Description

Crossroads Systems (OTC: CRSS)

Key Statistics:

Share Price: $7

Fully Diluted Shares Outstanding: 5.96 m

Overview

Crossroads is a fantastic business that has emerged from a complex situation involving a bankruptcy and subsequent merger. It is listed on the pink sheets with very limited public information(non-reporting), but those able to unearth the material will find a highly compelling investment opportunity. The business has significant competitive advantages, an experienced management team, and is growing in the high teens. After researching the company for months, we believe there is a very clear path to the company’s equity at least tripling in value over the next three - four years with a continued growth runway beyond that, all coupled with material downside protection.

Background and Context

The legacy Crossroads was a speculative patent litigation play that did not work out for investors, as their litigation claims reached the US Supreme Court and were all ultimately defeated. All that remained were massive NOL’s that had been accumulated over the previous two decades, and an additional portfolio of untested technology patents. Management realized that the NOL’s and public shell were valuable and embarked on a pre-packaged reorganization that would leave the structure and NOL’s intact.

The plan was to create a “new Crossroads” that was infused with equity and debt capital, then merge with a profitable private company. Old management would resign, and the company would delist from Nasdaq before re-emerging on the pink sheets. As expected, most investors indiscriminately dumped their shares due to the uncertainty and fact that it is rare for equity to emerge from bankruptcy with any value.

In December 2017, the plan came to fruition as Crossroads acquired Capital Plus Financial (CPF), a provider of affordable housing and mortgage financing to underserved communities. In conjunction with the aforementioned capital infusion, owners of CPF received $30.8M of cash and 2.9M newly issued Crossroads shares in the transaction. The transaction allows CPF to shield its significant profits with the NOL’s and created liquidity for existing shareholders. We have been studying CPF and think we have found a gem of a business. It serves a real societal need and has structural advantages that will allow it to capitalize on a long reinvestment runway. Additionally, the company is supported by an excellent board and management team that runs the business in a conservative and shareholder friendly manner.

The Business

CPF serves low to moderate income Hispanic populations as a one-stop shop in their pursuit of home ownership. It currently operates in three geographic markets within Texas – Dallas/Ft. Worth, Houston and San Antonio. There are two sides of the business that create the full-service platform. The first is the home. CPF purchases blighted homes and rehabs them so the buyer can move in without having to make any further improvements. The second is financing in the form of a traditional 30-year fixed rate amortizing mortgage which is provided, carried and serviced by CPF. We’ll walk through the process in some more detail. The company’s mission is highlighted below:

As a community development financial institution (CDFI), Capital Plus Financial provides capital to markets identified as underserved by the community. Capital Plus Financial focuses on homeownership in these underserved markets which will result in positive economic and social impact to the community. Capital Plus Financial originates first lien residential mortgages in low to moderate income communities across Texas.

Originating mortgages in these communities on homes purchased and significantly remodeled by us, helps enhance and sustain our ability to provide critical social services to the communities in which we live and work, positively impacting our quality of life. We believe this is part of a comprehensive solution to revitalize and grow our region.

Capital Plus Financial lends to low to moderate income documented Hispanic borrowers. Approximately 50% of our borrowers have no credit score and the majority are first time homeowners.

Home Sales

First, CPF procures homes to resell, identifying targets in low-income census tracts. They acquire a home for about $80k and invest $20-25k over a three-month period to rehabilitate the property. During this process, CPF acts as general contractor by sub-contracting out the individual projects to other contractors with whom they have relationships. Having density and a history in these markets allows them to negotiate better rates while avoiding the risk of keeping sub-contractors on payroll.

Once the house is ready, it is handed over to an internal marketing team that is comprised of local community members. The house is then marketed through word of mouth and social media with no traditional brokers involved. They announce an open house which usually draws 6 – 15 visitors, and a buyer is normally identified within two open houses. Buyers are free to bring their own financing but more often than not the prospect is interested in help financing the home purchase. At that point, the potential buyer is turned over to an internal loan officer who begins the underwriting and loan process. CPF is very careful to document borrowers against traditional underwriting criteria, and requires documentable evidence of the ability to support the required payments e.g. legal status, W-2, bank statements etc. In whole, closing takes approximately four to six weeks, during which time CPF begins to market their new properties to the other interested families. This gives the company great insight into demand, which to date has been insatiable.

In the end, the finished home is solid for roughly $125-165k, a price at which the typical buyer is able to comfortably support the required payments. Additionally, the buyer tends to have a very positive experience as they have been shepherded through the process by a CPF employee who is familiar with their community and culture. As home buyers have a quality experience, word of mouth becomes a powerful tool that helps build the pipeline of potential buyers.

The above is an example of how a home looks before and after CPF makes the improvements. To peruse one of their marketing arms for finished homes check out: http://vendocasasdfw.com/

Financing

Buying, improving and selling the home is one half of the equation for CPF. The other, equally important piece is providing financing to a buyer who likely doesn’t have access to traditional sources of capital and dislikes interacting with traditional financial institutions.

CPF has a unique and sustainable strategy to secure low-cost capital that allows them to fund their mortgage originations. The basis of this approach is two-fold. The first is simply to underwrite creditworthy customers, and they have been very successful at this over time. They have been in this business for over two decades, including through the financial crisis, and their default rate has been negligible. Our understanding is loans that did default resulted in zero losses. This is because the loans are secured by a deed in trust, which makes repossession relatively straightforward. The home is usually repossessed in no less than 120 days without lengthy judicial proceedings, rehabbed again, and quickly sold to customers on their waiting list. CPF works hard to keep owners in their homes, we believe often exceeding the minimum statutory thresholds, but unfortunately in rare circumstances that is not always the case. In essence, CPF has its own internal work-out group which is a further testament to the value of their vertical integration.

The second aspect of the model is creating a lower cost of capital for themselves than would otherwise be available. They are able to do this through reliance on the Community Reinvestment Act (CRA), which was enacted by Congress in 1977 to ensure banks served all customers in the communities they serve. In order to comply with the CRA, banks must lend and invest in underserved portions of their communities. This can be very cumbersome, especially for smaller banks who don’t have the resources to deploy and document their activities. For more information on the CRA, we recommend watching this video: https://youtu.be/rdOpsTLvbeY               

This pain point for banks can be addressed through what is known as a Certified Community Development Financial Institution (CDFI). The CDFI designation is awarded by the US Treasury to institutions that can demonstrate they promote community development along a stringent set of criteria. CDFI’s help smaller banks because the CRA states that if a bank “invests” through a CDFI, that investment will automatically qualify as CRA-eligible activity without further burden. Banks could choose to loan directly, but most lack the operational infrastructure to do so efficiently, making partnering with a CDFI a much more cost-effective solution.

Traditionally, CDFI’s are non-profits that provide services such as counseling consumers on financial literacy or how to navigate the foreclosure process. However, CPF is rather unique in that it is a for- profit CDFI. What CPF does is partner with local banks to obtain long-term, low-cost funds that they then use to originate mortgages. You can peruse the public CRA filing of many banks and they typically lend sub-4% on 15+-year terms structured as preferred equity or mezzanine debt, which we believe is the range of rates CPF pays. This is a true win-win. Banks love it because this activity counts toward their CRA requirement while earning a positive spread on their capital. CPF loves it because it provides them with low-cost, equity-like capital that they can deploy to their borrowers. Using the 4% assumption and backing into the interest rates in the financials CPF then lends to their customers at around 6.00% above this rate, which is where the company makes a majority of its profits. The typical payment for their customer is about $900/month after a 10% down payment, and they underwrite to traditional mortgage standards. These payments are fixed for the entire 30-year mortgage (with taxes and insurance, levied by third parties as the only variable component).

Beyond banks, CPF is in the process of borrowing from a US Treasury program that facilitates bonds specifically for CDFI’s. The program allows a CDFI to receive $100M (per year with a five year deployment schedule) for 29.5 years at the T-Bill rate, last year that rate was 3.4%. CPF has just submitted an application to participate in this program. Historically, the Treasury has not been able to deploy all funds allocated by Congress due to a lack of eligible borrowers. As such, we believe all signs point toward a $100M bond offering closing later this year. For more information, see the Treasury website on the program: https://www.cdfifund.gov/programs-training/Programs/cdfi- bond/Pages/default.aspx

While all this is happening on the back end, CPF has created a very simple process for the customer to make their monthly payments. Borrowers are able to pay by cash or check through a process that relies on third parties to keeps CPF costs low and the convenience for the customers high. Another source of value is their loan servicing operation that would be hard to replicate for a traditional bank given the socioeconomic and cultural nuances to the borrowing base.

The Market

Home ownership is an incredibly important part of Hispanic culture as homes provide a family with both social stability and a quality long-term investment. However, Hispanics in the US often struggle to attain financing through traditional channels, making home ownership a major challenge. CPF looks to fill this gap and has a long history of serving this unique and large market.

Looking at some market data gives one an appreciation for how large and underserved this market really is. We quote from the initial shareholder letter and Hispanic Wealth Report:

Statistics reported in the most recent Hispanic Wealth Report provide a clear picture of growth. In 2017, 7,472,000 Hispanic households owned their homes, a 167,000 increase from 2016. Since 2000, Hispanics have been responsible for 46.5% of net U.S. homeownership gains. In 2017, the Hispanic population reached a new high of 58.6 million, an increase of 1.1 million from 2016. CPF’s service offerings are tailored to this rapidly growing market. Many of our customers are first time homebuyers who require guidance understanding the complexities of a home purchase, but also simply want to realize the American dream and pride of homeownership. With over 2,000 completed transactions, the company has a deep understanding of the Hispanic market and believes this positions the company well for future growth.

Competitive Advantage

CPF has unique competitive advantages on each side of the business. In terms of sourcing homes, we think they have a very strong process, although this is ultimately replicable. They do, however, have a true advantage that stems from their reputation within the markets they serve. They are known as a fair and credible partner that creates a very pleasant experience for their customers. Density and scale in their chosen markets also affords them an advantage. On the financing side, they have their status as a Certified CDFI and history of being a great partner to banks. It would take a competitor many years to build the kind of brand equity they have built in their communities as banks would be taking a big risk by partnering with an unproven entity.

Our understanding is that there is a real barrier to entry here and that will only grow over time. In the end, however, we think the market is so big relative to CPF that they will always be able to profitably

operate in their niche. The company currently pushes 45-75 houses through their process each quarter, which is tiny relative to the 50M prospective Hispanic homeowners in the US.

Management

CEO Eric Donnelly is a former banker that bought CPF with an investor group from the founder, with the idea of scaling it along the path it’s on today. We believe he and his team are first class and critical to the success of the business. Donnelly has also built a board consisting of the right mix of financial and operating expertise. We would like to highlight a couple of the members – Robert Alpert and Claire Gogel.

Robert Alpert is one of the key architects of the Crossroads/CPF deal. While there is little public information about him, he has had a successful career investing and now runs his family office - 210 Capital. In studying Alpert, what stands out is how well connected he is in the Dallas area and how astute an investor he is. Numerous times, he has bought NOL vehicles out of restructurings and then found profitable companies to merge into them to minimize corporate level taxes while affording the target company some level of liquidity. We believe he is a long-term oriented investor, looking to buy profitable businesses that can grow while sheltering them from corporate level taxes. In that sense, Crossroads represents a textbook investment for him and our understanding is that 210 Capital controls roughly a quarter of the Crossroads equity.

Claire Gogel was a Partner at Greenlight Capital and a trusted lieutenant to David Einhorn. She was appointed to the restructuring committee of SunEdison, one of the most high-profile projects in the firm’s history. She has a reputation of both high intellect and integrity, and her presence is certainly a big positive for the company. She is no longer formally affiliated with Greenlight and now runs a separate partnership.

The remainder of the board is equally impressive, with varied backgrounds in real estate and Hispanic business. Please see their respective profiles here: https://www.crossroads.com/investor- information/board-of-directors/

Valuation

Given the simplicity of the business model and visibility into future performance, valuing Crossroads is pretty straightforward. Our general method was to start with the most recent earnings and normalize for all the one-time costs incurred in the merger. From there, we can make some simple assumptions on growth rates to predict future earnings.

Before diving into that, please see the most recent balance sheet and income statements below, as they will drive many of our assumptions. The big things to take note of are that there are $97M of mortgage notes receivable and $1.23M of net income for the quarter ended 4/30/18, which includes $712k of expenses from the legacy Crossroads.

Looking first at the legacy Crossroads expenses, we have been told that about $500k of the $712k are non-recurring in nature. We added that back to net income of $1.2M and have normalized earnings to $1.7M for the quarter. We chose to annualize that number to get annual run rate earnings of roughly $6.8M, but there might be a little seasonality to that number. On $97M of mortgage notes receivable, we get a ROA of roughly 7%.

CPF moves about 45-75 homes a quarter, on average, through its platform, which we believe equates to roughly $6.5M of mortgage originations per quarter (normalizing for prepayment, foreclosure and other factors). This will show up as actual houses they sell, but also mortgages that they have originated and still service for other banks that want to hold these CRA loans directly for some period of time. We have been told that those loans will likely end up back on the CRSS balance sheet after they season for 6-24 months and the bank can obtain CRA credit for them, so the 6.5 mm number will be very lumpy, but the yearly goal remains 25 mm a year of net new “paper” a year on the CRSS balance sheet, and this will be supported by additional market entries – we believe Arizona and Puerto Rico to be likely candidates. Additional factors that temper that growth are refinancing and possible foreclosures that flow right back into inventory. These ebb and flow from Q to Q, but based on the velocity of property sales we believe the 25 mm number is the right goal post, especially when considering new markets and new product entries over the next three years.

Therefore, doubling the earnings power of the business from the current $97M of outstanding mortgages will require 16 quarters (100mm/6.5mm); at which point Crossroads will be producing roughly $13.6M of net income across 6M shares, or $2.28/share. Note that we believe the CRA-linked funding and Treasury Bond Program will provide more than enough funding for the company, so we expect no additional shares to be issued. We also understand this is a simplification given some of the gross margin comes from the rehabbing activity, but believe the ROA methodology is a relevant proxy for the sustained earnings power of the business and directionally accurate.

Looking three/four years forward, we see a business growing in the teens with high returns on capital and reinvestment opportunities for the foreseeable future. Add in a strong management team and board that owns 75% of the business, and this should fetch a strong multiple. We also expect an up- listing 2019, which should help drive a re-rating of the stock.

Looking further into the future, we expect CPF to be able to grow by an additional $100M of mortgages by year five or six given the boost from an additional $100M Treasury bond, and moving into another 1 - 2 states. If this occurs, and we think it’s likely, then the company is looking at roughly $21M of earnings and $3.50/share (7% ROA over $300M of mortgage notes). Additionally, CPF is expanding into other lines such as small business loans, but we have chosen not to include any benefit from that business into our assumptions but hopefully they help get us to our desired targets.

In summary, we see a likely valuation of 3-6x the current price in about 4 years and 5-10x the current price in five/six years. Equally important, we don’t believe any of our assumptions are farfetched and that these returns can be achieved with minimal downside risk. Part of this protection is in the form of tangible book value, which is understated due to purchase accounting associated with the recent corporate actions [see management letter]. In fact, when you normalize for the accounting adjustments and the recent patent litigation settlement, NAV by year-end should be roughly $36M, or $6/share. This is only slightly below the current share price and we expect that number to continue to grow over time in tandem with earnings.

One final important element that we haven’t included in our valuation is the potential value from the legacy patent portfolio. Crossroads transferred the patent litigation to an affiliate of Fortress Investment Group. Fortress is responsible for all litigation costs moving forward, but Crossroads receives 50% of the upside above cost recovery and a small hurdle. We certainly aren’t holding our breath, but it’s worth noting that the company recently settled a claim against Dot Hill for $1M. While we see this as an indication that the IP does have real value, we don’t view this as anything more than a free, albeit potentially valuable, option.

Looking at the long-term, we believe management is aiming to scale operations for at least five years before eventually merging with a bank or insurance company. However, we think investors will realize a meaningful return on their investment long before that as earnings normalize over the next few quarters and the stock re-rates to a more appropriate multiple.

Risks                 

We have identified three primary risks with an investment in Crossroads. The first is that the company is non-reporting, so disclosure is very limited. This risk is somewhat mitigated by the fact Eric is very welcoming to investors, insiders own 75% of the company, and we expect an up-listing in 2019. The second is that there is a mismatch on the loan book until a Treasury bond offering closes; the company is lending long-term (30 years) but borrowing on a shorter term. The result is that a rapid rise in interest rates would decrease the earnings on the existing loan book, but we expect that to be rectified shortly, and an investor can also hedge against this risk. The final risk is that the CRA is repealed or significantly changed. If that were to happen, CPF would be forced to quickly merge with a bank. However, the CRA was enacted in 1977 and while there are talks of it being “modernized” (see attached article), there isn’t any indication to date that it will be repealed.

Summary

We believe the right way to think about CPF is not as a home flipper, but rather as a best-in-class loan origination platform. Instead of just collecting the margin for the value add of rehabbing a home, CPF is able to lock in a 30-year annuity through its world class lending platform. While other forms of lending, from credit cards to auto loans, have to recycle their capital quickly and manage high defaults, CPF is able to lock in quality economics for long periods of time, with big loans and with minimal losses. Additionally, this stream of low-risk annuities is growing in the high teens and has a defensible runway to grow for a long time with a low-cost of capital and minimal taxes. At today’s price, the loan book and origination platform can be acquired for just above book value, offering multiples on the upside with solid downside protection.

Websites of Interest:

CRSS Q1 Full Release:

https://www.crossroads.com/wp-content/uploads/2018/06/CRSS-2018-Q1-Earnings-Release-and- Management-Letter.pdf

CRSS Q2 Full Release:

 https://www.crossroads.com/wp-content/uploads/2018/06/CRSS-Q2-2018-Earnings-Release-and- Management-Letter.pdf

http://vendocasasdfw.com/

CRA/CDFI Resources:

https://youtu.be/rdOpsTLvbeY

https://www.housingwire.com/articles/46620-trump-administration-considering-changes-to- community-reinvestment-act

https://www.housingwire.com/ext/resources/files/Editorial/CRA-ANPR-082718.pdf

https://www.cdfifund.gov/Documents/BG%20Program%20Outreach%20Session%20for%2002222017% 20-%20Day%201.pdf

Catalyst

Time

Uplisting