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
Nice write up. I think you're right on this one. Downside should be fairly limited and large potential upside.
ReplyDeleteThank you for commenting! Yes, I believe so- the only thing near term is that insiders bought at the $15 level, and so a pullback can easily happen and the thesis still be valid.
ReplyDeleteOne thing to note is that HLSS will probably have to issue equity to buy more MSRs. So, the equity valuation will probably not scale linearly to UPBs. I think the key drivers will be financing costs + operating efficiency + prepays + investor perceived risk premium (if they can issue equity rich and if stock trades at lower yields).
ReplyDeleteAgreed re: equity issuance - they already did one follow-on @ 15.25 (http://ir.hlss.com/releasedetail.cfm?ReleaseID=714481) and probably will do more once the Homeward acquisition closes. In this case though, perhaps selling above book value (~400mm vs 600mm mkcap) allows it to 1) reduce their debt/equity leverage & issue debt to get more $ and 2) quite literally sell $1 for ~$0.66 of balance sheet and use the proceeds to buy $1 worth of assets (MSRs).
ReplyDelete^That actually sounds like a virtuous cycle that monetizes investor premium, which generates more underlying value?
(Alchemy of Finance maybe has a good example in mortgage reits, which have a boom/bust cycle as well http://seekingalpha.com/article/257247-gold-silver-boom-bust-and-george-soros). I wonder if/when the bust will come.
Agreed with rest, and so far believe all are moving in HLSS's direction. Exception might be operations, as I really would not be surprised if HLSS was one room in atlanta inside Ocwen's offices, haha, as all its assets are in bank accounts, contracts and people. I'm not sure if HLSS will get that much operational leverage? hmm. That might go to ASPS, the other spinoff.
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ReplyDeleteThat's a really good point on reflexivity. I see this bubble moving higher b/c there's still a large supply of MSRs and of the structural points you mentioned on bank balance sheets.
ReplyDeleteSome potential risks are for (1) CPR to move higher--any idea of sensitivity to CPR and vintage of the loans? (2) banks start to refi non-agency loans (seems unlikely at the moment as there's no primary market).
Good point on the lack of operational leverage. Upon more detailed analysis, it looks like this is a purely funding vehicle.
Looks like 2x debt to equity--if we take them at 8.6% yield and 2.95% financing costs as appropriate, then they should be earning ~4.8% on the MSRs they buy with their standard assumptions. Looks like the correct way to look at this is just a levered bet on servicing rate vs. funding costs.
So for every bp they can get in cheaper funding, this means 2bp gain in yield for equity and ceteris peribus, should mean equity prices move up by 2bp. Increasing leverage would be huge.
Agreed, increased prepayments/CPRs definitely risk, but in Q3 their prepayment rates actually decreased from 15% to 12% (resuling in 0.03$/share boost to net income). I've treated that as non-recurring, and would hypothesize, especially given the recent acquisitions, that the loans are (fairly) seasoned and that prepayments would be flat (esp given the long period of low interest rates).
ReplyDeleteQ: where'd u get 8.6% for yield? Am curious as to source, bc having hard time getting exact valuation data for msrs.
Btw, the reflexivity article you linked to...the author lost credibility when he wrote:
ReplyDelete"A quick look at the futures chart also suggests that the market expects gold to continue climbing for the next several years."
yikes!
I found the 8.6% yield from their recent earnings conference call. They indicated that they want to achieve that kind of yield on the MSRs they buy. Didn't read into the details, but just thought it may be useful for thinking about the big picture.
Yea, prepays in non-agencies will be low b/c people can't refinance. Seasoning is key. Do you know the avg vintage of their MSRs?
Haha yea that reasoning is a bit weak, agreed - just extrapolating trend ad infinitum (should have replaced "market" with "I")
ReplyDeleteOh, I see it in the May 2012 presentation - the 8.6% yield is the dividend yield in the market (now is ~7% trailing based on current price). Think there is a diff from that and the yield at acquisition of such rights (i.e. rate acquired and then rate disbursed to investors?).
Re: vintage, I've re-looked some more and still can't seem to find that data. From that same presentation above, they stress that it's mostly delinquencies/foreclosure sales that drive subprime prepayments, perhaps the implication being even the 2005-07 vintage years have seasoned, and therefore foreclosures from teaser-rate expirations are lower/more manageable.
Will continue to investigate, thx for bringing up!