market folly: 2013-07-07 : hedge fund tracking, SEC filings, investment conferences

The following is a guest post from Glenn Chan who is passionate about investing and maintains a blog at glennchan.wordpress.com. He is based in Toronto and is currently looking for a position as a junior analyst. He can be contacted at: glennchan [at] gmail [dot] com

Investment Thesis on Altisource Portfolio Solutions (ASPS)

Altisource is a rapidly-growing business that is riding the trend of financial companies outsourcing their mortgage servicing. The process of servicing mortgages has become more complex as the US government continually adds more regulations to protect homeowners from foreclosure. The cost of complying with government regulations and creating automated systems to handle mortgage servicing is mostly fixed. These economies of scale will likely push the industry towards consolidation.

Altisource has grown its revenues per share by an incredible 36%/year from 2008-2012 (historical stats) and currently trades at a P/E ratio of 21.6 (at $97.36/share). Its growth next year is practically guaranteed due to its unique relationship with Ocwen Financial (OCN). ASPS' forward P/E is roughly 11.8 (according to Yahoo Finance). I believe that Altisource is the best managed mortgage servicer in its field.

History and Financial Structure

Altisource spun off from the parent Ocwen in 2009. Altisource contains the “good” high-margin businesses while Ocwen is the “not as good” business with lower returns on capital. Interestingly enough, the CFO at the time (Robert D Stiles) chose to jump ship and join the smaller company. I’m guessing his stock options have done well since Altisource shares are up 508% since the spinoff.

Normally one would stay at the larger company as it is likely to pay a larger salary. He had the foresight to jump ship to the rapidly-growing Altisource. As the CFO, he structured Altisource as a Luxembourg company so that Altisource would save money on taxes. I personally think that he is a very smart guy. Unfortunately, he resigned on Feb 22, 2012. Some of the clauses in his separation agreement suggest that he and his bosses had disagreements. For example there is a clause that states: “The undersigned Managers agree not to disparage Stiles.” I suppose I won’t know what happened.

One key aspect of the spinoff is that Ocwen has to use Altisource’s services. This means that whenever Ocwen sells shares or raises debt to buy mortgage servicing portfolios, it brings business to Altisource. Altisource does not have to spend money on attracting this new business. And of course it grows when Ocwen grows. The financial structure also allows Ocwen to grow very quickly through selling stock, allowing both companies to enjoy economies of scale. If the endgame of the mortgage servicing industry is ‘survival of the biggest’, Ocwen and Altisource are well positioned. Unlike Ocwen, Altisource will not face share dilution. Altisource is buying back its shares, not selling them.

The Other Spinoffs and IPOs

William C. Erbey is the chairman of Ocwen and Altisource. His empire has since expanded into even more companies. Home Loan Servicing Solutions (HLSS) is an new company that raised funds in an IPO. It will focus on owning mortgage servicing rights (MSRs). HLSS use services from Ocwen and Altisource at cost plus a 15% markup.

Altisource split up into three stocks, of which there are four important entities:

ASPS - The parent company.

RESI - Altisource Residential. RESI’s business model is to (A) buy and manage portfolios of non-performing and sub-performing mortgages and (B) rent out the homes they get stuck with whenever foreclosure cannot be avoided. This is a new venture that has no operating history. ASPS will benefit from growth in RESI as ASPS will provide services to manage RESI’s real estate.

AAMC - Altisource Asset Management. AAMC is RESI's asset manager and is entitled to payments from RESI based on the level of RESI's dividend payments.

NewSource Title Reinsurance. NewSource will provide title insurance services to Altisource/ASPS and RESI. The financial structure is very tricky as all three companies have different positions in its ownership structure. AAMC will invest $2M in NewSource equity while RESI will invest $18M into NewSource non-voting preferred shares (12% dividend). ASPS will provide services to NewSource under a Title Insurance Services Agreement. ASPS will receive 90% of NewSource’s net income after “NewSource pays Residential a preferred dividend of 12% (which is an annual cumulative rate)”.

RESI will receive a 12% dividend yield... this is a good return.

AAMC will receive $840K (adjusted by CPI) in management fees from NewSource plus 10% of net income. This is a very high return for a $2M investment. Net income will likely consist of returns from the insurance float and profit from title insurance/reinsurance, which has extremely high margins. When homeowners buy a house, they typically go with the mortgage originator’s recommended title insurance company. They overpay for title insurance because:

1. They may not know any better.
2. Compared to the cost of the house, title insurance costs very little.
3. They may not want the inconvenience of shopping around for title insurance. A different title insurance company can lead to paperwork delays.

ASPS is the loser in this deal in my opinion. ASPS will be directing its profitable title insurance/reinsurance business towards NewSource where RESI and AAMC will take their cut. NewSource is expected to have a “steady stream of title insurance and reinsurance sourced by Altisource through its relationships with Ocwen and Lenders One, a national alliance of leading community mortgage bankers, correspondent lenders and suppliers of mortgage products and services” (see AAMC’s filings).

OCN, RESI, and HLSS will likely continue to raise capital and continue to do secondary offerings. They will drive more business towards ASPS and AAMC.

Following the Money

Overall, Erbey's stock ownership looks something like this:

1. Altisource Asset Management (AAMC): 30.1% according to this 13D filing
2. Altisource (ASPS) – 25.4% (5,935,343 shares / 23.36M shares outstanding)
3. Ocwen (OCN) – 13.2%
4. Altisource Residential (RESI) – 9.9% after the secondary offering closes according to this 424B1 filing
5. Home Loan Servicing (HLSS) – 2.8%

Based on these ownership figures, AAMC and ASPS are the stocks to own.

Erbey owns a larger portion of AAMC than ASPS due to unvested restricted shares. The 3-way split of ASPS/RESI/AAMC may have been designed to be beneficial to Mr. Erbey as he increased his ownership of the most desirable spinoff. However, AAMC is quite overvalued at the moment so I am not interested in it.

Institutional Ownership

(This section by MarketFolly): Numerous hedge funds have been involved in OCN and we posted up how Steve Eisman pitched OCN at the Ira Sohn Conference. Additionally, OCN has been analyzed in past issue of our Hedge Fund Wisdom newsletter.

Turning to top institutional owners of ASPS, Omega Advisors' Lee Cooperman is one of the largest owners of ASPS (he also owns OCN). In a recent interview he said he likes both as housing proxy plays.

Other top holders of ASPS at the end of Q1 included Matt Iorio's White Elm Capital. Prior to founding White Elm, Iorio worked at Steve Mandel's Lone Pine Capital. Like Cooperman, Iorio owns both OCN and ASPS (and both were top 5 holdings at the end of Q1).

In White Elm's Q2 letter, they note:

"Altisource now trades at 10x 2013E consensus earnings per share. Investors appear to be discounting (1) a material decline in foreclosure activity and (2) ongoing payments from Altisource to help fund Ocwen's future acquisitions. These concerns are perplexing given that Ocwen's growth has virtually guaranteed a large pipeline of foreclosed properties for Altisource over the next three years and the non-default businesses are growing rapidly. Over the next three years, we expect Altisource to grow earnings per share at a compound annual rate of nearly 40% and generate approximately $30 per share in free cash flow (or almost 40% of its current market value). Based on our earnings growth expectations and assuming a modest multiple of 12x 2015E EPS, we believe our road-map to a three-year double with Altisource is achievable."

Quant firm Renaissance Technologies is also one of the top holders at of the end of Q1, though the position size was only a miniscule portion of their overall portfolio. We won't see who the top holders as of Q2 were until mid-August due to SEC delay rules. Now back to the rest of Glenn's writeup:

Industry Overview

The Mortgage Lifecycle

On a mortgage, the lender has to handle paperwork and mortgage payments. If the homeowner is late on payments or stops paying entirely, then the lender has a lot more work to do. The lender may try to negotiate with the homeowner to get back on track with paying their mortgage. It may try to get the homeowner to participate in government programs designed to keep people in their homes (in the wake of the subprime housing crisis there are a lot of these programs). It may try to work with the homeowner on a short sale to avoid the costs of a foreclosure.

Some mortgages will end up in foreclosure. There are many laws and regulations designed to protect homeowners during the foreclosure process. Lenders have compliance costs in making sure that they follow all laws and regulations. After the lenders initiate the foreclosure process, things get really messy. Ex-homeowners often completely trash the property and may steal appliances, wiring for scrap metal, etc. Before the property is ultimately sold to a retail consumer, the property will need to be cleaned up and repaired. Some people squat in their home and may return to it even after they are kicked out; this can sometimes create scary situations for others who are cleaning up the property. Some lenders don’t want to deal with foreclosure-related problems so they will sell houses to investors for them to fix. These houses are often sold at large discounts. Or, they may pay fees to companies like Altisource to clean up the property. As an alternative, the lender could hold onto the property and rent it out (this is Altisource Residential’s business model).

Mortgage servicers may handle some or all aspects of the mortgage lifecycle. Some aspects of the mortgage lifecycle are very open-ended and create opportunities for adding value.

Ocwen/Altisource's Performance

A WSJ article makes the following points about Ocwen/Altisource:

- It "has won praise from consumer advocates for its willingness to re-work mortgages and help struggling borrowers stay in their homes".
- The vast majority of its labour force is in India and offshore. While this lowers costs, there are some concerns about protection of personal data and regulatory compliance.
- It has many offshore incorporations to keep taxes down.

Ocwen/Altisource tries to automate as much as possible. For example, delinquent mortgagers are sent multiple letters and a DVD explaining the situation (e.g. how to apply to HARP). This saves time from having a call center employee repeat information to mortgagers. However, there is still a need for trained call center workers as not everything can be automated. On Ocwen’s website there is a Morningstar “Operational Risk Assessment” report that contains a lot of detail on Ocwen’s operations.

As for foreclosures, Ocwen/Altisource tries to minimize its sales commissions by running its own real estate portal (Hubzu) and offering real estate agents lower commissions. Moving away from the traditional MLS models allows Ocwen/Altisource to lower their costs. Not surprisingly, real estate professionals complain about this (see complaints about Hubzu/gohoming.com/Ocwen/Altisource on pissedconsumer.com). For activities that require a human touch, Ocwen/Altisource is not perfect. The complaints page on pissedconsumer.com does suggest that Ocwen/Altisource employees do make mistakes. The webpage also suggests that Hubzu has a problem with fake bids.

Does Altisource Enjoy a Competitive Advantage?

Labour arbitrage: I don’t know why but it seems that Altisource’s competitors have not set themselves up to use offshore labour. Publicly-traded competitors such as Walter Investment Management (WAC) and Nationstar (NSM) only employ Americans. Outsourcing labour to foreign countries is a difficult problem. The problem is difficult enough that there are publicly-traded companies which specialize in it (G, CTSH).

Software: Starting a successful software company is very difficult. One of the hardest things to do is finding great programmers. Joel Spolsky (he runs his software company) has a blog post that explains why the process is difficult. Simply running a software company is very difficult by itself. It’s even more difficult if you add in the complications of running a foreign operation. My opinion is that the labour arbitrage is very difficult to pull off. I don’t know how well Altisource has pulled off its labour arbitrage. However, Altisource is highly profitable and has many job postings for Indian programmers/developers.

Business processes: Altisource is much better than its peers at working with delinquent mortgagers at restructuring loans. I don’t know how easy/hard it is to duplicate this.

Overall, I don’t think that Altisource’s high margins are based on a single thing. It is a combination of many things that they do well. The Morningstar report referred to earlier “Operational Risk Assessment” provides a lot of insight into the many things that Altisource is doing. Some of their practices seem to require hard-won experience. Altisource takes many steps to prevent payment processing employees from stealing (e.g. video surveillance, no drawers in the room, etc.).

Scale: I believe that scale gives a minor cost advantage. Ocwen/Altisource is not the largest mortgage servicer however. This Reuters article states that big banks such as BAC, Wells, Ally, JPM, and C are the leading mortgage servicers. All five of these banks paid settlements over robo-signing… this suggests that they are not very good at mortgage servicing. All these banks let ex-homeowners squat in their own homes without paying their mortgages for years during the subprime housing era (including Wells Fargo, a Warren Buffett favorite). I think that Altisource is well-positioned against these larger mortgage servicers. Ocwen has bought Ally’s Rescap unit and Goldman Sach’s Litton Loans.

Relationship with Ocwen: Altisource’s relationship with Ocwen has been hugely beneficial for Altisource since Ocwen is a captive customer. Better yet, Ocwen has been continually issuing equity and increasing its assets. Altisource has been growing without having to spend advertising/marketing money to get more business from Ocwen. However, Altisource would still do extremely well without Ocwen. Ocwen’s share of Altisource’s mortgage services revenues has been declining as organic growth from non-Ocwen customers has exceeded Ocwen’s growth. The 10-K provides relevant figures:

In 2010, related parties accounted for 73% of Altisource's mortgage services revenue.
In 2012, related parties accounted for 68% of Altisource's mortgage services revenue.

The Future of the Mortgage Servicing Industry

My guess is:

1. The major banks will get out of mortgage servicing and outsource. They don’t seem to be very good at it (e.g. robo-signing)… engaging in illegal activities suggests incompetent management.

2. The trend towards outsourcing mortgage servicing will continue. I think that this financial innovation does create value as companies that specialize in it have done a better job than the vertically-integrated operations of major banks.

3. The industry will consolidate into fewer players. The cost of regulatory compliance will limit the number of new competitors.

4. My thinking is that Altisource has executed very well compared to industry peers such as Wells Fargo. Altisource didn’t allow squatters to live rent-free for years. It didn’t engage in robo-signing. And it isn’t facing a litany of lawsuits for improper behaviour (simply go Google “Wells Fargo mortgage lawsuit“). In one instance Wells Fargo, the judge characterized Wells Fargo’s behaviour as “highly reprehensible” and issued a $3.1M fine.

5. Out of the publicly-traded mortgage servicing-related stocks, I think that Altisource (ASPS) will do better than Ocwen (OCN), Walter (WAC), and Nationstar (NSM). Its share price has certainly outperformed its peers.

Does Management Have Integrity?

Operationally, I think that the company is very ethical. They have not done anything illegal such as robo-signing. And they work hard to keep mortgagers in their homes.

As far as management goes, one could make some arguments against Mr. Erbey’s ethics. Some articles in the press have commented negatively on the fact that Ocwen overpaid for Bill Erbey’s Atlanta multimillion dollar home. (An 8-K filing shows that Ocwen paid $6.5M.) However, people deserve to be fairly compensated when they have to relocate for employment. Mr. Erbey can’t exactly enjoy his Atlanta home while working in the US Virgin Islands. The 8-K states that he will be working on setting up Ocwen Mortgage Servicing, a new subsidiary. AAMC is also headquartered in the Virgin Islands while Altisource is headquartered in Luxembourg.

As far as the ASPS/AAMC/RESI spinoff goes, the spinoff slightly enriches Mr. Erbey due to his restricted stock grants at AAMC. It’s kind of sneaky that Altisource is funneling profits into NewSource, of which AAMC will likely be the greatest beneficiary. A small amount of wealth may be transferred from Altisource to AAMC. Erbey will own more AAMC than Altisource. Overall however, Mr. Erbey compares favorably to John Malone. Malone’s spinoffs are far more complicated and craftier. Malone takes steps to goad institutional investors into making mistakes; Erbey has not done that.

As far as insider compensation goes, it is reasonable. According to the SEC filings, the directors range in compensation from $52,900 to $162,990 (Mr. Erbey is the highest-paid director). William Shepro, the CEO, has had his compensation range from $1.4M to $4.4M. His Altisource shares are worth about $30M ($96.16 X 311.327 shares) so he has plenty of skin in the game. The level of compensation paid to insiders doesn’t seem that out of line compared to other public companies. I believe that the value management has created far exceeds their compensation.

Accounting Tidbits

The depreciation method used by Altisource is fairly reasonable if not on the overly conservative side. Most of Altisource’s fixed assets consist of computer hardware and software. These are depreciated over 2-3 years. It is highly likely that Altisource continues to use computer hardware and software that is over 2-3 years old. These assets would be carried at a value of 0 yet have a market value slightly above that. Altisource’s accounting looks very reasonable to me and I do not see any signs of overly aggressive accounting. Unlike other companies, Altisource does not capitalize any internal software development costs. (Capitalizing software costs will increase reported profits.)

Hidden Assets

The relationship with Ocwen is arguably very beneficial to Altisource. In the short term, Altisource is guaranteed to grow as Ocwen has significantly increased its loan base. Altisource owns Hubzu.com (formerly GoHoming), which is an online real estate portal. The site is being opened up to third-party listings. In theory, this property can provide serious competition to the traditional real estate model and their MLS (multiple listing service) systems. This could potentially turn into a business with very high returns of equity if it becomes more popular. Hubzu has many competitors in this space including RedFin. Management may try to IPO Hubzu given that other Internet companies have been fetching high valuations in the past few years.

Hidden Liabilities

As discussed before, the deal with NewSource funnels some value out of Altisource.

Other Deals Between Altisource and Ocwen

Altisource has used $200M of debt (maybe around 2 years worth of earnings) to buy servicing businesses from Ocwen. Ocwen acquired those businesses when it made its large loan portfolio acquisitions.

Considering that Mr. Erbey owns a greater percentage of Altisource than Ocwen, this deal will likely be fair to Altisource shareholders.

Capital Allocation

Altisource has stated their share repurchase policy in their 10-K:

"We seek to deploy excess cash generated in a disciplined manner. Principally, we will continue to reinvest excess cash in developing compelling services that we believe will generate high margins. In addition, we may seek to acquire a limited number of complementary companies that fit our strategic objectives. Finally, given the tax inefficiency of dividends, the low returns earned on cash held and our current belief to pursue a limited number of acquisitions, we believe one of the best ways to return value to shareholders is through a share repurchase program."

For the most part, they have done what they said they would do. Altisource has been buying back its shares at prices lower than the current market price. However, the part about “the tax inefficiency of dividends” doesn’t entirely make sense. The ASPS/RESI/AAMC spinoff can be seen as a ‘tax inefficient dividend’ and caused shareholders to pay taxes right away. It was not structured in a way that deferred taxes. On the other hand, the spinoff should work out fine. RESI was able to raise a very large amount of capital, driving new business to Altisource. This will likely compensate for the tax inefficiency of the spinoff.

The Big Picture

Warren Buffett wrote in his 1989 letter to Berkshire shareholders:

"It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements."

I think that Altisource satisfies both criteria of a first-class business and a first-class management. It should be a business that will be able to compound capital at high rates for a very long period of time.

I believe that the mortgage servicing industry has good economics. It does not have the boom/bust cycles of commodity industries. And it does not face the risk of a technological shift that makes the industry obsolete (think phone book directories, bricks and mortar stores that compete directly with Amazon, etc.). On the other hand, mortgage servicing is a very tough field considering that the major banks have done a bad job at it and had to pay settlements. They may be trying to sell their mortgage servicing businesses because they are losing money at it.

Altisource’s management is excellent. However, if management were to leave, I’m not sure if the company will continue to do as well.

Overall, I see Altisource as a very attractive growth business with low risk and a reasonable valuation.

Other Considerations

ASPS Versus AAMC

In theory, AAMC is ‘better’ than ASPS because ASPS is structured to drive title insurance business towards AAMC (in the same way that OCN drives business towards ASPS). However, AAMC’s current valuation is ridiculous.

AAMC’s main assets are:

1. 10% of NewSource’s profits.
2. An agreement that entitles it to management fees from RESI.

At $270/share, AAMC’s market cap is a $632M.
At $17.55/share, RESI’s market cap is $400M (22.8M shares after the secondary offering).
At $96.16/share, ASPS’s market cap is $2,228M.

For $400M, you can buy RESI outright. So #2 can’t be worth more than $400M. This implies a valuation of >$232M for #1. If 10% of NewSource’s profits is worth >$232M, then NewSource in its entirety would be worth >$2,320M. >$2,320M is more than Altisource’s entire market cap.

Erbey's Insider Trading

Looking at Erbey’s trades, he has made small sales of ASPS and OCN while he has been making small purchases of HLSS. I am not going to read too much into these sales and purchases. Erbey had legitimate reasons to sell stock as he needed to pay taxes on the ASPS/AAMC/RESI spinoff as the spinoff was not structured in a tax-efficient manner. Erbey also needed money to startup HLSS as he invested $10M in the HLSS IPO. Underwriters like to see that company insiders have some skin in the game as it aligns their incentives closer to that of shareholders. (Of course if investors were smarter they would probably just buy ASPS instead.) Erbey’s open market purchases of HLSS helps to promote the stock and helps HLSS in raising capital.

Overall, I think that Erbey’s ownership of ASPS and AAMC will increase over time while his ownership of RESI, OCN, and HLSS will decrease over time

*Disclosure: Long ASPS. Not long AAMC, RESI, HLSS, OCN at time of write-up.

Thanks again to Glenn Chann for the write-up. He is based in Toronto and is currently looking for a position as a junior analyst. He can be contacted at: glennchan [at] gmail [dot] com

Warren Buffett's Berkshire Hathaway filed a form 4 with the SEC regarding their position in DaVita (DVA). Per the filing, Berkshire has disclosed that they purchased 639,200 shares on July 2nd and 3rd at weighted average prices ranging from $112.35 to $116.41. After all purchases, Berkshire now owns over 15.6 million shares of DVA.

DaVita shares have recently been hit on news that a proposal by the Centers for Medicare and Medicaid Services would decrease payments to dialysis facilities by $970 million in calendar year 2014 (more details here).

Berkshire has been slowly building a large stake in DVA and we've detailed their previous purchases. This coincided with new portfolio manager Ted Weschler joining the Berkshire team (DVA was a top holding at his previous hedge fund).

Berkshire originally built their position in DaVita between $70-85 it looks like and they've slowly added to the stake each quarter, recently buying at around $110 and now again at the prices outlined above.

Per Google Finance, DaVita is "is a provider of dialysis services in the United States for patients suffering from chronic kidney failure, also known as end stage renal disease (ESRD)."

For more from this manager, we've also highlighted some other recent Berkshire Hathaway portfolio activity.

market folly

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Monday, July 8, 2013

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