<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1997.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1935
For the transition period from to .
--------------------- ---------------
Commission File Number: 001-13533
NovaStar Financial, Inc.
------------------------
(Exact name of registrant as specified in its charter)
Maryland 74-2830661
- ------------------------------------------------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1900 W. 47th Place, Suite 205, Westwood, KS 66205
-------------------------------------------------
(Address of principal executive offices)
(Zip Code)
(913) 362-1090
--------------
(Registrant's telephone number, including area code)
______________________________________________
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange act of
1935 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes No X
--- ---
The number of shares of the registrant's common stock outstanding as of November
10, 1997 was 7,516,665.
<PAGE>
NOVASTAR FINANCIAL, INC.
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 1997
INDEX
<TABLE>
<CAPTION>
Page
PART I FINANCIAL INFORMATION
<S> <C> <C>
Item 1. Financial Statements:
Balance Sheets........................................... 1
Statements of Operations................................. 2
Statement of Cash Flows.................................. 3
Notes to Financial Statements............................ 4
Item 2. Management's Discussion and Analysis of Financial
Conditions and Results of Operations..................... 5
PART II OTHER INFORMATION
Item 1. Legal Proceedings........................................ 14
Item 2. Changes in Securities.................................... 14
Item 3. Defaults Upon Senior Securities.......................... 14
Item 4. Submission of Matters to a Vote of Security Holders...... 14
Item 5. Other Information........................................ 14
Item 6. Exhibits and Reports on Form 8-K......................... 14
Signatures............................................... 15
</TABLE>
<PAGE>
NOVASTAR FINANCIAL, INC.
BALANCE SHEETS
(dollars in thousands)
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
September 30, 1997 December 31, 1996
(unaudited)
<S> <C> <C>
Assets
Cash and cash equivalents $ 4,236 $46,434
Mortgage securities available-for-sale 267,835 13,239
Mortgage loans 418,897 ---
Accrued interest receivable 4,891 14
Investment in NFI Holding Corporation 1,857 ---
Other assets 1,417 109
-------- -------
Total assets $699,133 $59,796
======== =======
Liabilities and Stockholders' Equity
Liabilities:
Repurchase agreements $644,195 $ ---
Due to NovaStar Mortgage, Inc. 5,861 ---
Amounts due to brokers and dealers for
unsettled securities and loan purchases --- 13,255
Accounts payable and accrued expenses 2,041 176
-------- -------
Total liabilities 652,097 13,431
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000
shares authorized:
Convertible preferred stock, 3,549,999
shares issued and outstanding 36 36
Common stock, 216,666 shares issued and
outstanding 2 2
Additional paid-in capital 49,862 49,910
Accumulated deficit (1,643) (302)
Net unrealized gain (loss) on available-for-
sale securities 2,239 (16)
Forgivable notes receivable from founders (3,460) (3,265)
-------- -------
Total stockholders' equity 47,036 46,365
-------- -------
Total liabilities and stockholders' equity $699,133 $59,796
======== =======
</TABLE>
See notes to financial statements.
1
<PAGE>
NOVASTAR FINANCIAL, INC.
STATEMENTS OF OPERATIONS
(unaudited; in thousands, except share amounts)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the period
from September
For the nine For the three 13, 1996
months ended months ended (inception) to
September 30, September 30, September 30,
1997 1997 1996
<S> <C> <C> <C>
Interest income:
Mortgage securities $ 6,796 $ 4,555 $ ---
Mortgage loans 14,749 7,670 ---
------- -------
Total interest income 21,545 12,225 ---
Interest expense 16,224 9,786 ---
------- -------
Net interest income 5,321 2,439 ---
Provision for credit losses 1,444 726 ---
------- -------
Net interest income after
provision for credit losses 3,877 1,713 ---
Other income 326 259 ---
Equity in net income
(loss) of NFI Holding
Corporation (141) 290 ---
General and administrative
expenses:
Administrative services 2,450 1,200 ---
Compensation and
benefits 701 332 ---
Loan servicing 694 123 ---
Professional and
outside services 430 181 ---
Office administration 201 89 ---
Other 288 160 ---
------- -------
Total general and
administrative expenses 4,764 2,085 ---
------- -------
Net income (loss) $ (702) $ 177 $ ---
======= ======= ========
Net income (loss) per share $ (0.16) $ 0.04 $ ---
======= ======= ========
Dividends declared per
preferred share $ 0.18 $ 0.08 $ ---
======= ======= ========
Weighted average shares
outstanding 4,273 4,273 ---
======= ======= ========
</TABLE>
See notes to financial statements.
2
<PAGE>
<TABLE>
<CAPTION>
NOVASTAR FINANCIAL, INC.
STATEMENTS OF CASH FLOWS
(unaudited; dollars in thousands)
- --------------------------------------------------------------------------------------------------------------
For the period from
For the Nine September 13, 1996
Months Ended (inception) to
September 30, 1997 September 30, 1996
<S> <C> <C>
Net cash provided by operating activities $ 3,281 $ ---
Cash flow from investing activities:
Purchases of available-for-sale securities (380,820) ---
Settlement of amounts to brokers (12,676) ---
Proceeds from sales of available-for-sale securities 99,794 ---
Proceeds from paydowns on and maturities of
available-for-sale securities 22,506 ---
Investment in NFI Holding Corporation (1,980) ---
Mortgage loans acquired from NovaStar Mortgage, Inc. (229,364) ---
Mortgage loans acquired from others (219,995) ---
Mortgage loan repayments 27,402 ---
---------
Net cash used in investing activities (695,133) ---
Cash flow from financing activities:
Private placement offering costs (48) ---
Net borrowings under repurchase agreements 644,195 ---
Net change in amount due to NMI, Inc. 5,861 ---
Dividends paid on convertible preferred stock (354) ---
--------- ---
Net cash provided by financing activities 649,654 ---
---------
Net decrease in cash and cash equivalents (42,198) ---
Cash and cash equivalents, beginning of period 46,434 ---
--------- ---
Cash and cash equivalents, end of period $ 4,236 $ ---
========= ========
Supplemental disclosure of cash flow information:
Cash paid for interest $ 15,416 $ ---
========= ========
Dividends payable $ 284 $ ---
========= ========
</TABLE>
See notes to financial statements.
3
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO FINANCIAL STATEMENTS
September 30, 1997
- --------------------------------------------------------------------------------
Note 1. Financial Statement Presentation
The financial statements as of and for the periods ended September 30, 1997
and 1996 are unaudited. In the opinion of management all adjustments, which
were of a normal recurring nature, necessary for a fair presentation of the
balance sheet and results of operations, have been made. The financial
statements should be read in conjunction with Management's Discussion and
Analysis of Financial Condition and Results of Operations and the Company's
registration statement on Form S-11 (registration number 333-32327) declared
effective on October 24, 1997.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates that affect
the reported amount of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements. These estimates
and assumptions also impact reported amounts of revenues and expenses during the
reporting period. Actual results could differ from these estimates.
The Company owns 100 percent of the preferred stock of NFI Holding
Corporation (Holding) for which it receives 99 percent of any dividends paid by
Holding. The founders of the Company own the voting common stock of Holding.
NovaStar Mortgage is a wholly owned subsidiary of Holding. Certain key officers
of the Company serve as officers of Holding and NovaStar Mortgage and the
founders are the only members of the Board of Directors of Holding and NovaStar
Mortgage. The Company accounts for its investment in Holding using the equity
method.
Note 2. Subsequent Events
On October 30, 1997, the Company completed its initial public offering of
common stock. The Company sold 3,750,000 shares in the offering at a price of
$18.00 per share and received approximately $62 million in net proceeds.
Approximately 90 percent of the proceeds will be used to fund the acquisition of
the wholesale loan production of NovaStar Mortgage and the acquisition of
mortgage securities, in accordance with its business strategies. The remaining
10 percent of the net proceeds will be used for working capital and general
corporate purposes.
On October 1, 1997 the Company issued $264 million in a privately placed
Collateralized Mortgage Obligation (CMO), secured primarily by subprime
residential mortgage loans. For accounting purposes, the mortgage loans financed
through the issuance of the CMO are treated as assets, and borrowings under the
CMO are treated as debt of the Company. Borrowings under the CMO are fully
payable from the principal and interest payments on the underlying mortgage
loans collateralizing such debt. Proceeds from this issue were used to repay
amounts borrowed under the Company's master repurchase agreement.
4
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Safe Harbor Statement
"Safe Harbor" statement under the Private Securities Litigation Reform Act
of 1995: Statements in this discussion regarding NovaStar Financial, Inc. (the
Company) and its business which are not historical facts are "forward-looking
statements" that involve risk and uncertainties. For a discussion of such
risks and uncertainties, which could cause actual results to differ from those
contained in the forward-looking statements, see "Risk Factors" commencing on
page 15 of the Prospectus included in the Company's registration statement on
Form S-11 (registration number 333-32327) declared effective on October 24,
1997.
Overview
The Company is a specialty finance company engaged in the business of
acquiring primarily single family residential subprime mortgage loans. The
Company was incorporated on September 13, 1996. Through a private placement, the
Company raised $47 million in December 1996, allowing it to commence operations.
Investments earned $155,000, while general and administrative costs were
$457,000, resulting in a net loss of $302,000 during the period from inception
to December 31, 1996. Those operating results are not meaningful to the on-going
operations of the Company. The asset size of the Company has grown since the
initial capitalization to $699 million as of September 30, 1997. The operating
results and financial condition of the Company reflect this growth and should be
interpreted accordingly.
The Company owns 100 percent of the non-voting preferred stock of NFI
Holding Corporation (Holding) for which it receives 99 percent of any dividends
paid by Holding. The founders of the Company own the voting common stock of
Holding. NovaStar Mortgage is a wholly owned subsidiary of Holding. Certain key
officers of the Company serve as officers of Holding and NovaStar Mortgage and
the founders are the only members of the Board of Directors of Holding and
NovaStar Mortgage. The Company accounts for its investment in Holding using the
equity method.
The Company generates income principally from the earnings on its Mortgage
Assets. The Company uses a combination of equity and borrowings to finance the
acquisition of its Mortgage Assets. The Board of Directors has established
Capital Allocation Guidelines ("CAG") which assist management in assessing the
appropriate combination of equity and debt. The CAG are intended to keep the
Company properly leveraged by (i) matching the amount of leverage allowed to the
riskiness (return and liquidity) of an asset and (ii) monitoring the credit and
prepayment performance of each investment to adjust the required capital. Until
the Company is fully leveraged, it will not reach its full earnings potential.
Since inception, the Company has used less debt financing than the maximum
allowed under the CAG as it has reserved the use of equity funding for future
loan acquisitions.
A significant portion of the Company's Mortgage Assets earn adjustable
interest rates based on short-term interest rates. All of the Company's
borrowings bear short-term rates of interest. As a result, net interest income
depends on prevailing market rates, as well as the volume of interest-earning
assets and interest-bearing liabilities. Increases in short-term interest rates
will generally increase the yield on Mortgage Assets and the cost of related
borrowings. However, to the extent that borrowing costs adjust at different
times or amounts relative to the yield on Mortgage Assets, the Company is
subject to interest rate risk. When the cost of borrowings increases more
rapidly than the yield on assets, net interest income may be reduced.
Conversely, decreases in short-term rates may decrease the interest cost on the
Company's borrowings more rapidly than the yield on assets causing an increase
in net interest income. Management monitors and aggressively manages interest
rate risk. However, the Company's Mortgage Asset portfolio cannot be completely
hedged against changing interest rates.
A major component of the operations of the Company is the equity in
earnings (loss) of NFI Holding Corporation, which includes the results of
NovaStar Mortgage. Many costs of NovaStar Mortgage are directly related to the
infrastructure necessary to support current period wholesale loan production,
which has grown from a monthly total of $2.9 million in February 1997 to $51.3
million in September 1997. Revenue, on the other hand, is dependent on the size
and composition of the Company's Mortgage Asset portfolio. As a result, during
the first nine months of 1997, the Company's operating results reflect the
substantial costs related to building the mortgage lending and servicing
infrastructure and have exceeded the income from the Company's portfolio of
Mortgage Assets. Management believes that infrastructure will allow NovaStar
Mortgage to originate Mortgage Assets at favorable prices compared to those
which could be acquired in the secondary market.
The Company's borrowers generally have substantial equity in the property
securing the loan, but have impaired or limited credit profiles or higher debt-
to-income ratios than traditional mortgage lenders allow. The Company's
5
<PAGE>
borrowers also include individuals who, due to self-employment or other
circumstances, have difficulty verifying their income, as well as individuals
who prefer the prompt and personalized service provided by the Company. Because
these borrowers typically use the proceeds of the loan to consolidate and
refinance debt, and to finance home improvements, education and other consumer
needs, it is expected that the volume of loans originated by NovaStar Mortgage
will be less dependent on the general level of interest rates or home sales and
therefore less cyclical than conventional mortgage lending.
Principally through the mortgage lending operation of NovaStar Mortgage,
the Company will continue adding interest-earning assets to its balance sheet.
Prior to the initial public offering, the Company reached the maximum level of
interest-earning assets for the debt/equity mix allowed under its CAG. Securing
additional capital allows the Company to further develop and grow its balance
sheet. The initial public offering increased the Company's capital base by
issuing shares of Common Stock. Capital will, in the short term, be used to
retire certain borrowings. In the long term, proceeds would be used primarily
to acquire additional Mortgage Assets. The Company expects to be able to
continue adding interest-earning assets to more effectively utilize the
Company's human and other resources.
Forgivable Notes Receivable from Founders
The Company's founders received 216,666 units upon closing of the 1996
private placement. A unit consisted of one share of convertible preferred stock
and one common stock warrant. The founders delivered forgivable promissory
notes in payment for these units. Principal on these notes will be forgiven if
certain incentive performance targets are achieved. The incentive tests relate
to the total return generated to investors in the private placement. Total
return includes the appreciation of the Company's stock price, the value of the
warrant, and dividends paid. One tranche will be forgiven for each fiscal
period that the Company generates a total return of 15 percent to investors in
the private placement. All tranches will be forgiven if the Company generates a
100 percent return. As of September 30, 1997, the aggregate amount receivable
from founders was $3.4 million, including $210,000 of accrued interest.
Investors in the 1996 private placement offering paid $15 for each unit
acquired. Warrants issued in connection with the private placement were
assigned a value of $1.50. During October 1997, the Company completed an
initial public offering of its common stock at a price of $18 per share.
Accordingly, it is likely the Company will achieve a 15% return to private
placement investors during 1997, resulting in the forgiveness of one tranche of
the forgivable notes. This will result in the recognition of $1.1 million non-
cash charge to earnings during the 1997 fourth quarter.
Financial Condition as of September 30, 1997
During the first five months of 1997, the Company added over $200 million
in mortgage loans to its balance sheet through the purchase of bulk pools of
loans originated by other mortgage lenders. After that time, the Company has not
purchased any bulk pools of loans. During February 1997, NovaStar Mortgage
originated its first wholesale production loans. From that time through
September 30, 1997, NovaStar Mortgage has originated 1,602 wholesale production
loans with an aggregate principal amount of $227 million. The Company has
purchased all loans originated by NovaStar Mortgage during 1997. Table I is a
summary of wholesale loan originations and bulk acquisitions by month.
<TABLE>
<CAPTION>
Table I
Wholesale Originations and Bulk Acquisitions
Nine Months Ended September 30, 1997 (dollars in thousands)
- ------------------------------------------------------------------------------------------------------------------------------------
Wholesale Originations Bulk Acquisitions Total
---------------------- ---------------------- ----------------------
Number Principal Number Principal Number Principal
of Loans Amount of Loans Amount of Loans Amount
<S> <C> <C> <C> <C> <C> <C>
January........................................ - $ - 851 $ 94,710 851 $ 94,710
February....................................... 17 2,941 376 41,784 393 44,725
March.......................................... 51 9,747 195 20,938 246 30,685
April.......................................... 132 19,219 427 39,753 559 58,972
May............................................ 173 29,964 103 10,055 276 40,019
June........................................... 204 28,509 - - 204 28,509
July........................................... 271 35,228 - - 271 35,228
August......................................... 365 50,073 - - 365 50,073
September...................................... 389 51,280 - - 389 51,280
----- -------- ----- -------- ----- --------
Total.......................................... 1,602 $226,961 1,952 $207,240 3,554 $434,201
===== ======== ===== ======== ===== ========
</TABLE>
6
<PAGE>
Tables II and III set forth the Company's mortgage loan portfolio at
September 30, 1997 by credit grade and geographic diversification. Although some
credit grade and geographic concentrations exist due to the mortgage loans
obtained via bulk loan acquisitions, over time the Company intends to diversify
the credit grade and the geographic population of its mortgage loan portfolio.
Table II
Mortgage Loans by Credit Grade
September 30, 1997 (dollars in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Principal Percent of Loan to
Balance Total Value Ratio
--------- ---------- -----------
<S> <C> <C> <C>
A.......................................... $179,715 44% 76%
A-......................................... 112,794 28 77
B.......................................... 73,369 18 75
C.......................................... 28,367 7 69
D.......................................... 10,403 3 63
-------- ---
Total...................................... $404,648 100% 75%
======== ===
</TABLE>
Table III
Mortgage Loans by State
September 30, 1997 (dollars in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Principal Percent
Amount of Total
---------- ----------
<S> <C> <C>
California.......................................... $126,679 31%
Washington.......................................... 35,980 9
Florida............................................. 26,803 7
Utah................................................ 24,733 6
Texas............................................... 22,925 6
Others.............................................. 167,528 41
-------- ---
Total............................................... $404,648 100%
======== ===
</TABLE>
The Company has been an active investor in mortgage securities issued by
Government-sponsored entities. During the nine months ended September 30, 1997,
the Company acquired securities with an aggregate cost of $380.8 million and
sold securities with an aggregate carrying value, at the time of sale, of $99.8
million. As of September 30, 1997, mortgage securities totaled $267.8 million.
Loans originated through the lending operations of NovaStar Mortgage have
typically been funded through NovaStar Mortgage's $50 million mortgage loan
warehouse agreement with First Union National Bank. The Company has a $300
million master repurchase line with Merrill Lynch Mortgage Capital, Inc. and
Merrill Lynch Credit Corporation to fund acquisitions of Mortgage loans. During
the third quarter, the line was temporarily increased to $400 million while the
Company was preparing for the private placement of its CMO. During the first
nine months of 1997, funds borrowed under this agreement were used to acquire
some of the largest pools of mortgage loans acquired by the Company. Funds
borrowed against the master repurchase agreement are also used to buy loans from
NovaStar Mortgage, which in turn pays down advances under its warehouse line of
credit to free its use for further wholesale production. Management expects to
continue using this method for the short-term financing of its mortgage lending
operation.
Acquisitions of agency-issued mortgage securities have been financed by
using individual assets as collateral for repurchase agreements. These
agreements have been executed with a number of reputable securities dealers.
Management expects to continue using this method to finance its acquisition of
mortgage securities.
Under the terms of all financing arrangements, lending institutions require
"over-collateralization" from the Company. The value of the collateral generally
must exceed the allowable borrowing by two to five percent. As a result, the
Company must have resources available to cover this "haircut." Proceeds from the
private placement have been used for such purpose. Management expects to use
proceeds from future capital issuances in this manner.
Amounts outstanding under borrowing arrangements aggregated $644.2 million
as of September 30, 1997.
7
<PAGE>
The Company expects to make a regular practice of aggregating substantially
all of its outstanding mortgage loans to serve as collateral for the issuance of
its own collateralized mortgage obligations ("CMO"). Proceeds from these
issuances will be used to repay amounts borrowed under its repurchase and other
short-term financing agreements. This will free those facilities for further
asset acquisitions.
The Company issued its first CMO during October 1997 in a private
transaction in which approximately $276 million in mortgage loans serve as
collateral of debt issued with a face amount of $264 million. The debt issuance
has an estimated life of 2.0 years and bears interest based on one month LIBOR
plus 25 basis points, which resets monthly. Proceeds from the issuance of this
CMO were used to repay amounts borrowed under the Company's master repurchase
agreement.
Results of Operations -- Nine Months Ended September 30, 1997
Net Interest Income
Interest Income. The Company had average interest-earning assets of $351.6
million during the nine months ended September 30, 1997, including $135.4
million of mortgage securities, and $216.2 million of mortgage loans. During the
nine-month period, mortgage securities earned $6.8 million, or a yield of 6.7
percent, while mortgage loans earned $14.7 million, or a yield of 9.1 percent.
In total, assets earned $21.5 million, or an 8.2 percent yield.
A substantial portion of the mortgage loans owned by the Company have
interest rates that fluctuate with short-term market interest rates. However,
many of these mortgage loans have initial coupons lower than current market
rates ("teaser" rates). As a result, during the first nine months of 1997 these
assets, collectively, have not adjusted upward to their full potential coupon
rate. This results in a temporarily lower rate and lower interest yield to the
Company. As these assets "season," they should increase to their higher rates
and result in higher yields to the Company.
The Company acquires substantially all of its mortgage loans at a premium.
Such premiums are amortized as a reduction of interest income over the estimated
lives of the assets. If mortgage principal repayment rates accelerate, the
Company will recognize more premium amortization, thereby reducing the effective
yield on the assets. Decelerating repayment rates will have the opposite effect
on asset yields. To mitigate the effect of prepayments, the Company generally
strives to acquire mortgage loans that have some form of prepayment penalty. Of
all loans acquired from NovaStar Mortgage during the nine months ended September
30, 1997, 73 percent had prepayment penalties for at least the first two years
of the loan. Fifty-four percent of the loans acquired through bulk purchases by
the Company had prepayment penalties. For loans with prepayment penalties, the
weighted average prepayment penalty period is 2.7 years for mortgage loans
originated by the Company and 3.0 years for those acquired through bulk
purchases.
As noted above, interest income is a function of volume and rates.
Management expects its Mortgage Asset portfolio to continue to increase through
wholesale loan originations. Management will continue to monitor the market for
mortgage securities and whole loan mortgage pools and will acquire Mortgage
Assets that are appropriate for its overall asset/liability strategy. Increasing
volume of assets will cause future increases in interest income, while declining
balances will reduce interest income. Market interest rates will also affect
future interest income.
Interest Expense. The cost of borrowed funds for the Company was $16.2
million during the nine months ended September 30, 1997, or 6.4 percent of
average borrowings. Advances under the master repurchase agreement bear interest
at rates based on LIBOR, plus a spread. During the nine months ended September
30, 1997, the one-month LIBOR averaged 5.6 percent. As with interest income, the
Company's cost of funds in the future will largely depend on market conditions,
most notably levels of short-term interest rates. Rates on other borrowings
generally fluctuate with short-term market interest rates, such as LIBOR or the
Federal Funds rate.
Table IV presents a summary of the average interest-earning assets, average
interest-bearing liabilities, and the related yields and rates thereon for the
nine months ended September 30, 1997.
8
<PAGE>
<TABLE>
<CAPTION>
Table IV
Interest Analysis
Nine Months Ended September 30, 1997 (dollar amounts in thousands)
- -------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Daily Interest Annual
Average Income/ Yield/
Balance Expense Rate
Interest-earning Assets
Mortgage securities............................................... $135,380 $ 6,796 6.69%
Mortgage loans.................................................... 216,233 14,749 9.09
-------- ------- ----
Total interest-earning assets..................................... $351,613 21,545 8.17
======== ======= ====
Interest-bearing Liabilities
Master repurchase agreement....................................... 191,673 9,747 6.78
Other repurchase agreements....................................... 127,911 5,646 5.89
Other borrowings (1).............................................. 16,397 831 6.76
-------- ------- ----
Total borrowings.................................................. $335,981 16,224 6.44
======== ------- ----
Net interest income............................................... $ 5,321
=======
Net interest spread............................................... 1.73%
====
Net yield......................................................... 2.02%
====
</TABLE>
- -----------
(1) Represents borrowings of NovaStar Mortgage and interest paid thereon. The
Company reimburses NovaStar Mortgage for interest incurred under the terms
of an Administrative Services Outsourcing Agreement.
Net Interest Income and Spread. Net interest income during the first nine
months of 1997 was $5.3 million, or 2.02 percent of average interest-earning
assets. Net interest spread for the Company was 1.73 percent during the nine
months ended September 30, 1997. Net interest income and the spread are
functions of the yield of the Company's assets relative to its costs of funds.
During the first half of 1997, the cost of funds was relatively low and stable.
This lower cost of funds offsets, to some degree, the lower yield on "teased"
assets, as discussed above. In addition, the Company has entered into interest
rate agreements to mitigate the exposure to variations in interest rates on
interest-earning assets that are different from the variations in interest
incurred on borrowings. The volume of assets and liabilities and how well the
Company manages the spread between earnings on assets and the cost of funds will
dictate future net interest income.
Impact of Interest Rate Agreements. During the nine months ended
September 30, 1997, the Company entered into certain interest rate agreements
designed to mitigate exposure to interest rate risk. Two of these agreements are
interest rate cap agreements, with a combined notional amount of $170 million,
which require the Company to pay a monthly fixed premium while allowing it to
receive a rate that adjusts with LIBOR, when rates rise above a certain agreed-
upon rate. The other agreements are simple fixed to floating interest rate swaps
with an aggregate notional amount of $191 million. These agreements are used to
alter the interest rates on funding costs to more closely match the yield on
interest-earning assets. During the nine months ended September 30, 1997, the
Company incurred net interest expense on these agreements of $808,000. Net
income earned from or expense incurred on these agreements is accounted for on
the accrual method and is recorded as an adjustment to interest expense.
Gains and Losses on Securities Sales
The Company classifies its mortgage securities as available-for-sale
because management may deem it appropriate to sell securities, from time to
time, to reallocate the Company's capital. Since inception, the Company has not
sold any mortgage loans and, as a general rule the Company does not intend to
sell mortgage loans in the future. The Company's strategy is to hold and service
mortgage loans in order to earn the spread over the life of the loans, rather
than sell the loans and recognize the gain or loss in the current period.
9
<PAGE>
Provisions for Credit Losses
In 1997, the Company started providing regular allowances for credit losses
in connection with its initial bulk purchases of loans and wholesale
originations. The Company has not experienced any credit losses to date, but
management expects that losses will be incurred in the future. The Company
regularly evaluates the potential for credit losses for mortgage loans held in
its portfolio. Since the Company has limited actual performance history for its
loan portfolio, losses have been provided for primarily based on general
industry trends and on the judgement of the Company's management.
The Company believes that loan defaults occur throughout the life of a loan
or group of loans. As a result, the Company believes it is appropriate to record
provisions for credit losses against income over the estimated life of the
loans, rather than immediately upon acquisition of the loan. Currently, the
Company provides for credit losses depending on the type and credit grade of
loans comprising the portfolio. The amount of the provision as a percent of the
loans will vary. During the nine months ended September 30, 1997, the Company
provided $1,444,000 for credit losses.
Table V presents a summary of delinquent loans as of September 30, 1997.
The low level of delinquencies is reflective of the short amount of time loans
originated or acquired by the Company have been outstanding. Management expects
to experience higher rates of delinquency in the future and has established the
appropriate staff and policies to monitor delinquencies.
<TABLE>
<CAPTION>
Table V
Loan Delinquencies
As of September 30, 1997
- ---------------------------------------------------------------------------------------
<S> <C> <C>
Outstanding Percent of Total
Principal Mortgage Loans
Loans delinquent 60 to 90 days................. $ 7,179 1.77%
Loans delinquent greater than 90 days.......... 5,941 1.47
------- ----
Loans delinquent greater than 60 days.......... $13,120 3.24%
======= ====
</TABLE>
General and Administrative Expenses
Table VI displays general and administrative expenses for the nine months
ended September 30, 1997.
<TABLE>
<CAPTION>
Table VI
General and Administrative Expenses
Nine Months Ended September 30, 1997
(in thousands)
- -------------------------------------------------------
<S> <C>
Administrative services provided by
NovaStar Mortgage................... $ 2,450
Compensation and benefits.............. 701
Loan servicing (1)..................... 694
Professional and outside services...... 430
Office administration.................. 201
Other.................................. 288
-------
Total.................................. $ 4,764
=======
</TABLE>
- ------------------
(1) Included in this amount are servicing fees paid to NovaStar Mortgage of
$58,000. NovaStar Mortgage began servicing the loans of the Company
effective July 15, 1997. Prior to this date, the Company's loans were
serviced by an outside servicer.
The primary component of general and administrative expenses is the
administrative service fee paid to NovaStar Mortgage. NovaStar Mortgage provides
mortgage loan underwriting and funding services on behalf of the Company. During
the nine months ended September 30, 1997, the fee paid for these services was
$2,450,000.
10
<PAGE>
Compensation and benefits include employee base salaries, benefit costs and
incentive bonus awards. The number of employees and the related compensation
costs have increased throughout the first nine months of 1997 as the Company has
continued to hire staff.
Loan servicing consists of direct costs associated with the mortgage loan
servicing operation, which the Company outsourced until July 15, 1997. Effective
July 15, 1997, the Company engaged NovaStar Mortgage to service its mortgage
loans. Management believes that by servicing its own mortgage loans (through
NovaStar Mortgage), the Company will be able to more readily monitor and control
delinquencies and defaults. Management believes this is particularly important
in the subprime sector of the mortgage industry. In addition, management
believes cost efficiencies can be gained from servicing the Company's loans "in
house".
Professional and outside services includes the cost of contract labor, as
well as fees for legal and accounting services. Management has used contract
labor services extensively during the development of its operations during the
nine months ended September 30, 1997, particularly in the area of systems
development. As permanent employees are hired, management anticipates using
contract labor to a lesser extent during the remainder of 1997. Legal fees
during the nine months ended September 30, 1997 relate to the execution of
numerous agreements with market counterparties.
Office administration includes such items as telephone, office supplies,
postage, delivery, maintenance and repairs. Certain of these items have been
necessarily high during the start up phase of the Company. Management expects
many of these expenses to increase relative to production in future periods.
Equity in Earnings of Unconsolidated Subsidiary
The Company owns 100 percent of the preferred stock and receives 99 percent
of the economic benefits of Holding, which wholly owns NovaStar Mortgage. The
Company accounts for its investment in Holding on the equity method. For the
nine months ended September 30, 1997, Holding incurred a loss of $143,000, of
which the Company recorded its portion ($142,000). The loss generated by Holding
is a result of the significant general and administrative expense incurred by
NovaStar Mortgage in building its wholesale lending infrastructure. NovaStar
Mortgage incurs significant general and administrative expenses in generating
loan production. The Company pays NovaStar Mortgage an administrative
outsourcing fee for costs associated with its loan production operation as the
Company purchases these loans at the time of funding.
During the first nine months of 1997, NovaStar Mortgage incurred
significant costs in developing its infrastructure for the loan origination
operation. The primary expense for NovaStar Mortgage is compensation and
benefits for its sales, underwriting and supporting staffs. Substantial expenses
related to professional fees were also incurred.
Net Loss
During the nine months ended September 30, 1997, the Company recorded a net
loss of $702,000, primarily as a result of the significant costs associated with
the development of its operations and NovaStar Mortgage. During the first part
of 1997, the Company focused on the hiring of key employees and the development
of policies and procedures. The results for the nine months ended September 30,
1997 also reflect the significant cost of developing operations. During the
Company's rapid expansion in 1997, the Company's operating expenses have
increased more rapidly than its revenues.
Results of Operations - Three Months Ended September 30, 1997
Net Income
During the three months ended September 30, 1997, the Company realized net
income of $177,000. The components of net income are discussed in the following
paragraphs.
Net Interest Income
The Company had average interest-earning assets of $629.0 million during
the three months ended September 30, 1997, including $277.7 million of mortgage
securities, and $351.3 million of mortgage loans. During the three-month
11
<PAGE>
period, mortgage securities earned $4.5 million, or a yield of 6.6 percent,
while mortgage loans earned $7.7 million, or a yield of 8.7 percent. In total,
assets earned $12.2 million -- a yield of 7.77 percent.
During the three months ended September 30, 1997, borrowed funds for the
Company averaged $593.2 million on which interest was incurred of $9.8 million,
or 6.6 percent. During the three months ended September 30, 1997, one month
LIBOR (the rate on which the Company pays interest on its master repurchase
agreement) averaged 5.7 percent. Rates on other borrowings generally fluctuate
with short-term market interest rates, such as LIBOR or the Federal Funds rate.
Net interest income during the three months ended September 30, 1997 was
$2.4 million, or 1.55 percent of average interest-earning assets. Net interest
spread for the Company was 1.18 percent during the three months ended September
30, 1997.
Provisions for Credit Losses
During the three months ended September 30, 1997, the Company provided
$726,000 for credit losses. Reserves are maintained for losses management
expects to incur on loans in the portfolio.
General and Administrative Expenses
General and administrative expenses during the three months ended September
30, 1997 were $2.1 million. Consistent with prior periods, the single largest
component of general and administrative expenses is the administrative
outsourcing fee paid to NovaStar Mortgage. Compensation and benefits totaled
$332,000 during the third quarter. The Company continues to develop its benefit
structure and, therefore, employee costs are expected to increase relative to
staff size.
Professional and outside services include legal fees and contract labor for
the development of information systems.
Loan servicing costs include direct costs of managing the loan portfolio
which are not reimbursable by the borrower. In addition, loan servicing costs
include fees associated with the outside service provider who serviced the
Company's loans through July 15, 1997 and the fees associated with NMI servicing
the loans since July 15, 1997.
Equity in Earnings of Unconsolidated Subsidiary
For the three months ended September 30, 1997, Holding realized net income
of $293,000, of which the Company recorded its portion ($290,000). Earnings
during this period are primarily due to the significant increase in the
administrative fee received from the Company related to building its wholesale
lending infrastructure and to gains realized on the sale of mortgage securities.
Taxable Income (Loss)
Income reported for financial reporting purposes as calculated in
accordance with generally accepted accounting principles (GAAP) differs from
income computed for income tax purposes. This distinction is important as
dividends paid to the Company's stockholders are based on taxable income. For
tax purposes, the provision for credit losses is not deductible. In addition,
income reported for financial reporting purposes includes the results of Holding
under the equity method. Such entities are excluded in the preparation of the
Company's income tax returns. Table VII is a summary of the differences between
the net loss reported for GAAP, as reported herein, and taxable income of NFI.
12
<PAGE>
<TABLE>
<CAPTION>
Table VII
Taxable Income
Nine and Three Months Ended September 30, 1997 (in thousands)
- -----------------------------------------------------------------------------------------
Nine Months Three Months
Ended Ended
<S> <C> <C>
Net income (loss)...................................... $ (702) $ 177
Results of NFI Holding Corporation, Inc. and subsidiary 143 (393)
Provision for credit losses............................ 1,444 726
Other, net............................................. (14) (4)
------ -----
Taxable income--NovaStar Financial, Inc................ $ 871 $ 506
====== =====
</TABLE>
Liquidity and Capital Resources
Liquidity, as used herein, means the need for, access to and uses of cash.
The Company's primary needs for cash include the acquisition of Mortgage Assets,
principal repayment and interest on borrowings, operating expenses and dividend
payments. The Company has a certain amount of cash on hand to fund operations.
The Company requires access to short-term credit facilities to fund its
acquisition of wholesale loan originations and mortgage securities. Also,
principal, interest and fees received on Mortgage Assets will serve to support
the cash needs of the Company. Major cash requirements are typically satisfied
by drawing upon various borrowing arrangements.
The Company also has available a $300 million master repurchase agreement.
In addition, the Company has been approved as a borrower from other reputable
securities dealers for repurchase agreements to fund the acquisition of mortgage
securities. On a long-term basis, the Company will pool its mortgage loans to
serve as collateral for its CMOs. By doing so, the loans will be cleared as
collateral for the master repurchase agreement and the warehouse line of credit,
freeing those arrangements to fund further loan originations. Although it
generally does not intend to do so, all mortgage securities are classified as
available-for-sale and could be sold in the open market to provide additional
cash for liquidity needs.
On October 30, 1997, the Company also successfully completed its initial
public offering of 3,750,000 shares of common stock at $18 per share. Net
proceeds of the offering were $62,775,000, which approximately 90 percent of the
proceeds will be used to fund the acquisition of the wholesale loan production
of NovaStar Mortgage and the acquisition of mortgage securities, in accordance
with its business strategies. The remaining 10 percent of the net proceeds will
be used for working capital and general corporate purposes.
The Company's business requires substantial cash to support its operating
activities and growth plans. Management believes that net proceeds from the
initial public offering, together with existing funds and amounts available
under credit facilities, will be sufficient to fund its operations for the next
twelve months, if future operations are consistent with management's
expectations.
For the nine months ended September 30, 1997, operating activities and
financing activities provided cash of $3.3 million and $649.5 million, while
investing activities used cash of $695.1 million.
Inflation
Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates and other factors drive the Company's
performance far more than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates. The
Company's financial statements are prepared in accordance with generally
accepted accounting principles and the Company's dividends are determined by the
Company's net income as calculated for tax purposes. In each case, the company's
activities and balance sheet are measured with reference to historical cost or
fair market value without considering inflation.
Impact of Recently Issued Accounting Pronouncements
Note 1 to the financial statements of the Form S-11 dated October 24, 1997
describes certain recently issued accounting pronouncements. Management believes
the implementation of these pronouncements and others that have gone into effect
since the Form S-11 date, will not have a material impact on the financial
statements.
13
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As of September 30, 1997, there were no material legal proceedings pending
to which the Company was a party or of which any of its property was
subject.
Item 2. Changes in Securities
Not applicable
Item 3. Defaults upon Senior Securities
Not applicable
Item 4. Submission of Matters of Vote of Security Holders
(a) The 1997 annual meeting of shareholders of the Company was held
on September 18, 1997.
(b) The following matters were voted on at the annual meeting:
Vote
-------------------------
For Against Abstain
-------------------------
1. Election of Director Ed W. Mehrer 3,094,560 0 0
The following Directors' terms of office continue after the
meeting:
Scott F. Hartman
W. Lance Anderson
Gregory T. Barmore
Jenne K. Britell
Vote
-------------------------
For Against Abstain
-------------------------
2. Ratification of KPMG Peat Marwick
LLP as the Company's independent
public accountants for the fiscal
year 3,094,560 0 0
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed with this report are as follows:
11.1 Schedule regarding computation of per share earnings
27.1 Financial data schedule
(b) The Company filed no reports on Form 8-K during the quarter ended September
30, 1997.
14
<PAGE>
NOVASTAR FINANCIAL, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NOVASTAR FINANCIAL, INC.
/s/ Scott F. Hartman
DATE: November 13, 1997 ------------------------------------
Scott F. Hartman
Chairman of the Board, Secretary and
Chief Executive Officer
(Principal Executive Officer)
/s/ Rodney E. Schwatken
DATE: November 13, 1997 ------------------------------------
Rodney E. Schwatken
Vice President, Controller and
Assistant Treasurer
(Principal Accounting Officer)
15
<PAGE>
EXHIBIT 11.1
SCHEDULE REGARDING COMPUTATION OF PER SHARE EARNINGS
(OOO'S EXCEPT PER SHARE DATA)
NINE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, 1997 SEPTEMBER 30, 1997
------------------ ------------------
Net income (loss) $ (702) $ 177
Weighted average common shares 3,767 3,767
Common equivalent shares:
Dilutive Stock options 77 77
Dilutive Warrants 429 429
------ -----
Common and common equivalent shares 4,273 4,273
Earnings (loss) per common and common
equivalent share $(0.16) $0.04
====== =====
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND> THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM
THE COMPANY'S FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 1997 AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-END> SEP-30-1997
<CASH> 4,236
<SECURITIES> 267,835
<RECEIVABLES> 418,897
<ALLOWANCES> 1,444
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 699,133
<CURRENT-LIABILITIES> 0
<BONDS> 0
0
36
<COMMON> 2
<OTHER-SE> 46,998
<TOTAL-LIABILITY-AND-EQUITY> 699,133
<SALES> 21,545
<TOTAL-REVENUES> 21,545
<CGS> 0
<TOTAL-COSTS> 20,988
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 1,444
<INTEREST-EXPENSE> 16,224
<INCOME-PRETAX> (702)
<INCOME-TAX> 0
<INCOME-CONTINUING> (702)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (702)
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
