Description

In the sub-prime mortgage space, Accredited Home Lenders (LEND) is a company that stands out from its competitors. The company currently has the lowest loan origination costs in the industry at 1.57%. The cost to originate serves as a proxy for lender efficiency, and LEND is the most efficient non-prime originator.
In addition to its production efficiency, LEND also has the highest gain-on-sale margins in the industry (gain-on-sale margins are the spread the company is able to obtain on the sale of loans in the open market). The company rewards its account executives for producing loans that coincide with the goal of margin maintenance. Compensation is based upon the origination of loans with higher WACs and prepayment penalties. Although gain-on-sale margins have been coming down industry-wide due to funding cost increases, LEND’s leading margins allow them extra breathing room in this time of margin compression. The margin compression should be alleviated if the fed stops raising rates in 2006. Non-prime originators also began to increase their coupons in 3Q05 and this should start to alleviate some of this margin pressure towards the end of 4Q05.
Credit quality in the non-prime space has been a concern raised by investors as of late. Historically, credit is one of the main drivers of earnings in the non-prime space. This is another area in which Accredited has a reputation of being one of the best in the industry. The company’s loan loss reserve ratio of 1.75% equates to approximately $5 per share and is one of the highest in the industry. LEND is known for their measured approach to credit risk. When other originators have relied on increased interest only loan production for revenue, Accredited has consistently managed its amount of I/O origination to under 20% of total production. In addition, 74% of LEND’s originations are fully documented loans.
There are other factors that give LEND an attractive risk profile. The company does not complete off-balance-sheet securitizations, adding to its financial transparency. 62% of LEND’s income comes from gain-on-sale margin which is recognized as cash. This alleviates any concerns regarding the earnings quality of these revenues.
Despite inquiries into the topic, LEND has chosen to not transform into a REIT for the time being. This has been a wise decision so far as the company has been able to grow its balance sheet through retained earnings whereas its REIT counterparts have not.
Although not a REIT, LEND has begun to grow its loan investment portfolio to provide the company with a steady flow of earnings from interest income. Currently 62% of the company’s revenue comes from gain-on-sale, in 2000 this number was nearly 100%. This will most likely decrease further to 50% in the upcoming years.
LEND has had an ROE range of 53-35% over the last 6 quarters. Their ROE has been driven by their investment portfolio and their ability to continually outpace the competition when it comes to gain on sale in the whole loan market. Although Fed tightening has caused compression in interest margins, LEND should still be able to generate ROE’s in the low 30% range due to their loan pools being consistently superior on a credit basis and therefore receiving a premium in the open market. If the fed were to stop at 4.5% in the beginning of ’06, LEND would still generate an estimated 31% ROE for 2006. If the terminal fed funds rate were 5%, ROE would be an estimated 28%.
Management has stated a 15% earnings growth rate over the next 3-5 years. An estimate of 15% in earnings growth for LEND could prove to be conservative. A ROE declining from a depressed 25% to an even more depressed 17% over the next 7 years and then stabilize at 17% would still result in an estimated 17% growth rate, and LEND has proven to be able to generate much higher ROE’s in depressed times. LEND has a historical average P/E multiple in the 6.5-7x range. With estimated FY2005 earnings of $7.05 grown by managements projected growth rate of 15%, LEND is estimated to earn $9.32 in 2007. Multiplying that by the lower trading multiple of 6.5x gives a conservative target stock price of $60.

Catalyst

The anticipation of the fed stopping to raise interest rates