Lender Processing Services, Inc. (NYSE: LPS) provides technology and services to the mortgage lending industry, with its primary customers being top 50 financial institutions. It is the market leader in mortgage processing and default management services in the United States. Approximately 35% of revenues are derived from its Technology, Data and Analytics segment which provides solutions for automating loan servicing, with the remaining 65% derived from its Loan Transaction Services segment which helps mortgage lenders reduce the expense of managing defaulted loans and closing mortgage transactions.
LPS was spun off from Fidelity National Financial, Inc (NYSE: FNF) in 2008. As part of the transaction, FNF saddled LPS wish a significant amount of debt ($1.585 billion). It is common for parent companies to saddle their subsidiaries with debt when they are spun off. You can read more about this in Joel Greenblatt’s excellent You Can Be a Stock Market Genius. As Greenblatt points out, there are often opportunities to be had in spun-off companies, provided you conduct the appropriate due diligence and determine that the company can handle the debt. Now, we are several years post-spin in the case of LPS, so we can get an idea of the company’s profitability and cash flow over the period, and take a look at its actual ability to service the debt.
Here’s what we find about the company’s debt load at December 31st for each year since it was spun off:
- 2008: 1.547 billion
- 2009: 1.289 billion
- 2010: 1.249 billion
- 2011: 1.149 billion
So in three years, the company reduced its debt load by about $400 million, or 26%. This isn’t bad, especially for a company in the mortgage industry during the deepest housing downturn in a generation. That’s an important point: how DID the company manage to repay this much debt? Wouldn’t you expect the company to hunker down and conserve cash while waiting for a rebound?
It is important to recognize that the company has a natural (partial) hedge in the form of exposure to both new mortgages (in the form of its Technology, Data and Analytics segment, which helps the banks process new mortgage applications and service existing clients), as well as mortgages in default (via its Loan Transactions Segment). So when times are good, revenue should be expected to come largely from the TDA segment, and when times are bad (like now), revenue comes from its LTS segment (which currently makes up 65% of revenues). This reduces the cyclicality of the company’s revenues and allows it to generate relatively strong earnings throughout the business cycle.
Just how strong is the company’s performance? Well, first recall that the company started with a significant debt load. When debt is high, equity is low (holding the enterprise value somewhat stable). So any equity-based returns metrics would be useless. Instead, we would want to consider the company’s invested capital (Equity + Debt – Cash) over the period. One of my favourite metrics is CROIC (Cash Return on Invested Capital), which divides free cash flow by average invested capital.
Here’s what we find for CROIC:
- 2009: 20.9%
- 2010: 20.0%
- 2011: 22.7%
This performance is nothing short of phenomenal. It is really difficult to overstate how much free cash flow this company generates. It has generated $340 million on average each year (I have subtracted the cost of capitalized software as a capital expenditure because I think it is necessary given the company’s line of business to sustain operations). Last year the company generated $373 million. About a third of free cash flow has gone toward paying down debt, and then the company has split the remainder between reinvesting in the business and repurchasing shares.
Say what? The company has been on its own for just a few years and it is already contracting is shareholder base? Yes! When it was first spun off, the company had 95.3 million shares. Today it has 84.4 million, and a remaining share repurchase authorization of $95.1 million. This seems like a pretty clear signal that the company believes its shares are undervalued, especially when the same cash could have effectively doubled the amount of debt repaid instead.
So what gives? Why isn’t the company trading significantly higher given its prodigious free cash flow? Perhaps this gives us a clue:
Carson City, NV – Attorney General Catherine Cortez Masto announced today a lawsuit against Lender Processing Services, Inc., DOCX, LLC, LPS Default Solutions, Inc. and other subsidiaries of LPS (collectively known “LPS”) for engaging in deceptive practices against Nevada consumers.
The lawsuit, filed on December 15, 2011, in the 8th Judicial District of Nevada, follows an extensive investigation into LPS’ default servicing of residential mortgages in Nevada, specifically loans in foreclosure. The lawsuit includes allegations of widespread document execution fraud, deceptive statements made by LPS about efforts to correct document fraud, improper control over foreclosure attorneys and the foreclosure process, misrepresentations about LPS’ fees and services, and evidence of
an overall press for speed and volume that prevented the necessary and proper focus on accuracy and integrity in the foreclosure process
This relates to accusations regarding “robosigning.” The company’s response can be found here. Furthermore, the company has been dealing with federal regulators over similar concerns and has entered a consent order, whereby the company has been going through a three-stage process of reviewing its procedures with the regulators to uncover and problems. In the recent conference call, the company provided an update on this process (emphasis added):
The consent order includes three primary phases, and in the next few weeks, we will begin the third and final phase. A review of documents executed through our default services business between 2008 and 2010. Let me assure you again this is a top priority at LPS.
Phase 2, which was a risk assessment of our default related businesses, was completed in September. It included a six-month long independent risk review, which was conducted by a highly respected risk advisory firm made up of experienced former federal regulators. While we are prohibited from disclosing anything explicit about the risk review results, LPS has in most cases addressed the issues identified and has plans in place to address the remaining concerns as quickly as possible. And finally, Phase 1 was a development of the enhanced plan for board oversight, which included compliance and internal audit. This plan was completed in June of 2011. To emphasize our commitment, the audit, risk, and compliance functions now have a direct reporting relationship to the Board and to me.
At the conclusion of the consent order process LPS will be the only provider of technology and services to the mortgage industry that has undergone such a thorough examination and risk review. This rigorous review sets us apart from other service providers and demonstrates that we are aspiring to achieve the gold standard, which represents our commitment to compliance, operating with integrity, and continuous review and improvement in all we do. As you know, there have been various activities from State Attorneys General. We remain committed to working closely with them to resolve outstanding issues.
As it relates to third-party litigation, we have made positive progress in many of these cases. With regard to the pending fee splitting cases, 14 of the 15 cases have now been dismissed. Other pending litigation has been moved to arbitration and in one of the shareholder derivative lawsuits that was brought against LPS in December of 2010, the parties have agreed to dismiss the matter with prejudice.
A major catalyst will be for the company to resolves its remaining issues. It took a $78 million provision in the most recent quarter to reflect the costs it has estimated it will incur related to these issues. Here’s what the company said about the charge (emphasis added):
Glenn Greene – Oppenheimer & Co.
Thank you. Good afternoon. Just a couple of follow-ups. Just want to make sure I’m clear, Tom. The legal regulatory reserve is your best estimate of the full cost for all of these issues at this point, or otherwise I guess you wouldn’t have been able to accrue it. But I just want to make sure this is sort of the full charge that you are thinking about going forward?
Thomas Schilling
Yeah. Thanks, Glenn. That is exactly how I would frame it. It is comprehensively what we believe at this point is estimatable to resolve these issues. And we – as I mentioned in my prepared remarks, we will continue to reassess it on a quarterly basis to the extent that we believe we need to change it up or down. We will do so as necessary.
So where does all of this leave us? It appears that the company has some legal and regulatory issues which it is aggressively and proactively working on. Furthermore, the company has done its absolute best to set up a reserve for the amount it believes it will cost to fully resolve these issues. Besides these issues, the company is a free cash flow machine (generating about twenty cents for every dollar of capital it has invested, every single year!), and has been using that free cash flow to repay debt and repurchase shares, both of which will help shareholders in the long run.
By my estimates, it is really easy to get to an intrinsic value that provides significant upside from today’s prices. There appears to be a large margin of safety.
What do you think of LPS?
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