Ocwen Revived: Where Do We Go From Here? by Oozing Alpha
On June 17, 2016, I had posted on Oozing Alpha Has Ocwen Stock Been Sufficiently De-Risked?
Since that post:
- The company reported significantly improved Q2 results on July 27.
- During Q2 earnings call, it announced that it is negotiating with California regulator (CA DBO) and has set aside a $15 million reserve for a potential settlement, an insignificant amount when compared with $30 million that Ocwen spends on monitor fees on a quarterly basis.
- On August 4, Ocwen successfully priced a $500 million securitization.
- On August 9, Ocwen received an upgrade from S&P on its servicer ratings. This was critical since without an upgrade, Ocwen was at risk of losing ~ half its business next year. Thus, an existential threat was averted.
Due to these positive developments, the stock has appreciated 100% in a period of two months and now trades at $3.18.
My view is that there is tremendous upside potential in the stock. The risk-reward ratio is actually better now than it was back when it was trading at $1.60 but faced a grave threat to its business.
In my opinion, Ocwen stock is worth at least $7-$8 per share if the company were sold to a competitor. I say this based upon the fact:
- Ocwen had $5.27 per share in tangible book value on 6/30/2016.
- Owns another $4 per share of assets not reflected on its balance sheet (see slide #9 in Q2 earnings presentation.)
- Tangible book value does not reflect its lending business that generates around $30 million in pretax income and could be worth at least $1 per share.
That adds up to $10+ per share of intrinsic value. I am using $7 per share as the low end of the range to build a sizable cushion of $370 million for (1) MSR runoff until Ocwen is permitted to acquire servicing assets again and (2) future regulatory expenses and settlements – – a figure that many will argue is unrealistically large and unwarranted.
That said, at the moment, I have no reason to believe that a sale of the company is imminent so I value it as an independent, ongoing business entity. Over the long term, Ocwen stock could be worth much more than $8 but that higher valuation will take time to realize. Bear in mind that the stock is currently at $3.18.
Interested? Read on.
Servicing Biz: Ocwen has multiple lines of business but the one that matters and can “move the needle” is mortgage servicing. As of the end of Q2-2016, Ocwen serviced 1.5 million loans with an unpaid loan balance of $229.3 billion. Now in this business, a servicer is paid a fee based upon the unpaid principal balance (UPB) of mortgages that it services on behalf of lenders. To give you a historical perspective of Ocwen’s servicing segment’s size and profitability:
|Avg. UPB ($Bil)||33.8||35.3||37.9||47.8||55.3||46.2||41.1||59.6||81.3||118.8||415.7|
|# of Loans (Mil)||360||320||369||474||436||373||306||401||531||763||2,621|
|Pretax Inc ($Mil)||26||17||22||80||66||101||88||78||136||274||392|
So you can see in the table (above), up until the housing meltdown of 2007-2008, Ocwen was a niche player servicing $30-$40 billion in UPB.
But after the housing bubble burst, Ocwen grew by leaps and bounds as it acquired servicing assets (MSRs) that other financial institutions were unloading, reaching UPB of $415.7 billion in 2013.
In 2013, this segment generated pre-tax income of $392 million or 9 bips (calculated as pretax income divided by average UPB serviced). Due to the company’s extra-ordinary growth, the stock went from single digits to $60 per share during this time period and to paraphrase poet Browning, God was in His Heaven and All was Right with the World.
Now comes the ugly part of the story.
I am not going to get into the gory details about what ensued but to sum it up, after 2012, Ocwen grew too big too fast which impacted its service quality which got it in trouble with regulators. As a result, it was barred from acquiring any new servicing assets, had to pay hundreds of millions in penalties, and agree to have all sorts of regulators and monitors breathing down its neck, watching every move and trying to catch every mistake. That’s a tough way to live — Ocwen had no choice but to acquiesce.
So beginning in 2014, its servicing business began to shrink since it could not acquire any new MSRs which by the way have a natural attrition rate in low-to-mid teens. Additionally, Ocwen had a negligible origination business so it could not organically replace its diminishing MSRs and on top of that, had to sell a portion of its servicing business to improve liquidity. Hence, its top-line shrunk and elevated regulatory/monitoring costs, legal settlements, impairments etc. ate into profits.
|Avg. UPB ($Bil)||431.6||333.0||244.0||233.0|
|# of Loans (Mil)||2,669||1,625||1,551||1,506|
|Pretax Income ($Mil)||(174)||16||(68)||(15)|
As a result of these negatives, a business that was hugely profitable up until 2013 has been posting losses or near break even over the past 2.5 years. This is where things currently stand and the key questions investors are grappling with include:
- Once Ocwen gets past the remaining regulatory issues and distractions, can it generate a healthy profit in this segment and what level of profitability can it achieve?
- How long will it take to profitability because the servicing asset has a normal attrition rate in the low to mid teens and so the longer it takes, the less of a loan balance will be available for Ocwen to service?
- Can Ocwen stabilize its servicing asset (UPB) or even grow it again via acquisitions and get back on track?
I don’t believe that anyone, including Ocwen management, has definitive answers to these questions. What I can do, however, is sketch out a plausible scenario by making some assumptions. Feel free to dial up or down my assumptions and come up with your own conclusion.
In a fairly conservative scenario, I assume that it will take six more quarters (so year end 2017) for Ocwen to resolve its regulatory issues and be permitted to start acquiring MSRs. In the meantime, Ocwen will break-even or generate a small profit. I further assume that beginning in 2018, Ocwen will only be able to acquire just enough MSRs each year to stabilize its servicing asset (meaning zero growth).
Finally, I assume that it will never earn the high margins that it did in the past and that its pretax income in servicing will be down to 5 bips of UPB, which is what a close competitor, Nationstar (NSM) is currently generating in its servicing business.
So let’s do this:
MSR runoff at 13%, which is comparable to the current rate, gets me to UPB of $188 billion by the end of 2017. Five bips of pretax income on that UPB is $94 million. Ocwen has a lending business which I will not get into since it is small part of the story but still, it generated pretax income of $34 million in 2015 and $11 million in the first half of 2016. I assume this segment will generate $30 million of pretax income. Unallocated corporate costs are currently at a quarterly run rate of