|Shares Out. (in M):||103||P/E||6.4||5.5|
|Market Cap (in $M):||1,135||P/FCF||6.4||5.5|
|Net Debt (in $M):||0||EBIT||2||2|
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NSM is very attractive with 80% upside potential using conservative assumptions. There are a large number of factors that make it compelling right now. The stock and its sector are completely unloved (it is hard to think of a more out-of-favor/ignored sector than mortgage servicing). It is very overcapitalized, it trades at a ~20% discount to tangible book value (pro forma for negative interest rate marks YTD), and it is buying back lots of stock. It is under-earning and there is visibility to improved profitability because there is a “pig-through-the-python” dynamic as less profitable business burns off. It has a separate business (Xome) which is largely ignored, but it is very valuable and it will eventually be monetized. Finally, it is the last player standing in its industry, so it is in the pole position to win new business and to capitalize on the demise of its two main peers.
NSM is the largest non-bank mortgage servicer and 4th largest servicer overall with $403bn of unpaid principal balance (UPB) and 2.5mm customers. It is the lowest cost, most compliant platform among non-bank servicers. It is the only non-bank servicer with a 5-Star rating from Fannie Mae. NSM was written up twice before in 2014 and 2015 and it is down -62% and -32%, respectively, since those postings. I refer you to those write-ups for more detail on the business, and also for perspective on how expectations have disappointed since then, which I believe is the source of the compelling opportunity today.
The business mix based on 2016E pre-tax earnings is:
40% mortgage servicing.
37% mortgage origination. NSM is the 13th largest originator. It originates ~$20bn of mortgages per year which is ~1.5% share. Most of NSM’s origination is from its own servicing portfolio. ~30% of originations are refi’s through the HARP program which is winding down. NSM also has origination partnerships with homebuilders.
22% Xome (formerly known as Solutionstar). Xome is 3 businesses:
47% is from Homesearch.com, an auction site for foreclosed homes. It is mostly for selling homes that NSM has foreclosed on. It is selling ~20,000 homes annually.
53% is settlement services including appraisal, title agency and escrow.
Last summer Xome launched a new site/app which endeavors to be a one stop shop for real estate including searching, buying/selling, finding an agent, getting pre-approved for a loan, and closing. It is like Zillow or Trulia, but it lets one “transact.”
Roughly one-third of Xome’s revenues are from 3rd parties. Mgmt is aggressively trying to grow Xome and to grow 3rd party revenue. They have made 5 acquisitions, and they have ramped investment spending which is causing margins to be depressed in 2nd half of 2015 and the first half of 2016.
The stock is bombed out and earnings are at a cyclical low
The stock is down 60% since the start of 2015 and down a whopping 80% since its all-time high in 2013 as earnings expectations have been dramatically reset. There are three main reasons for the reset.
First, most of NSM’s UPB was acquired in 2012-2013, and at the time NSM misjudged the ultimate cost to service delinquent mortgages. It takes up to 18-36 months for a delinquent mortgages to be resolved and for NSM to determine the servicing cost. For example, the GSE’s only reimburse $2k for attorney’s fees per foreclosure, but in some states NSM’s actual attorney’s fees are higher, which leads to an un-reimbursable claim. Likewise, the GSE’s sometimes reimburse for fewer property inspections than NSM is required to perform. This dynamic led to a long series of earnings disappointments, most notably a drop in 2015 estimates from over $4.00 per share at the start to 2015 to $1.16 ultimately. The good news is that NSM now understands the profitability level of delinquent mortgages, the number of delinquent mortgages is burning off, and management has good visibility. 11.8% of its portfolio was delinquent in 2013 vs 9.9% in 2014 and 7.2% in 2015.
The second factor causing the dramatic earnings reset has been higher costs brought on by tighter regulatory standards. The foreclosure crisis was a major political issue in the last few years, and servicers were punished by every regulator imaginable for treating borrowers unfairly. At the same time, new servicing standards were put in place which required significant duplicate costs for servicers. Fortunately for NSM, it has been able to make substantial improvements in its operations while “drafting” behind OCN. NSM has been spared the costs and negative publicity that have been devastating to OCN to date. OCN was hit repeatedly with fines from 2012-2015 and its CEO was forced to resign in early 2015. As discussed more below, NSM has never been fined and I (cautiously) believe we are in the later innings of the regulatory headwind.
The third factor is the prolonged period of low interest rates which has had a negative impact through higher amortization of mortgage servicing rights (MSRs) as well as fair value write-downs. MSRs are a balance sheet asset which reflect the present value of expected future servicing fees. Interest rates are the key driver because as rates decline borrowers are more likely to refinance, in which case the servicer often loses the fee stream. Conversely, higher rates are beneficial for MSRs. Mortgage rates have generally been declining since 2013 and there was a mini refinance bubble in 2015 which drove higher MSR amortization and hit NSMs core servicing earnings by ~35% last year. Mortgage rates have continued to decline YTD, and NSM’s peers OCN and WAC have taken negative marks on their MSRs (WAC reported a 13% hit to its MSRs for its Q1 reported today). Based on NSM’s interest rate sensitivity disclosure ($129mm pre-tax hit for a -25 bps change in rates), and assuming a -50 bps decrease in rates in Q1, I assume NSM will take a ~$1.60 charge when it reports its Q1 tomorrow. I believe this is expected because it is an easily observable input, and its peers have already reported hits.
Today I believe servicing profitability maybe close to trough levels. Servicing pre-tax income as a % of UPB declined from 8 bps in 2014 to 3 bps in 2015. Management is guiding to 5-7 bps for 2016 and to potential for further improvement in 2017. Management’s guidance incorporates the expected hit in Q1/Q2 from lower rates. The drivers from 3bps in 2015 to 5-7 bps in 2016 include lower amortization, lower expenses and higher base servicing fees as delinquencies come down. There is a pig-through-the-python dynamic because delinquent mortgages are more expensive to service and because NSM does not collect servicing fees on delinquent GSE mortgages which are ~70% of UPB. Every 1 bps = ~25c per share of EPS.
Advantageous positioning in a consolidating industry
NSM is the largest non-bank servicer with the lowest costs and the best regulatory compliance record. NSM is in the cat bird seat to gain share as banks exit and the industry consolidates. Servicing will likely consolidate with fewer players due to the scale benefits and the new compliance/regulatory costs. NSM won a $50bn subservicing contract in Q4 last year from a large financial, a “hallmark client,” and management has indicated there are additional large subservicing opportunities. Subservicing is highly attractive because it is almost as profitable as primary servicing, but NSM does not have to hold any capital. NSM is also in a position to opportunistically acquire portfolios from its two main competitors WAC (which has liquidity issues due to levering up too much), and OCN which is barred by regulators from acquiring portfolios. In fact, NSM bought $25bn of UPB from OCN last year. Management believes there is pipeline of $200-$250bn of UPB being sold by banks and competitors. Growth of $40bn or 10% = 12c per share assuming 5 bps of pre-tax profit.
Per regulatory calculations, NSM has 16% tangible equity to assets vs a 6% FHFA minimum which implies $1bn of excess capital. However, management believes the functional excess capital is $300mm, or $2.92 per share. It bought back $66mm through February on a $150mm authorization announced in December, and it announced a $100mm tender offer in February, but only $70K worth of shares were tendered. I believe NSM will continue to buyback stock while it is trading at a significant discount to tangible book.
Xome value realization
For some quick history, one of the larger disappointments in 2015 was the failed attempt to monetize a stake in Xome through the sale of a minority interest to a venture capital firm. In 2014 NSM hired a new CEO for Xome who had senior level experience at Ebay and Amazon. His comp agreement effectively gave him 8.5% of any gain over a $1.4bn valuation for Xome, and management repeatedly said they thought they could realize >$1bn valuation for Xome. Management said that they were in “late stages of negotiations” with “multiple parties.” So, expectations were high for Xome. However, the CEO of Xome “resigned” at the end of November after a year at the company. He received $600K of severance, but forfeited his stock appreciation rights in Xome.
It turns out his departure related to an undisclosed “HR issue” and apparently there were also some operational issues related to backlog delays in the foreclosure sale business. The impact is, the sale of a minority stake has been delayed and NSM’s CEO has taken over running Xome on an interim basis. Management’s intent is to hire a new CEO in late 2016 and to pursue a monetization in 2017. This was yet another disappointment for NSM which has resulted in the stock being completely unloved.
I believe the market is not given any credit for Xome, nor are most sell side analysts. But, I think it is worth close to $800mm or $7.50 per share which is substantially below what management thinks it is worth. I think my estimates are based on reasonable, if not conservative, assumptions which are clearly detailed below. I calculate the value of Xome by forecasting out the next 5 years, applying a 14x multiple and discounting back to today at 15%. Importantly, my thesis does not depend on Xome being monetized. I view it as an asset with significant value that is not being accounted for, and one way or another it should be recognized in the share price.
There are two cross currents driving Xome’s results. First, revenue from the Real Estate Exchange business (website for selling foreclosed homes) should decline as distressed home sales decline. By 2018 I assume distressed home sales are back to the long term average prior to the financial crisis (2.9% of all home sales), so earnings after 2018 are at sustainable run rate. Meanwhile I assume Xome gains a little share because NSM’s servicing business is gaining share and because I expect 3rd party customers will grow. The second cross current comes from the Real Estate Services business which is enjoying very strong growth, especially in its title agency business. Xome is winning business because two large competitors, FNF and LPS, merged in 2014 and large bank clients of both firms are moving to Xome to diversify their vendor exposure. My margin assumptions for each segment are based on management guidance.
I value NSM on the SOTP below. I assume 8x P/E for the mortgage servicing/origination business which is equivalent to 80% of core tangible book value as of Q4. I think 8x is a conservative P/E. Arguably you could assume 10x EPS or 1x core tangible BV. Note, I think tangible book value will decline ~$1.30 or ~9% when NSM reports Q1 based on movements in interests rates during the quarter (~30c of core EPS less ~$1.60 MSR hit). This does not change my view of the normalized earnings level or the P/E. Finally, I am hitting NSM for $100mm of fines which I also think is conservative. I discuss the fines further below.
Below I show how I think about the normalized earnings and ROE for the non-Xome business, including a bridge from the actual Q4-2015 run rate levels. A couple of adjustments are necessary. First, I strip out the excess capital. Second, I assume the servicing profitability improves from 5bps (pre-tax earnings as a % of UPB) to 6bps relative to management’s guidance for 5-7bps in 2016 and for improvement thereafter. Third, I believe the originations segment is moderately overearning because HARP originations are 30% of total and are highly profitable. Per management guidance, I assume HARP originations are replaced overtime by other “streamlined” origination programs which are slightly less profitable. Net, net, I think “normalized” originations profitability is probably 20% lower. I caution that I am making assumptions based on estimates, but I believe management would agree that these are reasonable assumptions.
The two main risks are interest rates and regulation. Interest rates are fairly simple. A +/- 25 bps change in rates is +/- 5% change in tangible book value. The forward curve calls for higher interest rates, so this should be a tailwind, although in any given quarter there could be a hit.
Regulation is a tail risk, but NSM has fared extremely well relative to its peers OCN and WAC. Aviclara’s write-up does a good job describing why NSM is not like OCN. The facts speak for themselves. NSM has paid zero fines vs OCN has paid $246mm of fines and WAC has paid $137mm even though NSM has been subject to the same level of scrutiny. In addition, regulators have repeatedly approved NSM’s new portfolio acquisitions. I believe we are in the latter innings of the regulatory headwinds. Most of the fines were in 2014 and most of the new regulations have already been written. Politicians are no longer talking about the foreclosure crisis. Benjamin Lawsky, the most forceful regulator as the former head of the NY Department of Financial Services, left his post a year ago in May 2015. Nevertheless, there are still outstanding investigations by the CFPB and a consortium of state AG’s. I think it is possible that NSM could get fined for practices back in ancient history (say 2012) that have long since been corrected. I assume $100mm of fines pre-tax, which I think is conservative. I think there is a decent chance that NSM never gets fined and that this period of intensive political scrutiny and regulation will be behind us.
Return to normalized profitability
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