Does AAPL have a sustainable moat?

A fundamental contention between bulls & bears seems to be the ability of AAPL to continually sell new iphones/ipads at premium prices given the hyper-competitiveness of consumer hardware. One only has to see the meteoric rise and fall of RIMM to see this fact.

Of course, it's now in vogue to disparage Blackberries, but pre 2008 times were looking bright as ever. With a stranglehold on enterprise/business users, a proprietary security system/network, and an efficient phone design, RIMM could do no wrong. Was that a moat? In hindsight, most definitely not, as missteps in consumer phones (yes, I have one), have brought questions as to RIMM's survival, let alone growth.


For AAPL, bulls point to continual innovation driven backed by $100B-cash on hand, a cheap valuation ~13x ttm earnings vs. 20%+ ttm eps growth. Specifically, Einhorn points to the software/AAPL-halo argument, which says that users who enter the AAPL ecosystem (itunes, icloud, ios, etc.) will continue to upgrade.

In essence, AAPL is a (social) media software company that monetizes through high margin hardware.

Bears point to reduced innovation after Jobs' death, with the recent iPad mini premium-priced but lacking any real new features. At the same time, Samsung's Galaxy S3 has better hardware specs (larger screen, etc) and has outsold the iPhone 4S last quarter (except at AT&T).

Finally my 14-yr old brother, who has an itouch and uses itunes, likes the iPhone 4S better than iPhone 5.



Who is correct? I used to be of the former opinion, but with the recent sell-off and insider selling even into the iPhone 5/iPad mini, I'm not so sure and can think of easier longs to buy.


Other thoughts welcome!

-Stanley

Disclosure: no position in AAPL 
 

Full writeup - HLSS

Home Loan Servicing Solutions, Ltd.

Summary (Recommendation: Buy with 1-year target of $40)

Home Loan Servicing Solutions, Ltd. (NASDAQ: HLSS) is the next iteration of the unique opportunity in mortgage servicing rights. The second spinoff from Ocwen since 2009, HLSS is an income vehicle that holds non-agency/non-prime mortgage servicing rights bought by Ocwen Financial, the largest subprime servicer in the United States. After a 1000% 3-year return in his previous spinoff (NASDAQ:ASPS), I believe that William Erbey, the Chairman of both companies will replicate this success with HLSS as a dividend growth/income vehicle to directly hold new mortgage servicing rights that Ocwen acquires/holds. To review:

• Mortgage servicing rights are cheap because regulation and political risk have forced noneconomic selling and less competition. New capital requirements from Basel 3 limit the amount of mortgage servicing rights can make up 10% of Tier 1 capital, compared to 100% previously[3].

• As a result, HLSS gets business (from Ocwen) because banks and other financial institutions are forced sellers. Ocwen bought servicers from Goldman Sachs and other institutions because of the political/legal liability, as evidenced by the multibillion-dollar mortgage settlement in February of this year.[4] 

 

• At the same time, market conditions in credit and prepayments make such rights very valuable. Mortgage servicing rights are more valuable with low credit losses (specialization of OCN) and hurt by prepayments. Both are moving in favorable directions.

• Foreclosures are down, and through ASPS, the technology services firm and other spin-off from OCN, HLSS has access to the one of the top platforms in the industry (as shown by consistent profitability and 20% operating margins/return on assets of ASPS). This has limited credit losses, which from Ocwen has shown a reduction in delinquency from 28%  in 2010 to the lowest level in years at 21% in 2012. Macro data from Case-Shiller supports this view. 

• Prepayments are down. In Q3 investor presentation, HLSS notes that prepayment speeds slowed from 15.2% to 12.6%[7]. Because the company invests in non-agency mortgage servicing rights, it is not as affected by interest rate movements. In any case, rates have been low for so long that we believe any refinancing will not be as vigorous as previous rate decreases.

• HLSS is in a prime position to exploit such a dynamic and based our calculations, is valued at only ~7.6x 2013 forward earnings. With the Homeward acquisition earlier this month, UPBs (unpaid principal balances that are serviced by the rights) that HLSS may hold ultimately triples, from $47B to $124$B -$167B (47 + 77-120)[8]. We feel this trend may continue, with the optionality of a possible Rescap purchase.

• Ocwen continues to successfully bid for loan portfolios. It grew serviced unpaid principal balances (UPBs) $41.3B in 2011 and $34.2B in the first 6 months in 2012[9]. Annualized, that is a 50% growth that has been partially reflected in revenue/earnings. Last Q In particular, the last $10B of wins was only in June, meaning increased earnings have yet to be shown much on earnings.

• Even without operating leverage, we believe a 100%+ increase in UPBs will flow to 100%+ increase in net income, meaning the annualized 0.37$[10] (minus 0.03$ in nonrecurring earnings) = 4*0.33*(1+100%) = 2.64$ eps next year (2013). This means at the current price of ~$20, HLSS trades at 20/2.64 = ~7.6x next year earnings.

• HLSS current trades at 25x ttm earnings, which is somewhat overstated because of earlier losses (company only started in March of this year). Annualizing this quarter’s net income, we get ~15x normalized earnings multiple. At this current (market) multiple, a doubling of eps can double the stock, leading to the rough target of 20*2 = 40.

• Finally, consistently profitable outright insider buying by Chairman Erbey. After directly buying $10mm at the offering price, Erbey bought more shares at the $15 level in August just before the prior run. The chairman of this company is so confident and eager that he is outright buying shares just months after buying $10mm in the ipo, i.e. the most knowledgeable insider is so aggressive that he is averaging up even after owning 5%[11] of the company.

Catalyst

Continuing wins from Ocwen (including Rescap optionality)

Continuing revenue and eps growth

Risks

Unexpected slowdown in Ocwen’s portfolio growth

Change in relationship between Ocwen and HLSS (unlikely, as Erbey is the largest shareholder of both).

Implementation

Average into a position in the next week or two, as the stock remains volatile/illiquid day to day.

*Disclosure: we hold a sizable long position in HLSS, ASPS.

---

[1] Yahoo Finance

[2] Pareto Capital Research

[3] http://www.jdsupra.com/legalnews/proposed-basel-iii-capital-rules-for-mor-14054/

[4] http://www.nytimes.com/2012/02/09/business/states-negotiate-25-billion-deal-for-homeowners.html

[5] http://www.realtytrac.com/images/affiliates/Foreclosure_Trends_Case_Shiller_Home_Prices_Jan2006_to_Mar2012.jpg

[6] HLSS Q2 investor presentation, http://ir.hlss.com/events.cfm

[7] HLSS Q3 investor presentation http://ir.hlss.com/events.cfm

[8] http://ir.hlss.com/releasedetail.cfm?ReleaseID=714481

[9] OCN 2012Q2 10Q, page 29

[10]http://ir.hlss.com/releasedetail.cfm?ReleaseID=714481

[11] HLSS S-1 (August 2012)  p136

Continuing on mortgage servicing rights (HLSS $19.39)

We now aim to replicate the success of ASPS with Home Loan Solutions, Ltd. (HLSS), an income vehicle for buying mortgage servicing rights (MSRs)  - I believe this is the quintessential dividend growth vehicle for at least the next year or two.

Summary (Recommendation: Buy with 1-year target of $38)

Home Loan Servicing Solutions, Ltd. (NASDAQ: HLSS) is the next iteration of the unique opportunity in mortgage servicing rights. After a 1000% 3-year return in his previous spinoff (NASDAQ:ASPS), I believe that William Erbey, the Chairman of both companies will replicate this success with HLSS as a dividend growth company. To review:

• Mortgage servicing rights are cheap because regulation and political risk have forced noneconomic selling and less competition

• At the same time, market conditions in prepayments and interest rates make such rights very valuable

• HLSS is in a prime position to exploit such a dynamic and based our calculations, is valued at only 7x 2013 forward earnings   

• Finally, consistently profitable outright insider buying by Chairman

Will detail in later posts.

-Stanley

*Disclosure: Long HLSS

On shorting frauds (QIHU, GMCR)

Closed two shorts today - GMCR (Green Mountain Coffee Roasters) and QIHU (Qihoo 360). In both cases, I believe that revenues and cash on balance sheet are vastly overstated; indeed, I believe management has engaged in year-long fabrications in order to inflate their stock prices.

Why have I closed such shorts then? Because 1) frauds without hard catalysts are difficult to time, even harder with 20%+ borrow rates (i.e. I need to make 20%+ a year just to breakeven)

I've heard from some that fraud is the pinnacle of shorting - from this experience, I would add that fraud with hard catalyst (i.e. running out of cash, share lockup expiration) in a difficult and highly transparent industry is the pinnacle.

A tough short:

 There are simply easier shorts, in my opinion (FB, ZNGA, GRPN, SPLK).

-Stanley

*Disclosure: am short FB, ZNGA, GRPN, SPLK

Shorting Big Data (SPLK $31)

"Big Data" is the latest fad to hit the (investor) world, with an awfully good premise. With the increase in data collected doubling every ~40 months, (e.g. Walmart's collects more day than the Library of Congress per hour ), the growth of the market is quite literally exponential.

Splunk Inc. is the perhaps the purest play on this trend, a startup founded in 2007 and went public earlier this year. They make software which can read and analyze large amounts of raw machine-data. But there are three 3 specific reasons to sell/short:

1) Persistent insider selling + lockup expiration on Oct 15. Less than 3 months after going public (i.e. this July), SPLK announced a special secondary offering of shares by execs. This is a secondary offering, meaning, the company itself gets no money, only insiders selling. If the company's prospects were as good as they were touted during ipo 3 months ago, why are execs in such a hurry that they had to ask underwriters to waive the usual lockup?

A lock up is specifically designed to align the sellers of the company with new shareholders - yet without explanation, SPLK sells more in July? Even though another wave of selling is allowed in Oct 15, just 3 months later? At the very least, it is a grey area, perhaps smacking of desperation selling. 

There is another similarly-hyped technology company whose founder sold in a secondary offering months after the ipo at 12$, ZNGA (which is now at $2.49):

Could history repeat itself? 


2) Heightened competition from established players (ORCL, HP). Zack Buckley presented a full short thesis at the Value Investors Congress. Key point is that the company charges $120k for a product that others are charging 34k, and that even at $120K SPLK is losing money.


3) Weak revenue streams/growth by design. From the Q2 10-Q:

"A substantial majority of our license revenues consists of revenues from perpetual licenses, under which we generally recognize the license fee portion of the arrangement upfront" (p17, my emphasis).

also:

" Typically, when purchasing a perpetual license, a customer also purchases one year of maintenance service for which we charge a percentage of the license fee" (p17, my emphasis)

In other words, there is no recurring revenue stream - once someone buys the product, they the revenue that any customer will get is in the first 2 years and has mostly been recognized. This is not CRM with its SaaS platform that is actually "sticky" and has 90% recurring revenue.

The growth that people are looking for, even on the revenue side, is vastly overstated. Essentially out of the thousands of customers that SPLK claims, they won't make much more money from them.

Finally, this is why at a valuation of 20+x ttm sales and no profit, SPLK can go to 10$ (or even lower).


Careful investing to all,

-Stanley

*Disclosure: am short SPLK, ZNGA

A note about Chipotle v Taco Bell/Einhorn

A week ago today, David Einhorn of Greenlight Capital presented a short thesis of Chipotle (NYSE: CMG) at the Value Investing Congress. The crux of his argument seems to increasing competition from Taco Bell (specifically its new Cantina Bell menu) will slow CMG's growth and therefore CMG will trade at a lower multiple.

Einhorn is trading on the mis-perception that Chipotle has fundamentally different customers than Taco Bell and instead believes that CMG has no true moat and Taco Bell is the "new" entrant into its business that will lower prices/growth.

I will leave that customer-oriented discussion to the multitude of opinions out there, and believe that it is overall very tough to tell without surveys etc. Suffice it to say, CMG management believes such a moat exists, and Einhorn/Taco Bell believes it doesn't.

What I want to add to is the comparison of CMG and GMCR shorts.

People have been comparing this trade to the now-famous short-GMCR from last year, and a year later GMCR has declined from 80s to 20s. There is a key difference however.

GMCR had accounting irregularities (huge capex/inventories), negative free cash flow, and increasingly opaque (possibly misleading) management, reducing disclosures from one year to the next.

I haven't seen that from CMG, and as such believe this is more a valuation trade - and like Tilson shorting NFLX, is far more difficult.

-Stanley

Update:
Forbes article containing customer overlap (75%+ according to Greenlight's survey)

If only my words could move the market!

Two days ago, I posted about NASDAQ:ASPS.

Then:

While I've been holding it since June, today's announcement was one of the catalysts I was looking for - the acquisition of more cheap unpaid principal balances (UPBs). This is an industry term - basically, whoever services these mortgages gets 0.25-0.50% (25-50 basis points).

Homeward Residential Holdings, Inc had $77B in UPBs, and Ocwen paid $588 million in cash and $162 million in convertible preferred stock.

Therefore, Ocwen gets roughly $77B * 0.25% to 0.50% or 192.5$mm to 385$mm. The total purchase price was ~750$mm or 2 to 4 times the annual revenue rate! This is not even accounting for the origination business!

The best part of all this flows to ASPS, as Ocwen's technology provider.

Monetizing Mortgage Servicing Rights

Reminiscences of a Stockblogger had a great piece on mortgage servicing rights (MSRs) as one of the most compelling assets to buy in the market now (more so back in March).

The most compelling part arguments I see are: 1) regulatory concerns that have reduced competition in the industry and 2) the unique nature with respect to prepayments that make their payouts sustainable. 

1) Basel III regulations have made holding mortgage servicing rights (that is, the 25-50 bps of income in return from servicing the mortgage/unpaid principal balances) uneconomical for traditional banks. They have therefore been selling these rights en masse to companies such as NSM and OCN.

2) MSRs are dependent on people not selling their houses, people not refinancing, and people not defaulting.

But how best to monetize this? The most volatile names include NSM and has obviously done well.

But I'd like to point to more indirect but possibly more lucrative company that combines the above advantages with 3) a highly consistently profitable and high roa/roe business (pre and post crash),

 4) a (main) customer which has the capabilities to buy up these rights, even possibly getting involved in the ResCap deal.

and 5) repeated insider buying at 52-week highs.

The company is Altisource Portfolio Solutions S.A. (NASDAQ: ASPS), a spinoff from OCN which has a guaranteed 7-year contract with OCN to provide the key technologies/services necessary to service OCN's loans.

Careful investing,
-Stanley

*Disclosure: I am long ASPS