NovaStar Outlook Grim

Research analysts from Friedman, Billings & Ramsey reiterated their rating of “underperform” for Novastar on their expectation that the $150 million equity investment by Mass Mutual Capital Partners LLC and Jefferies Capital Partners IV LLC will only temporarily sustain Novastar due to subprime market pressures.

“We are not convinced the proceeds are sufficient to ensure NFI’s survival,” the analyst said in a report. “Specifically, the recent turmoil in the subprime capital markets have increased the likelihood of significant asset write-downs and increased both the capital required to execute securitizations and the cost of financing and reduced whole loan premiums.”

Adding pressure are the rapidly increasing costs to originate loans amid the dramatic decline in loan volume, according to the report.

The equity investment reportedly consists of the purchase of $48.8 million of convertible preferred stock and a commitment to purchase up to $101.2 million of any unsubscribed shares in an upcoming offering for a similar series of convertible preferred stock. NovaStar also intends to issue a $157 million REIT dividend in the form of convertible preferred securities.

With the intent to distribute the additional $157 million in preferred securities to satisfy the dividend requirement, the analysts said they project leverage increasing to an untenable 35-to-1 by yearend.

Depending on the conversion percentage, the analysts believe the transaction reduces projected year-end book value, including the impact of the dividend, from $9.50 to roughly $6. NovaStar shares are trading at $5.17 today.

The analysts maintained their estimates and outlook following NovaStar’s conference call on the equity investment.

The call reportedly revealed that the REIT dividend for 2006 of $157 million will be shared with Series D-1 and Series D-2 holders on a conversion share basis.

Thus, in addition to common shareholders’ ownership being diluted by the convertible preferred, their REIT dividend will be diluted from $4.21 per share to $2.67 per share, the FBR analysts said in a report subsequent to the call in which they described the diluted dividend as “adding insult to injury.”

“Nothing discussed on the call changes our outlook for NFI,” the analysts said in the report.

“We do not believe the $150 million injection is sufficient to ensure NFI’s viability, barring a significant improvement in subprime capital markets conditions,” the analyst continued. “We reiterate our Underperform rating and $4.50 price target.”