NewtekOne’s Business Model: Deep Dive On The Engine’s Mechanics

“If it looks like a duck, and quacks like a duck, it has to be a duck” seems to be the mentality mantra behind much of the discourse around NewtekOne (NASDAQ:NEWT). I hope I was able to put to rest the confusion stemming from the BDC wrapper with my previous article. Now that the transition towards financial holding company (‘FHC’) is complete, the next confusion is the community bank label that the markets have tattooed onto seemingly all discourse on NewtekOne. This confusion is just as bad as the BDC confusion, because I believe (still) that the market is way behind the curve on how to understand NewtekOne.

Once again, I will get a chance to legitimately use the straw-man argumentation technique, where I will construct the confused false image of NewtekOne that the market seems to have, and subsequently tear it down to show what NewtekOne really is. Until the markets understand what NewtekOne really is, the stock will languish in the parking lot of trading in terms of a multiple of tangible book value that reflects the community bank label. I strongly believe that the faster an investor is at understanding NewtekOne’s true nature, the more opportunity they will have at profiting from owning shares.

Straw Man: NewtekOne Is A Community Bank

NewtekOne has converted to an FHC. This means that it for all intents and purposes, it is identical to a small community bank, and should be treated and valued as one. Let’s paint an image of what a community bank is.

If it has $1 billion in assets, then suppose for simplicity, 80% of the assets are in the form of residential mortgages (mostly fixed rate), 10% of the assets are in the form of auto loans (essentially all fixed rate), and the remaining 10% is in cash & short term securities, and a rounding error for the real estate and office equipment the bank uses. Such a bank would have about $800-900 million in deposits, in a mixture of checking, savings, and CDs. The bank would need to pay interest on these deposits.

Notice that a community bank is entirely at the mercy of what are essentially commodity prices that just about all pure banks are subject to:

• Residential mortgage rates
• Automobile loan rates
• Checking & savings account rates
• CD rates
• Employee salaries

In no respect does this community bank partake in any activity on the secondary financial markets. If it ever does participate, it is in the trading of loans as commodities for liquidity or balance sheet purposes. So, how would market conditions affect NewtekOne’s profits?

The yield curve is the big one. If the yield curve inverts, rates on short term deposits must rise, thereby pressuring profit margins, because residential and automobile loan rates are fixed. Such a community bank would profit only when the yield curve has a positive slope. The right way to value a community bank is therefore to treat it as a commodity – there are thousands of these community banks floating around in the USA, each behaving in a similar way.

A multiple to tangible book value of 0.8x – 1.5x is about right, with room to quibble on the details of the financials and local market to dictate exactly where on the 0.8x – 1.5x range the valuation should be. And that closes the book on everything there could be to say about NewtekOne.

Not so. The conference call for Q4 2022 results included some illustrative slides which I found very helpful. Here is the link for reference.

NewtekOne Sells Guaranteed Portions Of SBA Loans At A Profit

The Q4 2022 conference call gave an excellent illustration of the economics of selling SBA loans. In this example, the loan is for $1,000,000, which is split between a $750,000 guaranteed portion and a $250,000 unguaranteed portion. The guaranteed portion is sold at a premium, while the unguaranteed portions are pooled and securitized.

The amount of premium that the guaranteed portion sells for is a function of the treasury yield curve and its motions. The term of the loan tells us the relevant part of the treasury yield curve for pricing. If the 25 year interest rate falls, then the premium is bigger, and if the 25 year interest rate rises, the premium is smaller. This premium is anywhere from 6-20% of the amount of the principal of the guaranteed portion.

In practice, any portion of premium above 10% is split 50/50 with the SBA, which is reflected in this example by NewtekOne keeping 10.50% of a total of 11% of premium, the “Realized Gains on Guaranteed Balance”. Then, the remaining $250,000 portion is securitized, and notes sold against it. The advance rate in this example is 83.5% of the face value of the loans, giving the $208,750 “Cash Received in Securitization”. The higher the advance rate, the better for NewtekOne.

Note that the “Realized Gains on Guaranteed Balance” cancels out the part of the advance rate that is not 100%. This means that after the cancelling, the cash created by securitization is $37,500. This means that securitization profits are sensitive to both the treasury yield curve (via the premium on selling the guaranteed portion), as well as the advance rate.

What this hides though is the leftover interest after the securitization notes are covered. Newtek effectively owns the subordinated preferred tranche of a CLO. Let me explain.

Example: Eleventh Securitization Transaction

In December 2021, NSBF completed its eleventh securitization which resulted in the transfer of $103.4 million of unguaranteed portions of SBA loans to the 2021-1 Trust, The 2021-1 Trust in turn issued securitization notes for the par amount of $103.4 million, consisting of $79.7 million of Class A notes and $23.8 million Class B notes, against the 2021-1 Trust assets in a private placement. The Class A and Class B notes received an “A” and “BBB-” rating by S&P, respectively, and the final maturity date of the notes is December 2048. The Class A and Class B notes bear interest at an average rate of LIBOR plus 1.92% across both classes.

– from 2021 10-K, page 115

Let’s do some arithmetic. Suppose that LIBOR today is 5.00%, the weighted average interest rate on the loans is prime + 3.0% (where prime is 7.75%), and NewtekOne got an 80% advance rate.

Assuming those numbers, on $103.4M of loans, NewtekOne is annually receiving $11.16M of interest income, and paying out $7.16M in interest on the securitization notes. This means that NewtekOne would be keeping $4.00M annually as a profit. If the Class A notes correspond to an A tranche of a CLO, and the Class B notes correspond to a BBB tranche of a CLO, then NewtekOne is effectively the owner of the subordinated tranche of a CLO.

Why is leverage so important to NewtekOne? One reason is the ability to own more of these de-facto subordinated tranches of the CLO. Part of the reason why NewtekOne can generate such high returns on equity is that in the loan issuance, sale, and securitization process, NewtekOne is creating for itself these subordinated tranches for free. The more leverage that NewtekOne can have, the more de-facto subordinated tranches NewtekOne can own.

Conclusion Here: assuming these numbers, for every $1M in loans that NewtekOne originates, NewtekOne is creating $37,500 of net cash up front due to sale of both the guaranteed and unguaranteed portions of the loans. Additionally, the $250,000 of unguaranteed portion that goes into the CLO that NewtekOne is creating, whose subordinated tranche is kept by NewtekOne, and keeping means that NewtekOne additionally receives an additional $9,671/year in income from that tranche, for as long as the CLO and trust are in force.

NewtekOne’s Fully Controlled Companies

The 2022 10-K might be the last really good glimpse we have of how the fully controlled portfolio companies are performing, before they get consolidated away into the FHC’s financial statements. So while we can see them, I’ll outline what contribution these companies are projected to make in the next two years, per management’s forecasts. These two images are excerpts of the Q4 2022 Conference Call slide deck, slides 17 and 18:

There is much fine-grained detail that is lost in these consolidated projections, written for a top-down view of an FHC. The first half of the projection shows that Newtek Bank will be the primary contributor of Net Interest Income. However, this is not the star of the show. Remember that acquiring the bank to reverse merge into an FHC was intended to both increase the amount of leverage allowed on the regulatory basis, as well as be able to retain earnings. The primary purpose was not to become a community bank. The star of the show is the Noninterest Income and Expenses (immediately above and below).

Not directly shown (but easily calculable figures) for Net Noninterest Income are shown below, that I prepared:

Net Noninterest Income ($ in millions)	FY 2023	FY 2024
Newtek Bank	25.0	48.8
Non-Bank Entities	42.2	64.2
TOTAL	67.2	113.0

Click to enlarge

As you can see, the nonbank entities are responsible for the bulk of the earnings and earnings growth in the projections for the next 2 years. To be precise, these figures are for Newtek Small Business Finance (‘NSBF’) combined with the smaller subsidiaries in payment processing, payroll solutions, etc. As an analyst, I would hope for some more granular breakdown of these figures into the contributions of the constituent subsidiaries. But, there is one last clue about the non-NSBF entities to be gleaned.

Breakdown of Non-Bank Entities

The following breakdown of nonbank entities at Newtek as of December 31, 2021 was obtained and adapted from the 2021 10-K filing.

Most of the value of the nonbank entities are concentrated in four subsidiaries:

• Newtek Technology Solutions
• Newtek Merchant Solutions (which accounts for most value growth)
• Newtek Business Lending
• Newtek Conventional Lending

How were these values arrived at for reporting on the 10-K? Since these are subsidiaries and are not on the market, there are no market quotes or bids for them, so their values depend on significant unobservable inputs. However, if we dig up these significant unobservable inputs, we can get a sense for just how much profit these companies contributed in 2021, by reversing the computation.

The $208.106M of equity was valued at 8.3x EBITDA, implying that in 2021, these subsidiary companies had a total EBITDA of $25.1M. Given that Newtek in 2022 paid a total of $67.1M in dividends, these subsidiary companies are very substantially valuable to shareholders.

In particular, Newtek Merchant Solutions seems a very popular auxiliary service that Newtek’s customers adopt. To put it into perspective, here is its LinkedIn Page. This subsidiary processes $6 billion in transactions annually – a wonderfully impressive tech company inside the NewtekOne wrapper!

Deposit Growth & Cost Of Funds Savings

Before I conclude, my penultimate point will be management’s projection of the growth of deposits at NewtekOne:

Recall that part of the benefit of becoming a FHC and holding a bank is the lower cost of funds. When the Fed Funds rate was zero, BDC bonds were yielding around 4%, which suggests via my own estimate that any new BDC (and by extension FHC) bonds issued in this environment with 4-5% Fed Funds Rate to yield about 8-9%. Becoming an FHC eliminates the credit risk premium on any marginal leverage that NewtekOne uses in its operations, which amounts to the 4% difference between the BDC/FHC bond yield and the Fed Funds Rate.

Naturally, these cost savings would pass right through to the shareholder via dividends or increases in retained earnings. However, how quickly the benefits from this cheaper source of funding is entirely dependent on how quickly NewtekOne can gather deposits. Fortunately, as explained in my last article, NewtekOne has a ready-built funnel for converting customers to wanting to deposit their funds at Newtek Bank. That said, the conference call did not provide any insights as to how management arrived at these numbers, so they will remain purely projections to us. However, that said, any deposit is a net benefit to the shareholder, and I would not be surprised if the problem of optimizing the gathering of deposits is a question of foremost importance to customer-facing personnel at NewtekOne.

Conclusions

In this article, I wished to divert the discourse on NewtekOne away from the easily imagined community bank label, and towards an image that reflects the truly unique business model that NewtekOne has, and projects having in the near future. I hope that you can see the further reasons why NewtekOne is my top stock pick, and not be daunted by the recent choppiness in its trading and possibly see it as convenient entry points for a long-term holding.