shares. The preferred shares carried a coupon of 13.5% that has now been renegotiated to 12.75% and will be reduced further to 12% on January 1st 2010. Preferred shares have been subtracted in the calculation of book value above.

The company has 49 loans outstanding with total principal of $369.8M. They have taken provision for loan losses of $20M. The company classifies loans as impaired when either principal or payment becomes past due by 90 days. 17 of the 49 (34%) loans outstanding have been deemed impaired as at the end of Q2. Total impaired principal is $162M (44%). However, management’s estimate of fair value of the collateral underlying these impaired loans is $171M.

There is also $6M of loans past due but not yet classified as impaired. For the purpose of this analysis I will assume this amount is already impaired. The $6M appears to be the last of the past due loans.

The nature of the business is such that the balance sheet can be used to determine the value of the business to a purchaser of the company’s common shares.

The majority of the loans outstanding should be partially recoverable, if necessary, through the monetization of collateral. Since the total collateral value is estimated at $171M, which is more then the total value of the impaired loans, it is reasonable to assume that most, if not all, of the principal will eventually be recovered. For this reason, I feel there is a higher probability for a positive outcome.

It seems as though the current price offers an appealing risk-reward scenario. Of course the success of this investment depends on stability in the real-estate market. Even if a relapse were to occur, it is not certain that a purchaser of the shares at these prices would suffer a permanent impairment of capital. The situation as it is along with the fact that the CEO is purchasing shares seems to provide a sufficient margin of safety to warrant an investment of capital in this situation as part of a diversified portfolio.

Disclosure: I own shares in QC. This is not a recommendation to purchase or sell securities.