Walter Could Still be Ocwen Déjà Vu

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(Update 4/13/17: My timing was atrocious on making this call just days before Q4 results.  The stock got decimated in reaction to company disclosure that it had hired Houlihan and Weil, Gotshal for a debt restructuring.  I believe that investors expect this to mean a bankruptcy filing or a highly dilutive out-of-court debt exchange.  In my opinion, the former is almost out of the question and the latter a remote possibility.  I will update my thesis and valuation sometime in 2017 but at ~$1, this stock in my opinion offers an excellent payoff prospect.  And after reading the proxy statement filed on April 5, I am convinced that the Board and management are committed to equity and a turnaround.  I continue to hold a position in the shares.

And if I am proven wrong on this in the end, hey, the stock is now at a $1 so the upside/downside is ridiculously better than it was when I had initially written on it.)

Here’s my write up from March 6, 2017:

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.

SERVICING 2013 2014 2015 Q1-16A Q2-16A Q3-16A
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 2013 2014 2015 Q1-16A Q2-16A Q3-16A
Locked Volume 18,067,366 19,271,632 25,119,837 4,580,833 5,307,111 5,775,101
Total Revenue 630,441 481,822 493,845 100,277 110,209 133,440
Origination pretax income 226,395 117,104 123,536 16,401 45,615 51,672
Pretax Margin 35.9% 24.3% 25.0% 16.4% 41.4% 38.7%

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 from the present run rate.  This assumption can very easily end up being too optimistic – I just don’t know.  I will assume annual pretax profit of $100 million here.

3. Reverse Mortgage: Honestly, I have no fucking idea what a reverse mortgage is nor do I have any interest in finding out.  And I don’t care how many celebrities this industry uses in its ads to lure retirees into taking one out, you wont catch me anywhere near a reverse mortgage loan.  Here is a description of the excrescence:

A financial agreement in which a homeowner relinquishes equity in their home in exchange for regular payments, typically to supplement retirement income. “unlike traditional mortgages, which decline as you pay down the loan, reverse mortgages rise over time as interest on the loan accrues”

… Christ!  Sounds like the American Dream in reverse gear.

Now this segment captures the essence of Walter’s poor past performance.  See the table below:

REVERSE MORTGAGE 2013 2014 2015 Q1-16A Q2-16A Q3-16A
Total Revenues 167,664 157,161 147,609 44,095 16,137 27,023
Adj pretax income (loss) 23,196 (19,204) (47,932) (12,682) (12,432) (15,598)
GAAP pretax income (loss) 5,201 (101,168) (112,337) 5,027 (26,944) (23,023)

So no matter how you look at it, financially it’s been a disaster.  What adds insult to injury here is that this segment accounts for 2/3 of Walter’s $17.5 billion balance sheet!  Can it be shuttered or fixed?  I hope that the new management chooses the former but in any event, merely discarding this money-loser would be a tremendous benefit to the company’s bottom line.  I will be an optimist and assume that new management will close down this segment or find someone to buy it.  So zero pretax income.

From Q3-2016 conference call:

Anthony Renzi (Walter’s New CEO): And finally management continues to evaluate options for both the sale of our insurance business, as well as opportunities related to reverse mortgage business with the objective of reducing the size of our balance sheet.

4. Other: This segment is mainly corporate interest expense.  As of September 30, 2016, Walter had  corporate debt of $2.12 billion.  In recent months, it has been selling business lines and its servicing assets to pay down debt to a more manageable level. Interest expense in Q3 was $37 million (average interest rate 6.83%) and this segment’s pretax loss was $25 million.  As I mentioned before, Walter wants to continue to sell servicing assets until it gets to a mix of 50/50 servicing/sub-servicing.  I assume a go-forward loss in this segment of $25 million per quarter or $100 million per year.

So let’s do this:

Pretax income Servicing $99 million+Origination $100 million+reverse mortgage zero-Other loss $100 million=99 million

Subtract income tax (rate of 35%)= $64.4 million divided by total shares outstanding of 36.1 million = EPS of $1.78

The stock trades at $3.30.

A lot of my “rough sketch”of a fixed-up Walter coming to fruition will depend upon if and when this newly hired management can turn things around. The new CEO Anthony Renzi was hired in late 2016 so he didn’t have much to say about his vision for Walter in Q3-2016 conference call.

The company will announce Q4 results on March 14.  I expect to get some details about Renzi’s game plan.  Q4 earnings release could also be an inflection point in that Walter will likely print very healthy EPS for the quarter due to fair value mark-up of its servicing asset from rising interest rates.

Suffice to say that at present, based upon where the stock is trading, investors are skeptical of a turnaround and probably find Walter to be a hopeless basket case.  And that is usually the best time to take a close look from a value perspective.


Appendix (Business description from Walter’s 2015 Form 10-K):

Executive Summary

The Company

We are a diversified mortgage banking firm focused primarily on servicing and originating residential loans, including reverse loans. We service a wide array of loans across the credit spectrum for our own portfolio and for GSEs, government agencies, third-party securitization trusts and other credit owners. Through our consumer and correspondent lending channels, we originate and purchase residential loans that we predominantly sell to GSEs and government entities. In addition, we operate several other complementary businesses which include managing a portfolio of credit-challenged, non-conforming residential mortgage loans; an insurance agency serving borrowers and credit owners of our servicing portfolio; a post charge-off collection agency; and an asset management business through our SEC registered investment advisor. These supplemental businesses allow us to leverage our core servicing capabilities and consumer base to generate complementary revenue streams.

At December 31, 2015, we serviced 2.2 million residential loans with a total unpaid principal balance of $266.6 billion. We have been one of the 10 largest residential loan servicers in the U.S by unpaid principal balance for the past three years according to Inside Mortgage Finance. Our originations business originated $25.1 billion in mortgage loan volume in 2015, ranking it in the top 20 originators nationally by unpaid principal balance according to Inside Mortgage Finance. Our reverse mortgage business is a leading integrated franchise in the reverse mortgage sector and, according to an industry source, was the third leading issuer of HMBS in 2015.

During 2015, we added to the unpaid principal balance of our third-party mortgage loan servicing portfolio: $21.3 billion relating to acquired servicing rights, $7.3 billion relating to sub-servicing contracts and $18.6 billion relating to servicing rights capitalized upon sales of mortgage loans, while also adding $2.7 billion of unpaid principal balance to our third-party reverse loan servicing portfolio. Our third-party mortgage loan and reverse loan servicing portfolio was reduced by $39.5 billion of unpaid principal balance in payoffs and sales, net of recapture activities, during 2015. Also in 2015, we originated and purchased $1.4 billion in reverse mortgage volume and issued $1.5 billion in HMBS.

Our mortgage loan and reverse mortgage originations businesses diversify our revenue base and offer various sources for replenishing and growing the Company’s servicing portfolio. During 2015, we originated and purchased $25.1 billion of mortgage loans, substantially all of which were added to our servicing portfolio upon loan sale. Of these originations, we added $17.6 billion of unpaid principal balance to our servicing portfolio through our correspondent channel. The majority of the remaining originations resulted from our retention activities associated with our existing servicing portfolio. Through our retention activities, we assist consumers in refinancing their loans, which reduces the runoff on our existing servicing portfolio.

We manage our Company in three reportable segments: Servicing, Originations, and Reverse Mortgage. A description of the business conducted by each of these segments is provided below:

Servicing — Our Servicing segment consists of operations that perform servicing for third-party credit owners of mortgage loans for a fee and the Company’s own mortgage loan portfolio. The Servicing segment also operates complementary businesses consisting of an insurance agency serving residential loan borrowers and credit owners and a collections agency which performs collections of post charge-off deficiency balances for third parties and the Company. In addition, the Servicing segment holds the assets and mortgage-backed debt of the Residual Trusts.

Originations — Our Originations segment consists of operations that originate and purchase mortgage loans that are intended for sale to third parties. In 2015, the mix of mortgage loans sold by our Originations segment, based on unpaid principal balance, shifted from substantially all Fannie Mae conventional conforming loans during 2014 to approximately (i) 56% Fannie Mae conventional conforming loans, (ii) 35% Ginnie Mae loans, and (iii) 9% Freddie Mac conventional conforming loans. A substantial majority of our Ginnie Mae mortgage loan originations in 2015 were FHA-insured loans.

Reverse Mortgage — Our Reverse Mortgage segment consists of operations that purchase and originate HECMs that are securitized, but remain on the consolidated balance sheet as collateral for secured borrowings. This segment performs servicing for third-party credit owners and the Company and provides other complementary services for the reverse mortgage market, such as real estate owned property management and disposition.

Other — Our Other non-reportable segment primarily consists of the assets and liabilities of the Non-Residual Trusts, corporate debt and our asset management business, which we operate through GTIM.

Overview

Our profitability is dependent on our ability to generate revenue, primarily from our servicing and originations businesses. Our Servicing segment revenue is primarily impacted by the size and mix of our capitalized servicing and sub-servicing portfolios and is generated through servicing of mortgage loans for clients and/or credit owners. Net servicing revenue and fees includes the change in fair value of servicing rights carried at fair value and the amortization of all other servicing rights. Our servicing fee income generation is influenced by the level and timing of entrance into sub-servicing contracts and purchases and sales of servicing rights. The fair value of our servicing rights is largely dependent on the size of the related portfolio, discount rates and prepayment and default speeds. Our Originations segment revenue, which is primarily gains on sales of loans, is impacted by interest rates and the volume of loans locked as well as the margins earned in our various origination channels. Gains on sales of loans include the cost of additions to the representations and warranties reserve. Our Reverse Mortgage segment is impacted by new origination reverse loan volume, draws on existing reverse loans and the fair value of reverse loans and HMBS.

Our results of operations are also affected by expenses such as salaries and benefits, information technology, occupancy, legal and professional fees, the provision for advances, curtailment, interest expense and other operating expenses. In addition, during 2015 and 2014, our expenses were impacted by non-cash goodwill impairment charges of $207.6 million and $82.3 million, respectively. Refer to the Financial Highlights, Results of Operations and Business Segment Results sections below for further information.

Our principal sources of liquidity are the cash flows generated from our business segments and funds available from our 2013 Revolver, master repurchase agreements, mortgage loan servicing advance facilities, issuance of HMBS and excess servicing spread financing arrangements. We may generate additional liquidity through sales of MSRs, any portion thereof, or other assets.


If you have an interest in learning in great detail, how residential mortgage servicing works, I refer you to a Mortgage Bankers Association White Paper linked here.  Happy reading!


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