|Shares Out. (in M):||139||P/E||0.0x||0.0x|
|Market Cap (in $M):||5,530||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
Ocwen Financial (OCN) is a mortgage servicer that has gone from being a small, niche servicer ten years ago to being the fourth largest mortgage servicer in the US. In 2000, Ocwen serviced $11bn of unpaid principal balance (UPB) and at the end of 2013 it had $465bn of UPB, 57% of which is Agency (including jumbo prime) and 43% of which is non-Agency (subprime and Alt-A). The current book of business excluding lending operations will generate cash in run-off close to Ocwen’s current enterprise value. Running off the portfolio is a very low probability event; far more likely is that the company uses its strong cash flows to continue to grow the business by buying bulk MSR transfers, investing in lending operations, expanding into new spaces adjacent to its core business, and repurchasing shares.
Ocwen’s primary asset is mortgage servicing rights (MSRs). MSRs grant the mortgage servicer rights to earn a contractual servicing fee for servicing mortgage loans as well as ancillary revenue, such as late charges, modification fees, change in status fees, interest on escrow balances, ACH payment fees, etc. Servicing fees are paid on a percentage to UPB basis. Agency loans are 25-30 bps, whereas non-agency are typically between 45-50 bps. Ocwen acts as either the servicer (owns the MSR) or the sub-servicer of mortgages (contracts with the holder of the MSR to service the loans). Traditionally, it sub-serviced loans as a specialty servicer (banks would hire Ocwen to collect on non-performing loans). Recently, through its relationship with HLSS, Ocwen has begun to shift its business model towards more sub-servicing as a way to be a capital-light, fee-for-service type of business. It earns less revenue on a basis points/UPB basis, for example, Ocwen gets ~50% of the contractual servicing fee in the deals with HLSS, but it doesn't have an MSR amortization charge; it doesn't tie up capital in financing the MSR; and it doesn't need to fund advances (that is, payments of principal, interest, taxes and insurance to securitization trusts for borrowers that are delinquent on their monthly mortgage payments). Because of this, sub-servicing is lower margin but it has a much higher ROE. 50% of Ocwen’s servicing portfolio is actually being sub-serviced for HLSS, though the sales to HLSS of MSR are not technically sales but treated as financing under GAAP (more on this below). Adjusting for this, Ocwen’s UPB was 60% sub-serviced and 40% serviced at the end of 2013.
Ocwen is the lowest cost, highest return servicing business. It has a strong management team — Chairman Bill Erbey moved down to the Virgin Islands to lower Ocwen’s tax rate; that is showing commitment to shareholder value. And it has an undemanding valuation. The current valuation basically assumes the company is a melting ice cube that is just going to slowly liquidate over time. The "indefinite hold" requested by the New York Department of Financial Services on Ocwen's purchase of $39bn in UPB from Wells Fargo is weighing on the stock, but the whole nonbank mortgage servicer space is beaten down right now. Walter and Nationstar are also trading at low multiples of earnings/cash flow. See nantembo629's excellent write-up from last week on Walter (WAC).
What is Ocwen worth? Honestly, I don’t know. But as Benjamin Graham said, "You don't need to know a man's exact weight to know he is fat." That is the situation with Ocwen (this is not a joke about Erbey). The company will generate over $1bn in cash in 2014 and 2015. Management says the business will generate $8.4bn in cash over the next 10 years under very low-hurdle scenarios: no UPB growth apart from origination activity; cash reinvested at only a 5% return; and prepayment speeds and delinquencies staying elevated. You have a business that will generate a lot of cash over the next few years and a management team with a great track record for allocating capital. Ocwen is trading at ~5.5x FY14 cash flow from operations. To keep cash flow in steady state, there has to be some re-investment back in the business. Cash from operations is not equal to free cash flow. Through HLSS and OASIS (see Lending section), however, Ocwen is transitioning to a far more capital light company and will be able to grow or stay in steady state with fairly low capital re-investment of its own. It is reasonable to assume that HLSS and OASIS could supply the capital for at least half of Ocwen's steady-state reinvestment needs, which would put 2014 steady-state free cash flow at ~$800m or $5.75 per share. This estimate for steady-state maintenance re-investment on Ocwen's part is, I believe, too high, but it will depend on how successful HLSS is at raising additional capital and how deep the demand is for OASIS notes.
Relationships with “Strategic Allies”
Altisource Portfolio Solutions (ASPS) was spun-out of Ocwen in 2009. ASPS was created to capture adjacent revenue that was difficult to keep within Ocwen. ASPS provides REO management, property inspection, residential property valuation, and other mortgage related services. In its filings, you will notice that over 70% of its revenue is from Ocwen. This is revenue generated off of Ocwen’s servicing portfolio, but only a portion of it is actually an expense borne by Ocwen. In 2013, Ocwen paid $55m in expenses to ASPS, nearly all of which was related to technology services. This amounted to 7% of ASPS' 2013 revenue.The remainder of ASPS' related party revenue was derived from Ocwen's servicing portfolio but was paid by either the mortgagee or the investor to ASPS.
Ocwen also has a relationship with Home Loan Servicing Solutions (HLSS). HLSS was established in 2012 to hold MSRs, Rights to MSRs and Advances. To date, it has purchased only Rights to MSR from Ocwen. HLSS appeals to income-oriented investors and its goal is to provide a steady and predictable dividend and earnings stream with stable NAV. HLSS investors do not demand the same ROE as OCN investors, so this is a cost of capital arbitrage vehicle, helping Ocwen shift towards a capital-light entity and grow its servicing business at a faster rate. HLSS contracts with Ocwen to service the mortgages.
The economics to HLSS are the same whether it owns the MSR or has Rights to MSR. HLSS gets the contractual servicing revenue (~45 bps of UPB). It pays Ocwen to sub-service the mortgage portfolios: Ocwen gets a base fee of 5 bps and an incentive fee of up to 18bps. The incentive fee will be collected as long as advances don’t exceed a certain threshold; this threshold slides down over time and if Ocwen isn’t clearing up delinquencies, the reduction in the incentive fee serves to compensate HLSS for its cost of capital in funding advances. Ocwen should continue to collect the 23 bps, or very close to this. Ocwen also retains any ancillary revenue (late charges, float earnings) on the portfolio. Sub-servicing generates lower revenue but it has lower costs (no amortization, no interest cost) and a much higher return on equity.
Ocwen’s financials need to be adjusted to account for the fact that its sales of MSR to HLSS don’t actually qualify as technical sales. Instead, they are accounted for as financings and as a result, revenue, amortization expense and interest expense are all overstated. For MSRs to be transferred, various third parties, including ratings agencies, must approve of or consent to the transfer. If Ocwen does not obtain the necessary approvals or consents, HLSS acquires the rights to the MSR economics. HLSS books a note receivable rather than a mortgage servicing right and Ocwen retains the MSR on its balance sheet and books a financing liability. The MSR stays on OCN's balance sheet and full servicing revenue is recognized by Ocwen. HLSS' portion of the servicing fee is paid out as interest income . Upon receipt of the approvals or consents, HLSS takes legal ownership of the MSR (this has yet to happen for any of the MSR). In 2013, $316m of servicing fees were collected on behalf of HLSS. All of this was included in revenue and then deducted as interest expense ($246m) and amortization expense ($70m). My discussion of the financials is on an adjusted basis, including adding back items to “normalize” expenses. Because Ocwen has either been preparing for a portfolio or platform acquisition or integrating a recent acquisition every quarter for the last few years, servicing transfer and integration expenses have ebbed and flowed. One should always be careful with “normalizing” expenses, but looking at the adjustments made quarter to quarter over the last 12 quarters, it is consistent with acquisition and integration activity. The adjustments make sense. They have been elevated over the last four quarters as the company has been integrating the ResCap acquisition ($176bn in UPB). This was a big acquisition, nearly doubling Ocwen’s UPB, greatly expanding its prime servicing capability, adding several offices and data centers, and leading to high integration costs. The bulk of these adjustments back out the cost of running two platforms over the extended on-boarding process, which should be completed during 2Q14. Backing them out makes sense, although in a steady-state scenario there will be integration expenses, as the company needs to replace loan and UPB run-off. Steady-state replenishment of purchased UPB, however, would be far lower than the expenses over the last several quarters, especially as they would likely be portfolio acquisitions rather than platform acquisitions. See below to get a feel for how the adjusted numbers differ from the reported numbers over the past three years:
|Opex after Adjustments/UPB||0.15%||0.20%||0.14%|
In modeling Ocwen’s financials, it is easy to use a basis points/UPB model, but while convenient it overlooks the fact that, simply, not all UPB is created equally. UPB is not as relevant as the underlying assets: a $10bn highly delinquent non-prime portfolio might be more profitable than a $50bn prime portfolio. A non-prime portfolio has a higher contractual servicing fee, potential for much higher ancillary revenue, a lower cost to acquire, lower average prepayment speeds over the life of the portfolio, and higher deferred servicing fees. Moreover, the cost of servicing is driven by loan and not UPB. For example, it takes the same time, effort and money to service a $50k loan as it does a $1m loan. A UPB model doesn't do a good job taking into consideration that the revenue, cost to service and profit of $1 in UPB fluctuates due to the size of the loan, the servicing spread, and the level of delinquency. It is much more expensive to service a non-performing loan than it is a performing loan. A non-performing loan requires that a collector contact the borrower, often multiple times over the course of months. Loss mitigation options are reviewed, paperwork is sent back and forth. This takes the time and attention of a number of employees within the firm. As delinquencies improve costs come down dramatically. The variable per loan cost of servicing a non-performing loan for Ocwen is ~$300, whereas a performing loan is under $75.
Then how does one model the business? Management has indicated just look at equity employed in the business. The goal is 25%+ and the last four quarters, using GAAP net income plus after-tax adjustments, has been: 20.4%, 31.2%, 27.7% and 29.3%. Note that margins have been lower due to ramp-up costs in 2013, but ROE has been assisted by the ongoing shift toward capital-light business model. Cash from servicing operations — calculated as the cash from operations on the cash flow statement, less repayment of advance liabilities, and excluding cash from lending operations (proceeds from loans held for sale and cash used to originate loans) — has exceeded adjusted net income every quarter since 1Q11 but 4Q13 when advances increased $129m.
In 2013, Ocwen earned $499m in adjusted net income and $851m in cash from servicing operations. In 2012, adjusted net income was $203m and cash from servicing operations was $738m. Average UPB was $413bn in 2013 and ended the year at $465bn. Expenses will be lower in 2014, absent any large purchases of MSR, and delinquencies will come down allowing for collection of deferred servicing fees and ancillary revenue. Cash from servicing operations should exceed $1bn in both 2014 and 2015. This pick up in cash flow would be consistent with the year 2 and year 3 experience after doing acquisitions. Homeward closed December 2012; ResCap was acquired February 2013; and the OneWest portfolio was brought on 4Q13.
What does Ocwen need to re-invest to keep the portfolio at steady-state? One would need to know what UPB is running off: is it prime or non-prime? serviced or sub-serviced? It is hard to estimate what Ocwen would need to re-invest to keep cash flow at a steady-state $1bn or thereabouts. If it buys non-prime portfolios similar to what is on the books, average prices have been ~60 basis points of UPB. Say it needs to replace $70bn of UPB each year; this would cost $420m, excluding the cost of advances. Insofar as it is prime UPB that is running off, Ocwen should be able to replace at least a portion of this through its lending operations. Prime is far less profitable than non-prime though. Is $420m then annual maintenance capex? No. HLSS is a willing and able buyer of non-prime UPB and would purchase (or finance) this from Ocwen. Ocwen would only be out this $400+ million for a few months before selling the Rights to MSR as well as the advances. To keep cash flow at steady-state, Ocwen would actually have fairly low reinvestment requirements. Rather than a steady-state scenario, at least in the near term, Ocwen will continue to use its cash to grow the business. Keeping the portfolio at steady-state is likelier than a slow run-off, but the odds are on Ocwen growing.
Though Ocwen is the fourth largest servicer, it is not even a top 25 originator. Its scale in servicing hasn’t been matched by scale in lending for a few reasons. First, it has come to be the largest non-bank servicer by picking up legacy servicing rights that others don’t want, so it has scaled up quickly in servicing. Second, it didn’t want the credit and reps & warranty risk of subprime origination. Third, it wasn’t equipped to handle prepayment risk with respect to prime MSRs.
At its Investor Day, Ocwen mentioned that it has higher aspirations for lending than it has indicated in the past. Ocwen inherited a prime origination arm in the Homeward acquisition (Dec 2012) and through its relationship with Lenders One (a co-op that originates ~13% of U.S. mortgages) has access to other prime originations. In 2013, Ocwen originated $7bn in forward loans. It also acquired Genworth's reverse mortgage origination arm in 4Q12 and has ~15% share of the reverse mortgage market. Recently, Ocwen set up a structure that will help it shift prepayment risk off its books. The plan has been for Ocwen is to set up a prime HLSS-like vehicle that can hold the MSR asset and bear the prepayment and interest rate risk (there are investors, foremost among them mortgage REITs, who are attracted to prime IO assets as a great way to hedge the risk in their MBS portfolios). The vehicle in this case is actually a securitized note – OASIS (Ocwen Asset Servicing Income Series)– that pays a 21 bps monthly share of Ocwen’s contractual servicing fee based on a reference basket of loans. The Series 2014-1 Notes were issued 2/26/14 and raised $123.6m on a $11.8bn reference pool (~5x annual servicing fee).
OASIS brings Ocwen’s cost of capital down to comparable levels to the big banks with respect to prime origination and servicing. It currently has $220bn in Fannie/Freddie UPB and $40 in GNMA UPB that could be sold into an OASIS securitized vehicle. Ocwen holds prime MSR on its books at 3.1x annual servicing fees. The OASIS notes are trading at ~5.2x and notes secured by new originations would price closer to 6x. If Ocwen financed $250bn of prime UPB that is currently on the books at where the OASIS notes are trading, it could issue over $2.7bn in notes. Time will tell how deep this market is and what demand for OASIS but the market pricing of prime MSR is far above where Ocwen holds it on its books and doing further financings through OASIS would free up substantial capital.
The nonbank mortgage servicer space is attractive and beaten down. Ocwen is the best player in the space. It has the highest margins and returns on equity; the most conservative accounting; and is the lowest cost provider. Its low cost position stems from its focus on technology and process, which will allow it to continue to scale up (the company doesn't need to hire experienced collectors) and move closer to a zero-defect policy (because decisions are "centralized," Ocwen can better control the actions of its collectors).
Though transfers are currently at a standstill due to the regulatory climate, they will restart at some point. The banks don't want to service highly delinquent portfolios. There is currently around $1 trillion of loans that are not performing in subprime, prime, and Alt-A. If these loans were bundled into portfolios that had 25% delinquencies, which nonperforming pools that trade currently look like, that is $4 trillion of UPB that could trade (n.b., I don't think anything close to this amount will trade). JP Morgan Chairman and CEO Jamie Dimon told investors at the recent JPM investor day: "If I had a choice, I would never be in default servicing again. I would tell anyone who took out a mortgage with us: 'If you're 60 days late, we're selling your mortgage and we don't want to do any business with you anymore.' It's just far too painful."
Additionally, each year in the U.S. there is ~$1.5 trillion of new mortgage originations. Assume that 3%, or $45bn, of these becomes non-performing. If these were packaged into portfolios with a 25% delinquency, that is a $180bn per year market opportunity for Ocwen. Say that Ocwen gets one-third of this, or $60bn. This is enough new UPB to keep a $400bn portfolio at steady-state with similar economics to the current portfolio mix.
Ocwen is cheap. It will benefit from the continued improvement in housing through essentially free cures on its delinquent portfolio; its cost of servicing will come down as delinquencies improve and it will collect on ancillary revenue. Management has a great track record for allocating capital intelligently and over the next few years Ocwen will generate a lot of cash which it can use to grow the business or buy back stock.