I could have titled this “Can Walter Investment Regain its Footing?” But why mess around with platitudes and innuendo? I think that there is a fair chance of the stock doubling or even tripling from here which is why I am writing about it. Of course, it could also halve or go to zero on more bad news but when a stock deflates from $50 to $3, $47 of risk has already been taken out of it – – a simple mathematical concept.
So a few months ago, I highlighted Ocwen (NYSE: OCN) on this website because I had noticed that it had been left in the dust, trading at 1/3 of its tangible book value. With a little dose of good news from the company, the stock climbed from $1.60 to ~$6 within a matter of six months. Was it luck? Sure, why not, but you got to make your own luck.
Now I see another stock in the same sector that has been left for dead and could be on the verge of a renaissance. It is too early for me to make a definitive call but as Buffet famously said “We pay a high price for certainty”.
Anyway, here is my in-a-nut-shell view of Walter:
Walter Investment Management has been a poorly-managed company that has recently hired a new CEO with extensive operational experience and good reputation in the industry. If cleaned up and run properly, I can see the company to have the ability to generate as much as $1.80 in annual earnings per share within two to three years. And the stock trades at $3.30 or a P/(potential)E ratio of less than 2x. Walter has a lot of debt but the lion’s share of it doesn’t mature until December 2020, thus giving management quite a runway to fix things up.
Like it? Then read on.
For the purpose of this exercise, I want you to forget this company’s past. Because the stock won’t trade based upon what has already happened to it but what can and will happen in the future.
Walter has four operating segments.
1. Mortgage Servicing: You have a home mortgage or ever had one? Your bank or some company calculates principal, interest and taxes etc and sends you a bill each month. If you get behind in payments, it mails you notices. If you stop paying altogether, it tries to work things out with you by modifying loan terms. If you still wont pay, it kicks you out of your home and sells it through a broker or it gets auctioned. That’s mortgage servicing.
To perform these functions, a servicer gets paid a fee by the lender. As of 9/30/16, Walter handled servicing of 2.1 million loans with an unpaid principal balance (UPB) of $235 billion. See the table below – – In 2013, the company generated pretax income, excluding non-cash adjustments, of $192.6 million or 10 bips (basis points). Since then, profit has significantly eroded and is now in the red.
|Ending balance UPB||202,103,316||238,081,027||246,564,118||255,288,773||248,611,094||235,035,052|
|Adjusted Pretax Inc (Loss)||192,623||92,384||30,769||9,191||(7,063)||(54,563)|
|Adj Pretax / Avg UPB||0.10%||0.04%||0.01%||0.00%||0.00%||-0.02%|
What happened? I mean, back in 2013, it was servicing loans with UPB of 202 billion, now that number is much higher. You would expect that servicing a higher number of loans would result in more profit, not red ink. A few things going on here – one is that HAMP, a program initiated during Obama administration to help modify loans for distressed borrowers ended in 2016. Revenues from that program have declined from $141 million in 2013 to ~$60 million in 2016. Also, Walter has been selling its assets, retaining sub-servicing rights and using proceeds from sales to pay off debt. That has also resulted in lower profits since the economics are shared by the acquirer and the sub-servicer in such a transaction.
At the same time, expenses have not been cut enough. For example, G&A expense was $283 million in 2013 and $415 million in 2014. It is still running at a quarterly rate of $120 million. Same is true for salaries and benefits expense. I expect the newly instated management to fix that. Also, Walter has stated that it will likely continue to sell servicing assets to pay down debt and its mix will be 50/50 servicing and sub-servicing going forward.
So how much profit can this segment generate if and once it is fixed? I will quote Nationstar’s CEO (a competitor company) from a recent conference call:
Analyst: Okay. So on that note, so given that you have roughly $450 billion in UPB now and I think approximately 30% of that is subservicing. So how should we think about your five basis point, I know you said that you expect to hit that pretax for Q4. So how we think about that going to 2017?
Jay Bray (CEO): Yeah, I think it’s fairly straightforward, right? I think on the primary servicing business, you know, which in 2017 will be probably 60% to 70% of the overall book. We expect to earn six basis points on that. On the subservicing business we expect to earn, call it, three to four basis points, so when you look at that that’s a blend of, you know, five. That’s how we think about it. With the additional $250 billion, it’ll be consistent with the three to four on the subservicing book.
Can Walter also achieve this level of profitability in its servicing business? I don’t really know but it’s in the exact same business as Nationstar so I don’t see why not. Assuming $220 billion UPB (down from 235 billion at the end of Q3-2016 due to natural attrition) with a 50/50 mix, and using 6 bips for servicing and 3 bips for sub-servicing gets me to pretax profit of $99 million.
2. Origination: Have you ever taken out a loan to buy a home or refinanced an existing home mortgage? To do so, either you called a bank or someone called you. Then you went through a terribly intrusive process in which you shared minute personal and financial details of your life with perfect strangers. You then signed dozens of documents at a lawyer’s office without having the faintest idea of what you were signing. At the end of this taxing experience, you walked out of the lawyer’s office, both physically and emotionally exhausted, with a keen desire for a stiff drink. That’s mortgage origination.
This segment has been a rare bright spot for Walter. See table below:
|Origination pretax income||226,395||117,104||123,536||16,401||45,615||51,672|
As you might imagine, when interest rates drop, people refinance their homes and are also able to afford buying a new home more easily. So origination activity increases. Conversely, when rates rise, the opposite happens. That said, while rates are currently rising, they are still very low so this business could continue to be profitable. But I don’t see how Walter can continue to generate pretax profit of $40-$50 million per quarter going forward.
Time will tell what level of profitability can be sustained by Walter in this segment in the next 2-3 years but I will assume that pretax profit will be cut in half