HLSS - A Follow Up

I've written about Home Loan Servicing Solutions, Ltd. since last year and added from 19$ all the way until $25. With the price at $23.90 as of today's close, I'm still in the money, but a bit from the highs.

Despite being different than a traditional mREIT, HLSS has fallen similarly from its highs. From fears about book value to lower dividends, HLSS has become a victim of the general shift away from (financially-driven) dividend stocks. An even more fundamental reason is that in a time of rising rates, the relative value of other fixed income-like investments are less (similar to duration risk for treasury bonds).

Bill Erbey (Chairman) did address this on the Q3 conference call, referring to the current valuation and weakness relative to equity market as a whole as due to 1) interest rate volatility and 2) an assumption of low-growth and relatively high valuation due to book (~1.4). The latter does seem the most interesting, as Erbey hints (but not does detail) that this assumption is not true. But where/how does growth come from?

There are plenty of articles about the market opportunity for mortgage servicing rights (MSRs) in general (see Nationstar's S-1 last year for one), but how does the selling reach HLSS? Ocwen can buy rights at about 3% of UPB or less  and sub-sells a portion to HLSS. 3% is roughly 6 times the  (max) 50 bps fee that Ocwen gets. MSRs are a wasting asset with principal (pre)payments, however, and 6 times is higher than the 4 or even 2 times paid for homeward. Granted, there are more details (quality of borrowers, delinquencies, etc.) which could make either one worth it or not, but the multiple is a bit worse than before. On the other hand, HLSS only needed to use 0.64% for ~0.20% annual revenue in cash to subservice the same asset from Ocwen by borrowing the rest. In other words, HLSS paid the full purchasing price that Ocwen paid, allowing Ocwen to gain revenue without paying for it (a nice business model). HLSS gains the ability to lever by keeping the less volatile part of the fee (variation is usually paid by Ocwen).

HLSS gets most of that cash from equity raises as 90% of net income is paid out as dividends, so that doesn't necessary increase (or even maintain) the dividend. What does? the 90-250% of net income that is cash available for reinvestment (from the Q3 investor presentation):

The non-cash amortization of the MSR portfolio (due to prepayments) means that HLSS has more cash to buy assets and the the dividends are only part of the story. It is true that the amortization means lower future revenue from the existing revenue, so it is up to HLSS to deploy that cash in an accretive manner.

The result? HLSS has an insurance like-free float available to invest in more MSRs - if prices remain low and there is more selling from banks such as Citi (banks currently 50% of $10 trillion market).

Based on the next $50B to be acquired (after 2 quarters and given that amortization decreases per the conference call, then 5% quarterly UPB increase after):

With a 7.66% yield, that means in one year, HLSS could be trading >$30. My previous write-up underestimated the sizes of the equity raises necessary, so this is closer to the mark.

*Disclosure: still long HLSS