Altisource Portfolio Solutions

Date: 04/28/2014 / Ticker: ASPS / Price: $102.45/ Market Cap: $2.3 billion / Idea Type: GARP

Altisource Portfolio Solutions is currently my largest position. Here’s why:

ASPS is a 200% return on capital business with a five-year top-line CAGR of 37% per year, is run by the best operator and capital allocator in its industry, that currently trades for less than 10 times this year’s estimated free cash flow. If that still doesn’t interest you, it’s also buying back the maximum legally allowed amount of its share count.

Overview

ASPS is the highest quality business within Bill Erbey’s mortgage finance empire. The company was a unit of Erbey’s Ocwen mothership and was spun off in 2009 to highlight its higher quality cash flow stream and to capture adjacent revenue sources in the mortgage industry.

ASPS is a process outsourcing business that collects fees on a transactional basis by providing a large set of services to the mortgage industry. The range of ASPS’s services is so diverse that no description suits it better than this graph from the company’s Investor Day slides:

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Two thirds of the company’s revenue derives from Ocwen’s mortgage servicing portfolio, but over the last few years ASPS has also diversified its revenue stream by offering services to other parts of the mortgage finance value chain, such as origination and online real estate auctions.

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Why The Opportunity Exists

– ASPS has a very unique business model with no direct public peers. It is often inappropriately compared to mortgage servicers such as Ocwen and Nationstar, when in fact, ASPS’s business model is more comparable to process outsourcing businesses such as Accenture and ADP. The high quality nature of the business model is well documented in its ROC profile.

– Despite being a $2.3 billion company, ASPS is very much under the radar and is covered by only two sell-side firms.

– Trading at 20 times 2013 GAAP earnings, the stock doesn’t screen well. GAAP numbers obscure the company’s earnings power for four reasons: 1) significant investments have been made to upgrade ASPS’s software offering; this was fully expensed and temporarily depressed margins; 2) ASPS made over $400 million of tuck-in acquisitions in the last four years, which added amortization cost due to purchase accounting; 3) there is a 1-2 quarter lag between the boarding of MSRs onto ASPS’s platform and when the company starts generating service fees; 4) significant 2014 growth is almost guaranteed as Ocwen more than tripled its MSR portfolio in 2013, giving ASPS a much larger backlog to service (ASPS gets paid a fee per service transaction). I estimate that ASPS will generate $10 – $11 of free cash per share in 2014, double what it made a year ago.

– There is quite a bit of hidden value in ASPS’s online real estate auction business, Hubzu, which is a relatively small contributor to ASPS’s earnings but should deserve a very high multiple in the public market.

– The stock dropped a lot early this year due to a NY financial regulator halting a MSR portfolio sale to Ocwen (in turn freezing most MSR transfers in the market). I will explain later why I think this is mostly short-term noise and is unlikely to harm ASPS’s long-term prospects.

Industry

ASPS’s main business is subservicing mortgages in Ocwen’s mortgage servicing right portfolio. A mortgage servicing right (MSRs) entitles its servicer a predetermined annual fee (typically 25 bps – 60 bps depending on credit quality and Fannie/Freddie involvement) for the duration of the mortgage’s existence.

Ocwen is one of the largest players in the MSR space, which has traditionally been dominated by the big banks but is gradually being taken over by non-bank servicers as banks scramble to sell their MSR portfolios in anticipation of the implementation of Basel III regulations.

Recent years have seen the entrance of other non-bank servicers such as Nationstar Mortgage Holdings, which are investment entities backed by private equity firms and hedge funds. In general, these non-bank servicers perform higher quality services than the big banks and are lower cost. The non-bank space is currently dominated by four players, and has a fairly high regulatory barrier to entry, as firms must employ hundreds of compliance staff to ensure servicing quality.

The MSR industry is very capital intensive, as the servicers must make large upfront payments to purchase MSR portfolios. These portfolios experience run-offs due to a combination of default risk and refinancing risk, both of which end the economic life of an MSR and the associated cash flow streams.

ASPS was an attempt by Bill Erbey to create a capital-light model out of the mortgage servicing channel, by separating high value-add servicing platforms from the financing of MSRs (Ocwen). ASPS’s advantage is that like Ocwen, it gets paid every time it performs a service, except ASPS does not have the capital requirement to maintain an MSR portfolio.

Over the years, ASPS has made several bolt-on acquisitions and introduced new services to diversify away from mortgage servicing. It now has a sizable presence in the mortgage origination space, where it owns the Lenders One originators’ cooperative (14% market share) and provides origination services to its members. ASPS’s online marketplace Hubzu, is one of the largest online real estate auction sites and primarily sells homes that Ocwen forecloses on.

Moat

ASPS has a strong moat, which combined with its capital light model, has given the company a terrific ROC profile:

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Most of what ASPS offers are essentially IT “platforms” that operate with inherent scalability, and therefore, the best way to think of ASPS is that it is basically a high-margin royalty on the mortgage industry (especially Ocwen’s MSR portfolio).

I believe ASPS’s moat is constructed with the following advantages:

Switch Cost: The MSR industry is highly regulated and the processes involved in servicing an MSR portfolio are very complex (many processes that interact with each other and must also comply with regulations and investor contracts). ASPS’s services are mission-critical platforms that incur a huge switch cost to their users.

Technology: ASPS has the best technology. Technology is usually not a source of sustainable competitive advantages, but in the case of ASPS, I believe it is.

ASPS’s core technology is inherited from Ocwen, who has spent over two decades and hundreds of $ millions developing automation software that has significantly improved service quality and the scalability of its service platforms.

The best example is Ocwen’s “dialogue engine” (now owned by ASPS and leased to Ocwen) used in dealing with delinquent borrowers, which was developed with the help of a large team of specially trained, in-house team of psychologists. The dialogue engine employs artificial intelligence to analyze borrower interactions, taking into consideration of many variables (the borrower’s mood and financial circumstances, for example), and automatically generates optimized responses to feed to the loan servicers at the call centers. Since customer interaction is completely controlled by artificial intelligence, it doesn’t make any difference if the caller is American or Indian. Whereas Walter/Nationstar/big banks use expensive American employees (especially when dealing with delinquencies which involves extensive interactions between the homeowner and the mortgage servicer), Ocwen/ASPS’s technology focus has allowed them to successfully offshore most of their labor to India, where labor costs are a fraction that of the US.

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This offshore service model has allowed Ocwen to gain a substantial 70% cost advantage over its competitors and is extremely difficult to replicate given that 1) competing non-bank servicers have capital intensive business models and are focused on MSR portfolio acquisitions, leaving little capital available to invest in technology; 2) even if Ocwen’s competitors seek to switch to a similar offshore model, they run the risk of potentially weakening service quality (keep in mind ASPS’s core software took over 20 years’ worth of trial and error to develop), which could subject them to severe regulatory repercussions.

I believe Ocwen/ASPS’s business model advantage is akin to GEICO/Progressive’s distribution advantage. GEICO’s larger competitors had trouble replicating GEICO’s direct channel distribution model because the organizational changes that were needed for the transformation to occur implied too great a switch cost that they became content with the higher cost agency model that they had traditionally embraced and thrived on.

Furthermore, the way I see emerging non-bank players (ie. Nationstar), which are backed by private equity firms, is that they take a more speculative view on their industry and are mainly designed as investment vehicles for investors to play the rising interest rate theme (MSRs are effective hedges against rising interest rates since refinancing activities decrease when rates rise, extending the life cycle of the cash flow stream). Nationstar, for example, books its MSR portfolio at “fair value” and reports fair value adjustments as revenue, as if capital gains on its servicing portfolio were a core business activity. Compared to Ocwen, the other non-bank servicers are not as incentivized to take the risk to offshore their labor base in order to lower costs.

Bill Erbey: Ocwen is a sticky customer to ASPS. Bill Erbey owns 29% of ASPS and 15% of Ocwen and controls both companies.

Growth Option

1. Continued massive MSR transfers from the big banks to non-bank servicers.

“If I had a choice, I would never be into bulk servicing again.” – Jamie Dimon

The total size of the mortgage industry is roughly $10 trillion in the United States. The vast majority of this is controlled by the big banks, which are inefficient at servicing mortgages. This is evident in the robo-signing scandal in 2010 and the fact that MSRs have been a major loss center for the banks for many years. Further exacerbating the pain is the upcoming implementation of Basel III, which will increase the risk weighting of MSRs to 250% (from 100% under Basel II) and cap the total value of MSR portfolios to 10% of banks’ capital base (from 50%).

The increasing capital requirement makes MSRs even more uneconomic for banks to own. The result is that the banks are exiting the MSR industry en masse and outsourcing the responsibility of servicing to non-bank servicers like Ocwen, which do a much better job at a lower cost.

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Ocwen’s current servicing portfolio has an unpaid principal balance of $464 billion, representing a paltry 4.6% market share. Basel III is expected to go into effect in 2018, and the banks are expected to offload the vast majority of their MSR portfolios ($4 trillion +) between now and then, which is a huge opportunity for Ocwen/ASPS.

Ocwen’s unique cost leadership means it can generate the highest ROE on new MSR portfolios, allowing the company to outbid its competitors on MSR acquisitions. Innovative financial engineering initiatives such as setting up REIT structures (HLSS) to help finance advances has also helped Ocwen lower its cost of capital and transition toward a capital light model itself.

I believe Ocwen’s capital structure/offshore operating model have given it a theoretically infinite capacity in acquiring MSRs. The best part of this is that any new MSR purchases will be financed by Ocwen (and HLSS) and ASPS can benefit from this growth at virtually no cost to itself.

2. ASPS’s non default management related businesses are also growing at a rapid rate. These include origination services and the Hubzu  real estate portal. ASPS’s Financial Services unit also serves primarily customers outside the mortgage industry such as credit card and auto lending companies.

Management projects that these three businesses will account for roughly $600 million of revenue in 3-4 years:

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Management

ASPS is controlled by its chairman, Bill Erbey, whom I briefly profiled in this post: https://oraclefromomaha.wordpress.com/2014/03/12/what-do-mike-white-and-bill-erbey-have-in-common/.

Thestreet.com also wrote a fabulous profile story on Erbey: http://www.thestreet.com/story/12083751/1/bill-erbey-made-23b-off-your-underwater-mortgage.html

Erbey is an incredibly talented capital allocator who has mastered the art of spin-offs to maximize shareholder value. Over the last five years, he has done four spin-offs, all of which have been multi-baggers.

Most of Erbey’s spin-offs are done to take advantage of capital markets’ perception of different quality cash flow streams. For example, HLSS and RESI, which are structured as REITs and pay a dividend, trade above book value and that allows them to grow via what Erbey calls the “Accretion Model” – issue equity above book and buy portfolios of new assets at book; the achievement of growth is rewarded with a higher multiple over book; rinse and repeat.  ASPS and AAMC, which are capital light businesses, were spun off to highlight their royalty-like cash flow generation, which deserves a higher multiple than a capital intensive mortgage servicer.

Management is well-aligned with shareholders. Erbey personally owns 29% of the company while the rest of management owns another 3%. Management ownership will continue to increase over the years as the company aggressively shrinks its share count through repurchases.

Erbey is also very conservative in managing and structuring his businesses, as the culture of conservatism at Ocwen/ASPS can be seen everywhere:

– Ocwen is by far the best capitalized servicer in the industry, with the lowest leverage.

– Ocwen is the only large player in the non-bank mortgage servicing space that books its MSR portfolio at cost, while Nationstar and Walter use very aggressive fair value accounting. Ocwen also does not recognize fees earned on delinquent loans until payments has been collected from the borrower.

– ASPS does not play the silly non-GAAP EPS game that many other software companies engage in (http://www.salesforce.com/ca/company/news-press/press-releases/2013/11/131118.jsp) to artificially boost EPS figures. Management’s definition of non-GAAP net income at ASPS is simple: GAAP net income + purchase accounting amortization (1 – tax rate %). Stock-based compensation is treated as an expense, not a source of cash flow.

– Ocwen/ASPS were one of the very few, if not the only large mortgage servicer that chose not to engage in robo-signing after the housing crisis.

– Ocwen/ASPS were among the very few companies in the mortgage industry that made money in 2008/2009.

Ben Lawsky and NYDFS

In early February, the New York Department of Financial Services, led by Superintendent Ben Lawsky, halted the transfer of $39 billion of MSRs from Wells Fargo to Ocwen and put an indefinite hold on the deal. Lawsky is known to have been scrutinizing the non-bank servicing industry for over a year and this move effectively froze most MSR transfers in the market.

Ben Lawsky is clearly the biggest risk overhang that the market is pricing into non-bank servicers, as the group has dropped over 30% since early this year (~40% for ASPS from its high). I believe Lawsky’s concerns over the industry’s practices are unsubstantiated and the halt in the MSR transfer market will most likely prove to be temporary, and here is why:

Lawsky’s assertion no.1: Non-bank servicers (Ocwen) are lightly regulated and are playing the regulation arbitrage game, while cutting corners to save on costs. (http://www.dfs.ny.gov/about/press2014/pr1402121.htm)

Rebuttal: Ocwen is heavily regulated. In fact, Ocwen is the only non-bank servicer that has signed a national settlement with state regulators, subjecting its services to the same level of servicing standard and compliance monitoring as the major banks.

Thousands of audits are done at Ocwen every year by state/federal regulatory agencies, mortgage investors and banks. Ocwen also employs a massive compliance team to ensure quality. Even ASPS has 175 professionals in its compliance department.

Lawsky’s assertion no.2: Non-bank servicers are hurting homeowners by performing low quality services and putting too many borrowers into otherwise avoidable foreclosure.

Rebuttal: The facts suggest the exact opposite. This is so wrong it is actually laughable.

– Ocwen has a reputation for favoring loan modifications over foreclosures in most cases. Despite having a much smaller MSR portfolio than any of the major banks, Ocwen performs FAR more modifications every year than all the banks. According to data from the U.S. Treasury, Ocwen accounts for 20% of all HAMP modifications since the consumer relief program was started and has performed 36% more than the next highest servicer. It also accounts for 39% of all HAMP principal modifications and out-modifies the next highest servicer by a factor of 2 to 1:

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– Ocwen also goes out of its way to help borrowers who cannot quality for a HAMP modification stay out of foreclosure:

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– Ocwen is on the forefront of financial innovation to help delinquent borrowers avoid foreclosures. In 2011, Ocwen invented something called the “Shared Appreciation Modification” program, where the homeowner would see his loan principal reduced by 5%, in exchange giving the mortgage investor 25% of any appreciation in the value of the property when the borrower refinances or sells it.

– In terms of service quality, Ocwen’s rating among authorities on the subject ranges from average to excellent:

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– Most ironic of all, Ocwen is being considered by a group of RMBS investors for a lawsuit for keeping too many delinquent homeowners in their homes: http://dealbook.nytimes.com/2014/02/27/a-house-with-a-modified-loan-is-a-symbol-of-servicers-tug-of-war-with-investors/.

– Lawsky’s whole case against Ocwen is based on the volume of complaints he has received from homeowners against the servicing companies. Kyle Bass showed a terrific table on CNBC that demonstrated how weak this argument is:

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“The banks are almost three times worse at this, and yet the regulatory inquiry is in the non-bank sector? I think Ben Lawsky should focus on who the worst players are, not who the best are.”

“(Referring to Nationstar) 11,000 are seriously delinquent, and Lawsky claims that in his letter, that he’s received hundreds of complaints….This is a business where there’s always going to be complaints…and if the numbers are in the low, low single digits, then that’s just a fact of life.”

– Kyle Bass on CNBC

Lawsky’s assertion no.3: Ocwen’s affiliate relationship with ASPS and its various other spin-off companies involve conflicts of interest that may incur higher costs to homeowners.

Rebuttal: The supply agreement signed between Ocwen and ASPS specified that all of the services Ocwen/ASPS provide must be priced at market or lower. Before Erbey did the ASPS spin, he must already have anticipated that potential conflicts of interest among his companies could be scrutinized by regulators. All evidence suggests that the companies have gone to great lengths to ensure that their pricing is fair.

Why Lawsky is Messing with Ocwen/ASPS

Out of the fifty state regulators and various federal regulators that Ocwen deals with, Ocwen is in good standing with virtually all of them, so how come Lawsky is the only one who has a problem with the company?

The answer is that Lawsky has political motivations in going after the non-bank mortgage servicing industry. It doesn’t takes a genius to figure out that Lawsky’s political ambition is to become the next Elliot Spitzer and his whole campaign against non-bank servicers is designed to for him to earn votes as a future politician.

Why This is Just Noise

– If what Lawsky wants is political points, the best way to get it is not to go on a publicized fight (especially when the other party has the facts on its side), but to settle quickly and let business move on: http://www.nytimes.com/2012/08/15/business/standard-chartered-settles-with-new-york-for-340-million.html?pagewanted=all&_r=0

– The banks are desperate to get out of the MSR business but currently the whole market is frozen because of Lawsky. This is going to put a lot of pressure on him to make peace with the non-bank servicers.

– Lawsky is a state regulator and does not have regulatory power outside NY state. Okay, in the worst case, suppose Lawsky’s ego grows so large that he is going to be completely unreasonable to Ocwen/ASPS. Call me naïve, but what’s going to stop Ocwen from simply exiting the NY market and acquiring only ex-NY MSR portfolios? Ocwen serviced only 129k loans in NY, which accounted for less than 5% of its portfolio; that’s peanuts compared to the potential ex-NY MSR pipeline that it can access.

Valuation

I believe ASPS can earn $10.4 a share this year in normalized earnings, which I define as (net income + acquisition-related amortization). At $102.55, the stock trades at a multiple of 9.8 x.

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Valuing ASPS is difficult because it is impossible to forecast future revenue growth without knowing if/how fast Ocwen can purchase new MSR portfolios and board them onto ASPS’s servicing platform. The good thing is that regardless of whether ASPS can service more loans, its non-servicing related businesses are already a large chunk of its revenue and will continue to grow. For illustrative purposes here I will use two scenarios:

Worst Case: in management’s long-term revenue projections, management indicated that should Ocwen simply go into run-off mode and stop buying MSRs, ASPS should generate roughly $1.2 billion of service revenue by 2017.

About $600 million of this will be unrelated to default management (Ocwen’s MSR portfolio) and will be recurring revenue. On a 25% net margin and a modest 13.0 x multiple, this business will be worth $1.95 billion.

Default-related revenue will be $600 million. Valuing this on a run-off basis (30% margin and 5.0 x multiple), it’s worth $900 million. I further assume that management will repurchase shares at the current rate (7.5% per year).

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That doesn’t seem like a very good return, but wait until you see the more reasonable case.

Best Case: In my best case, I assume that Ocwen is able to buy $100 billion of non-GSE MSRs every year (it has been buying more than that).

Based on management’s slides, run-rate revenue will increase to roughly $1.9 billion, splitting between $1.3 billion for default-related services and $600 million for others. Assuming flat margins, the company should earn close to $500 million after-tax by 2017, or over 20% of today’s market cap.

Furthermore, ASPS recently restructured its subsidiaries to remove the limitations that Luxembourg securities law had placed on its share repurchase program, which had been limited to 15% of share count in two years. The current maximum share repurchase capacity, according to Erbey, is $2.8 billion plus future earnings.

ASPS’s market cap is only $2.3 billion so this means the company can basically buy back as many shares as it wants. Management believes the stock is undervalued and under-levered and has expressed a willingness to leverage up the balance sheet to expand the buyback program at the last conference call. If ASPS levers up to just 2.0 x EBITDA (which is very conservative given that there is very little D&A and taxes), the excess debt capacity in the next three years, combined with the company’s free cash generation, should total roughly $2.2 billion. Under this scenario, if the stock stays flat over the next three years, ASPS should be able to buy back ALL of its shares.

In my buyback model, I assume the stock appreciates by 30% annually, in which case ASPS will be able to shrink its share count by 55%. Putting a conservative 12.0 x multiple on 2017 earnings, the stock will be worth $550 a share, or more than five times its current price.

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As you can see, the range of possible outcomes is very large and depends primarily on Ocwen’s ability to acquire future mortgage servicing portfolios from the big banks. The eventual outcome, I believe, will likely fall in between the two scenarios, but much closer to the best case.

The important point to keep in mind is that once Ocwen is allowed to participant in the MSR transfer market again, Ocwen/ASPS will have very few capacity constraints in adding new portfolios to their platforms.

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Other Risks

Long-term run off of MSR portfolio

The greatest risk to Ocwen/ASPS, in my opinion, is the fact that the current transformation in the MSR industry is largely one-time. As the non-bank servicers buy an unprecedented amount of MSRs from the banks, the sudden build up of portfolios and the inevitable run-off will be very difficult to replace given that annual origination (~$1 trillion) is only one tenth of the total market size (~$10 trillion).

What mitigates this risk is 1) it’s hard to get into the non-bank servicing business due to the regulatory/fixed cost requirement and the industry will likely remain an oligopoly post-Basel III; 2) Ocwen/ASPS have the most scalable model among the servicers and are able to outbid rivals on future acquisitions without significantly diluting ROE.

Once the banks are completely out of the $10 trillion MSR market, Ocwen should control a very respectable market share. It’s current portfolio ($465 billion) has a run off of only $70 billion per year and it already has its own origination platform that does perhaps $15 billion/year. With a sustainable US origination volume at $1 trillion per year, if Ocwen gets just 15% of this market, it should be able to acquire $150 billion per year, more than enough to replace the run-off.

For ASPS, most of their revenue is generated from non-agency, or private label MSRs, which tend to be higher credit risk. Subprime lending is at a historical low (~ low single digit % of total originations) but I believe it will pick up quite significantly once the economy recovers further, as the banks now face higher regulatory/underwriting requirements and reduce lending activities.

Decrease in delinquencies: ASPS gets a lot of its revenue from managing defaults. If default rates go down, ASPS will see its per-loan revenue shrink.

Regulation and Politics: The non-bank servicing industry is an easy target to go after because it is overall less regulated than the major bank servicers and it is a relatively new industry.

Catalysts

1. Lawsky decides to become reasonable to Ocwen/ASPS and lets them acquire more MSRs. Note that Lawsky will most likely make a decision this year.

2. Management decides to lever up ASPS to expand the buyback program.

3. Hubzu, which according to Erbey, makes more money in a quarter than Zillow makes in a year, will most likely get spun off in the next two years. Management mentioned in past conference calls that Hubzu has a margin north of 60 – 70% pre-tax.

Hubzu did a little over $70 million in revenue last year and generated $33 million in the first quarter. I believe this year, its revenue base will be as large as half of Zillow, which has an inferior model. If Hubzu gets just half of Zillow’s market cap (~$4 billion), it will be worth almost as much as the entire ASPS’s market cap today.

ASPS vs. Ocwen

The primary advantage of ASPS over Ocwen is that since ASPS does not own any mortgage servicing portfolios, it is not exposed to any of Ocwen’s operating risks. Some material ones are:

1. Legal: Ocwen could get sued by mortgage investors and homeowners. ASPS is just a software company and is relatively protected from legal liabilities.

2. Financing: Currently MSRs trade at multiples (3 x to 4 x annual fee) far below their historical averages (5 x to 7 x). This is largely a result of forced selling by the big banks. MSRs’ potential as an effective hedge against interest rates has made them very attractive to institutional speculators such as hedge funds, many of whom are buying MSR portfolios in bulk without ever having the ability to service them profitably, simply in the hope that they can resell such portfolios at higher multiples once interest rates spike up. Higher MSR prices as a result of higher demand can materially increase Ocwen’s maintenance/growth Capex requirements. ASPS, on the other hand, is not affected.

3. Erbey’s ownership in ASPS (29%) is twice as much as Ocwen (15%). Clearly he thinks ASPS is where the money is. ASPS is also buying back more shares under its current repurchase program (15% over two years) vs. Ocwen ($500 mil or 10% over two years).

4. The intellectual property behind Ocwen’s low cost advantage is controlled by ASPS, which has a non-exclusive supply agreement with Ocwen. The reason ASPS does not license its technology backbone to Ocwen’s competitors is that they know Erbey would not sacrifice Ocwen’s cost advantage just to help ASPS make more money.

However, in the extremely unlikely event that Ocwen goes into run-off mode and never gets to buy any more MSRs, ASPS will have the optionality value to license its superior technology platforms to other servicers (Erbey can simply dump Ocwen’s portfolio to another servicer and focus his attention exclusively on ASPS the technology business). Keep in mind that regardless of who does the servicing, it MUST be done by somebody and ASPS controls the best technology in the industry.

Ocwen’s advantages:

1. Ocwen is cheaper on a multiples basis. It trades for < 7 times this year’s earnings. Ocwen’s current market cap ($4.9 billion) is also below what management estimates to be its run-off value (assuming no more MSR gets added onto its platforms and management reinvests excess cash at 5% return per year):

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2. Ocwen is currently undergoing a transformation into a capital light model, through 1) getting HLSS to fund its non-agency advances for a fixed fee, 2) the OASIS program: http://www.urban.org/UploadedPDF/413086-Oasis-A-Securitization-Born-From-MSR-Transfers.pdf

Both initiatives will dramatically decrease Ocwen’s effective cost of capital and help increase ROE (I believe this can go from ~30% currently to as high as 60% once Ocwen’s advances are fully offloaded to these yield vehicles).

Conclusion

I find both Ocwen and ASPS very attractive. I own both because they are good natural hedges against each other (ASPS benefits from rising delinquencies while Ocwen suffers from it).

ASPS is currently my largest position.

Disclosure

The author of this write-up owns shares in the companies mentioned (NASDAQ:ASPS, NYSE:OCN) and may purchase or sell shares without notice. This write-up represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the write-up is designed to be timely and accurate and should be used only for informational purposes. Readers of the write-up should perform their own due diligence before making investment decisions.

 

 

25 Comments

  1. great writeup. how can you prove that OCN/ASPS’s servicing cost is 70% lower than the industry?

    in OCN’s presentation, they used a chart that showed the 850ish cost per serviced loan vs. 270 for OCN, but ASPS’s servicing revenue per nonGSE delinquent loan is $400, so it doesn’t make any sense!

    Reply

    1. Hello,

      I think what I meant is that because of ASPS’s technology. OCN’s cost is 70% lower than the industry.

      ASPS’s revenue is made from the borrowers/mortgage investors on the Ocwen MSR pool. Only a small portion comes from directly providing services to OCN.

      Reply

  2. Nice writeup.

    I don’t think that their dialogue engines make the process braindead though. Erbey mentions that the employee’s empathy matters a lot. Also, sometimes employees decide not to follow the dialogue engine. (And um… Americans about to lose their homes will not necessarily be enthusiastic to talk to a call center worker with an Indian accent, which can make them more difficult to understand. Computer companies like Dell have experimented with Indian call centers with mixed results.)

    2- I believe Altisource sells its technology platform to Ocwen’s competitors.

    Reply

    1. Hello, glad you like it.

      1. Agree with your points. But so far it has seemed that they are able to maintain high quality with Indian employees. I think Erbey did comment that they are only interested in hiring people that “follow the process”, so it’s unlikely the employees have a lot of autonomy over what they can say.
      2. Not the core technologies that allow them to offshore labor, which is where the vast majority of the cost advantage comes from.

      Reply

      1. I don’t think they really have technology that allows them to offshore labour.

        Part of the rationale for breaking ASPS off Ocwen is so that they could market the technology to other companies. (This was before Ocwen’s growth spurt.) From the customer’s perspective, you’d be skeptical about buying technology from one of your direct competitors. If they were to stop providing support for the technology platform you were using, you could be in huge trouble! Spinning Altisource off of Ocwen reduces the potential conflicts of interest.
        It so happened that Robert D Stiles recognized the opportunity and went to the smaller company. He must have made a lot of money on his stock options even though there was some sort of falling out between him and his boss(es). There were some minor spinoff shenanigans that happened.

      2. The vast majority of their labor is offshore. I showed that in the table. The only reason they’ve managed to do that is because of their technology. If the technology wasn’t a barrier then everybody would be using offshore labor for 1/8th the cost. Clearly that’s not the case. Nationstar and Walter hardly make any money from servicing if you take out their origination earnings and fair value adjustments so if they can get their hands on technology that gives them a 70% cost advantage while holding servicing quality constant, I think at least they’d be tempted.

        ASPS has a ton of different technology platforms. The major ones like the dialogue engine are only licensed to Ocwen because none of their competitors uses offshore labor that’s compatible with the core tech. ASPS licenses some minor ones to Ocwen’s competitors but the revenue contribution from those is tiny (65% of revenue is from Ocwen’s MSRs, a big chunk is from originations and Hubzu so you can take an educated guess about how small that revenue stream is).

        This is from Ocwen’s 10-k

        “We are dependent on Altisource for our technology. We believe that we have competitive strengths and achieve our results through the use of proprietary technology and processes. Our servicing platform runs on an information technology system that we license under long-term agreements with Altisource. We believe this system is highly robust and manages more data than the systems used by most other mortgage servicers. If Altisource were to fail to fulfill its contractual obligations to us or were to become unable to fulfill them (for example, because it entered bankruptcy), or if Altisource failed to continue to maintain and develop its technology so as to continue to provide us with competitive strengths, our business could suffer.”

      3. Some of Ocwen’s competitors are moving to offshore labour. Nationstar for example is contracting with third parties for operations in India and the Philipines. This is just my opinion, but the reason why offshore labour is somewhat difficult is because you need to setup operations in another country. So you need employees who are go-getters, who speak both languages, who are willing to live in that country, and are people you can trust (otherwise they will run up a huge bill or steal from the company when you’re not looking). There are entire companies like CTSH that specialize in offshoring labour, much like how there are companies that specialize in outsourcing IT. The barriers and complexities aren’t solved with a software program.

  3. “Erbey’s ownership in ASPS (29%) is twice as much as Ocwen (15%). Clearly he thinks ASPS is where the money is.”

    Though Erbey’s percentage ownership of ASPS is twice what it is for OCN, ASPS also has half the market cap of OCN, so he seems to have about the same dollar amount invested in each. Isn’t the % of his net worth invested (about equal in this case) more relevant than what percentage of the companies he owns?

    Really interesting post. Great work!

    Reply

    1. Thanks!

      On the ownership point. Suppose Erbey transfers $100 from Ocwen to ASPS as a gift. He’d lost $100 x 15% and gain $100 x 29% for an overall gain of $14. He benefits disproportionally from ASPS’s progress compared to Ocwen,

      Reply

    2. % of the company matters more. If OCN and ASPS do deals with each other (like ASPS buying servicing platforms from OCN)… it may end up favoring the entity in which Erbey owns a higher % of the stock. You’re safer off in ASPS in that context.

      Reply

  4. How much of your $10.40 EPS number comes from short sales or sales of REO via Hubzu? Do you believe the number of foreclosures and resulting short sales / REO sales to be going up or down over the next few years? Can an argument be made here that the origination element of ASPS’ business is so small that they are over-earning now given the cyclically high point in the default cycle that we are coming through? Additionally, how much in the way of non-agency MSRs are out there left for Ocwen to acquire? It is my understanding that non-agency MBS is effectively no longer being created and short sales / REO sales for Fannie, Freddie and Ginnie backed MBS are managed by the wrapping agency themselves.

    Reply

  5. Agreed with ED on ASPS top ticking the default cycle. The potential success with their new businesses will be more than offset by the decline in default cycle. Based on my model, ASPS has a 30-50% downside. OCN is a better investment given that their financials benefit from a better delinquency trend. OCN also has a much lower downside given it’s trading at close to liquidation value right now.

    Reply

  6. How did you arrive at your estimate of $10.4/share for 2014 normalized earnings? Predicting that the company will earn 2x what it did last year seems a bit aggressive.

    Reply

  7. Lawsky in the past has targeted forced placed lenders insurance, mainly targeted at assurant and balboa(qbe) where he believed conflicts of interest resulted in (perceived) overcharging…. What parallels can be drawn from this?

    Based on how that played out, its likely other states may start their own investigations. Elongated process. Settlements likely. Increased compliance costs and lower margins going forward.

    Reply

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  10. Hello,

    very, very interesting analysis. I studied ASPS a bit… then went ahead and bought some shares.
    -30% since you wrote that blog post, and while the legal threat is there, it doesn’t seem to warrant the huge discount.

    I must say, I really admire the work you’ve done. It seems you’re taking some time away from blogging… any chance you’d come back with more ideas? 😉

    Regards

    Reply

  11. Just curious if the author has anything material to add at this point with concerns that are clearly in the market. Certainly looks very interesting in the 50s and this article gets me excited as it was written at $100. I just honestly don’t know enough about the current litigation and was wondering you had any light to shed.

    Reply

  12. Hi.
    Very interesting and well written.
    Do you hold the same opinion even today? If so current pricing gives great opportunity

    Reply

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