October 30, 2011 - 10:18pm EST by
2011 2012
Price: 26.00 EPS $0.00 $0.00
Shares Out. (in M): 28 P/E 0.0x 0.0x
Market Cap (in $M): 740 P/FCF 0.0x 0.0x
Net Debt (in $M): 810 EBIT 0 0
TEV ($): 1,550 TEV/EBIT 0.0x 0.0x

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  • Financial


Not every financial firm will be a net loser in the current environment.  There are some zero-sum situations that offer compelling upside for those companies fortunate enough to be on the right side of the game.

So while everyone is trying to figure out just how large a financial blow banks face from the litany of litigation and regulation now in process (and debating how much of it is priced in), I prefer to focus on a company that will be a direct beneficiary of some of the banks’ pain.  With its recent acquisition of Green Tree, Walter Investment Management (WAC) has positioned itself as a clear winner in the current financial industry mess. 

Regulators, ongoing legal settlements, Basel III, MBS investors, and cost considerations are driving massive volumes of mortgage servicing activity away from JP Morgan, Bank of America, Wells Fargo, Citi and others traditional servicers towards specialty mortgage servicers.  As one of two publicly traded companies that focuses in mortgage servicing (OCN is the other), Walter is positioned to grow its business by 2-3x or more in the next couple years.  This will drive impressive earnings and cash flow that will benefit shareholders.  It is easy to build a case for 50%+ upside for the stock, and downside risk is limited.

A further intriguing feature of WAC is that you can invest in it without a macroeconomic view.  The transfer of servicing rights will happen no matter the fate of the US economy, or just how soft or hard a landing China has, or in what way European politicians choose to handle their current crisis.  In fact, the worse the macroeconomic view, the more opportunity there will ultimately be for WAC and its peers.

The Business
WAC has been written up in the past, but the business has materially changed as a result of the Green Tree acquisition, which closed in July 2011.  WAC was in slow runoff, had excess capital, and was looking for acquisitions to create a real on-going business.  You can read previous writeups to better understand the legacy business, but as it will account for ~10% of PF EBITDA and is effectively in slow runoff, I will not focus on it.  

The core of new WAC is Green Tree.  Green Tree is a capital-light specialty mortgage sub-servicer.  What this basically means is that Green Tree specializes in servicing at-risk, delinquent, or defaulted mortgages.  The company is contracted out by traditional mortgage servicers or mortgage owners to maximize the cash flow potential of problem or risky loans.  Green Tree closely monitors risky loans, works with delinquent homeowners to figure out possible payment plans to get borrowers current, and when borrowers cannot make payments, Green Tree uses loan modifications, short-sales, foreclosures or other methods to minimize losses on mortgage investments.

A traditional mortgage servicer buys mortgage servicing rights (MSRs), and then tries to cost efficiently collect payments from mortgage holders and distribute these payments to mortgage owners while earning a small and relatively fixed fee.  This traditional model works for performing loans, but not for large numbers of problem loans, which have very different service needs.  Robo-signing and foreclosure-gate were direct results of traditional servicers’ inability to handle large numbers of non-performing loans.

Green Tree is capital light because it does not buy MSRs.  Instead, it gets contracted for a fee to perform the servicing functions.  The fee is a base fee plus incentive fees for performing certain functions or achieving certain results.  Examples of incentives fees include making contact with the borrower if the primary service has not done so (as an aside, this is amazing to me), collecting payments from a delinquent borrower, completing a modification, and executing a short sale.
(note, Green Tree does have some legacy contracts where it did buy MSRs, but it transitioned its business model and now primarily focuses on sub-servicing). 

The Market
The current mortgage market is approximately $10 trillion.  Of that market, 45% is controlled by GSEs, 33% is on balance sheet portfolios, and the remaining 12% is in private label trusts.  As of Q1 2011, $1.3 trillion of these mortgages were delinquent, and there are hundreds of billions of new delinquencies each year.  Also at the current $1 trillion mortgage origination market, there is still ~$300b of new higher risk loans being generated each year largely thanks to the FHA.  This puts the total available market for special servicing at ~$2 trillion (give or take a few hundred billion), with ongoing new opportunity measured in the $100s of billions. 

The Transfer of Market Share
The largest servicers are Bank of America, Wells Fargo, Chase, Citi, and Ally.  Combined, they service $6 trillion in loans.  These and other traditional servicers are being forced to sell or sub-service their delinquent portfolios for several reasons.  

Business strategy – First, traditional servicers are not equipped to handle risky loans – they don’t have the staff or systems to do so and they have too many problems to deal with immediately.  Second, there are 2 clearly separate business models here – traditional servicing which requires a low cost, low service strategy and specialty servicing which requires high cost, high service infrastructure.

Regulatory – The OCC has issued a consent order that provides minimum requirements for servicers.  There is a list of ~50 compliance requirements for servicing, of which, most large servicers only meet 10-20 (as opposed to specialty servicers who comply with virtually all requirements).  Traditional servicers are forced to either add considerable expense to get in compliance, or sell/outsource servicing activity to avoid the oversight.

Capital – The financial crisis has created pressure to reduce leverage at big banks, the largest players in the servicing market.  New Basel III regulation also has specific caps on the amount of Tier 1 capital attributable to MSRs, which the large banks already exceed.  This is forcing banks to shed servicing portfolios to de-lever and meet new capital regimes.  Also, given the increased costs and regulation required to service, returns on mortgage servicing capital are much less attractive on a forward basis.  This further reduces the incentive for banks to hold MSR capital as they look to ways to maximize ROEs with lower leverage.

Investors – Owners of mortgages have realized that poor performance of traditional servicers has impacted the cash flow and NPV of their mortgage portfolios.  The Bank of America settlement with MBS investors in Q2 2011 was telling in that there were specific provisions requiring and detailing processes for transferring servicing of delinquent mortgages.

How Big is the Opportunity?
The servicing of mortgage unpaid principal balance (UPB) is being transferred fairly quickly as these various forces have combined over the last 12 months.  Green Tree estimated that $250b of loans was transferred to specialty servicers in 2010.  It indicated that a similar amount would transfer in 2011, but this is way too low because the pressure to transfer delinquent servicing to specialty firms increased substantially in 2011.  On its second quarter earnings call, OCN alone stated that it is currently in some form of negotiation on $250b of loan servicing rights.  This is after it already had $40b of loans transferred from Goldman Sachs (Litton) earlier this year.  On its recent third quarter earnings call, Ocwen announced another $30b of UPB from Saxon (Morgan Stanley portfolio), and increased its current backlog of deals in some discussion to $300b.  Ocwen thus effectively increased its backlog of opportunity from $250b to $330b between 2Q and 3Q, if you add in the Saxon deal won.  Bank of America reached a settlement with MBS investors in Q2 2011 that transferred $221b of UPB (~$100b of which is delinquent or in foreclosure).  And while the overall settlement is being contested in court, the transfer of servicing is proceeding since this is the only point of agreement between the parties.  Bank of America also sold $73b of servicing rights to Fannie Mae in Q3 2011 – separately from its deal with MBS investors.  Fannie does not conduct its own servicing and has 5 approved sub-servicers (including Green Tree) to handle high-risk loans.  All of this suggests that there is now a rapid transfer of servicing activity away from the traditional servicers and towards the specialists. 

WAC is clearly benefiting.  Walter disclosed that it had reached $60b of UPB as of September 30, 2011 after starting the year with $32b.  Back in May, the company guided to over $60b by year end, which now seems conservative given the activity in the space.  Importantly, the Fannie Mae transfer and Bank of America settlement are not in these numbers as neither happened in time.  So even without these very large and high profile deals, WAC doubled its UPB.

It is hard to know how much balance will ultimately move, but it seems fair to assume that WAC – with $60b of UPB today can double or triple its current base of business in the next few years as >$1 trillion of UPB is ultimately transferred.

Financial estimates
Admittedly, it is tricky to precisely estimate the financials here since we do not yet have great guidance from the company and each new deal can have a unique profile.  The acquisition of Green Tree did not close until July, so WAC has not reported results as an owner of the business yet.  And WAC has yet to provide guidance about financial targets with Green Tree.  We do have some pro forma historical information that helps.   Here are a couple ways to frame the financials and valuation. 

Simplistic approach
The simplistic approach highlights the earnings power and primary driver of EBITDA, cash flow, and eps. 

WAC disclosed pro forma EBITDA of $235m and core eps of $2.56 as of Q4 2010.  I estimate that the interest expense came in approximately $10m higher than the company initially indicated (the most recent credit crisis made the rate on its debt higher than initially anticipated), so eps is probably closer to $2.35.  That puts WAC at 6.4x EBITDA (assuming corporate debt of $810 and 28.4m shares outstanding) and 10x eps as of year end 2010 – before it recently doubled its UPB. 

These numbers are based on average UPB in the low $30b range.  If we add $30b of UPB @ 35bp of servicing revenue (company has been running in the 45bp range plus incentive fees, but I want to be very conservative), the company will earn an incremental $105m of revenue.  Assuming 40% incremental margins and 38% tax rate, this creates an incremental $42m of EBITDA and $0.90/share of incremental eps.  That puts WAC at $277m of EBITDA and $3.25 of eps at its current $60b of UPB.  This puts WAC at 5.4x EBITDA and 8x eps on current UPB.

On a forward basis, each incremental $10b of net UPB added generates $14m of EBITDA and $0.30/share of eps.  As an example, if I assume $50b of incremental UPB through the end of 2012 (ending at ~$110b of UPB), I get $112m of incremental EBITDA and $2.40/share of incremental eps for a total of $346m of EBITDA and $4.75/share of eps.  This puts valuation at 4.3x EBITDA and 5x eps.  I have ignored cash flow in this analysis, which would take down EV (as debt is paid off) and would also increase eps (as interest expense falls).

This approach also ignores a couple pieces of the model which are important to highlight now.  One is that Green Tree has a collections business that it calls asset receivable management (ARM).  ARM gets a revenue share of deficiency balances collected and is currently focused on collections with existing mortgage relationships.  However, the company intends to expand to include other areas of collections.  This business should grow faster than UPB growth.  Another business is the insurance agency segment which is a broker for both voluntary and lender placed insurance.  As it has significant manufactured housing, this business is in slow decline (along with manufactured housing UPB declines).  However, as residential UPB grows, this will offset some of the lost manufactured housing revenue.

My model
Below are more detailed assumptions I use to create my estimates.  I am not including a full model since I have trouble with the formatting on this website, and I recommend interested investors create their own anyway. 

Key assumptions:
New residential UPB:  $50b that gets added throughout the year in 2012, resulting in ending UPB of $210b
Residential housing:  20% decline rate on beginning period balances, 45bp on UPB for servicing revenue, declining to 40bp of UPB and 16bp for ancillary revenue
Manufactured housing:  12% decline rate on beginning period balances, 107bp of revenue on UPB, no new UPB
ARM:  UPB grows with residential UPB, 40bp of revenue on UPB
GM%:  55% (lower than historical 60%)
Indirect expenses:  grow 10% per year
Legacy Walter PBT:  $35m and $20m of incremental interest expense
Synergy:  $19m
D&A:  $22m
Corporate interest expense:  $75m
Tax rate:  38%
Shares:  28.4 

This gets me to $330m of EBITDA and $4.70 of eps for 2012 assuming that the UPB gets added throughout the year.  For 2013, assuming flat UPB of $100b (so the company gets full credit for UPB added throughout the year), my EBITDA goes to $385m and EPS to $5.80/share.  On today’s EV (assuming no debt paydown and no interest reduction), that yields 3.9x EBITDA and 4.1x eps.

Out year assumptions
From here, the numbers may decline some as residential UPB has current decline rates of 20% (though this should slow materially in out years as rates can’t go down anymore and foreclosures/short sales eventually slow).  However, there are many ways for WAC to offset decline with incremental flow business from 1) new problem loans, 2) new high risk loan issuance, and 3) private label servicing for smaller banks (a specific opportunity WAC has recently highlighted).  I do not expect significant growth once the one-time industry servicing transfer is complete, but keeping UPB flat to slightly growing from a base of ~$100b does not seem difficult given the industry data highlighted above.

Valuation and Risk/Reward
If I assume EV/EBITDA of 5x and 7x eps (this seems conservative as comps like OCN, ASPS, PHH trade at 7-11x eps), I get a valuation of $40/share or 50%+ upside from current share price at the ~$100b of UPB level. 

Using these multiples, it is very difficult to get a share price below the current one unless I assume that the company cannot grow beyond the $60b of UPB it currently has.  If I assume flat UPB at $60b, and 5x EBITDA and 7x eps, I get a share price of $20/share or downside of 25%.

So even with very low multiples and very conservative assumptions on UPB, I get better than 2:1 upside to downside which I find compelling.  And it is very reasonable to assume that WAC grows materially higher than $100b of UPB.

WAC serving performance falls, reducing incentive fees.

WAC is not able to win significant new UPB.

WAC is unable to sufficiently scale its infrastructure.

Lender place insurance risk.  This should not apply to WAC as they are a broker and they do not set pricing – this is set by state governments in many cases.


New deals announed that transfer large UPB to WAC.
WAC provides financial guidance and EPS estimates on Q3 earnings call.
Earnings grows as subservicing deals get boarded.
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