Description

I am proposing a long position a low-profile spin off with a disguised single digit earnings multiple and significant future growth potential.

Altisource Portfolio Solutions provides outsourced services for mortgage loans and credit card receivables. The stock price of $14.78 represents a pro forma run-rate earnings multiple of 8.9 after considering $0.50 of cash per share. LPS is the relevant comp and it sells for 13.3 times "adjusted" earnings guidance of $3. At a multiple of 13.3 plus net cash Altisource would trade for about $22. Additionally, there are a number of catalysts which may increase their earnings by more than 60% over the next few years; if so, the business value would increase to the mid-$30 range.

Altisource was a subsidiary of mortgage servicing firm Ocwen Financial prior to their recent spin off. Ocwen is regarded as the lowest cost mortgage servicer and Altisource provides the technology and services behind that cost advantage. As a spin off, the goal of the company for 2009 is to increase the breadth of services offered and round out their geographical footprint. In 2010, Altisource will target signing new customers in both the US and overseas. The services they provide include: mortgage servicing software and technology, residential property valuation, title and closing, business process outsourcing, property inspect and preservation and default management. Many of these services have a large default and foreclosure element. The credit card services they provide are for defaulted receivable collection. This segment's profitability is inversely correlated with the economy; in tough times, there is more work to do but collection rates decline.

Altisource reported net income of $7M in the second quarter, which is an EPS run-rate of $1.15. On a pro forma basis they earned $10.5M.

Pretax earnings ($1,000's)                        10,009
+ Financial Services segment loss                1,736
+ Interest expense                                       796
+ Spin off expense                                    1,850
= Q2 adjusted pretax earnings                  14,391
Q2 adj. pretax earnings, annualized           57,564
- Public company expenses                       (2,500)
= Pro forma pretax earnings                      55,064
- Taxes at 24%                                       (13,215)
= Pro forma earnings                                41,849
Pro forma earnings per share                      $1.61

Stock price                                               $14.78
P/E ratio, net cash                                        8.9x
Target price: 13.3 P/E ratio plus cash          $21.91
Upside                                                      +48%

As you read through the various SEC documents (10-Q, Form 10, 8-Ks) and speak with the company it becomes very clear that revenue and profits in the Mortgage Services segment will increase in the near future. It is also clear that the losses incurred in the Financial Services segment will be eliminated through cost reductions (most recently the closure of two offices in July). The spin off expenses are nonrecurring, although there will be some expenses incurred in the third quarter. As a separate company overhead will cost an additional $2-4M, most likely at the low-end of the range. The tax rate will be in the low to mid 20% range because of the Luxembourg headquarters (24% may be conservative). I use 26M diluted shares (24M basic plus dilution from 2M of the 3M options). Cash flow should exceed earnings because the business is not capital intensive and because of $2M of annual amortization of acquired intangibles. Thus, I believe the pro forma earnings run-rate outlined above is a good number to use for valuation and 2010 earnings will exceed this figure.

What else?
Ocwen spends about $400M per year in their loan servicing operation and Altisource is targeting taking a high $200M share of that amount. Year to date they are generating slightly less than $100M from Ocwen. This demonstrates some of the business logic to the spin; due to real and perceived conflicts of interest in the servicer/investor relationship it was not possible for Ocwen to in-source as many of these services as Altisource will be able to provide as a third party. If the company is successful in generating revenue of $275M from Ocwen, revenue will increase by $175M and earnings by >$1 per share (20% pretax margin, 24% tax rate). A less certain source of upside will come in 2010 when Altisource begins to market their services more aggressively in the US and Europe. Many of these services, particularly for mortgage servicing, are sticky businesses so I assume no success, but acknowledge the possibility of some upside.

Ocwen issued $275M in stock to use for servicing portfolio acquisitions, which would lead to an expansion of the $400M they spend on vendor services. "We are currently negotiating the purchase of at least one substantial servicing platform" - Bill Erbey on the second quarter conference call. It is unclear how this will play out, but Ocwen has $440M of cash to make acquisitions that will be beneficial to Altisource.

What's the catch?
Revenue is concentrated between Ocwen (50%) and American Express (25%) with the balance spread among the large credit card issuers, investment banks and insurers. However, Ocwen is locked in with an 8 year contract, there is plenty of market share to take within Ocwen's annual spend and Ocwen is positioned to grow aggressively via M&A. American Express has been a customer for 30 years.

The other issue is that this business is benefiting from cyclically high default and foreclosure activity. It's difficult to determine exactly how much revenue is counter-cyclical, but it may be 50% of mortgage services segment revenue. Much of the recent growth is an expansion of services offered to Ocwen and not just higher default rates.
Offsetting any potential cyclical decline may be: 1) improved origination-related activity, 2) growth in the number of services offered, and 3) currently depressed receivables collections income. In the near-term this exposure may be positive; LPS is forecasting growing default related services in both 2009 and 2010.

Incentives.
It's not huge money, but the CEO and CFO stock option packages are exceedingly fair for shareholders. The 113K shares have a $14.15 strike with 25% vesting over 4 years, 50% vesting if the stock doubles and compounds at 20% annually and 25% vesting if the stock triples and compounds at 25%.

I have left much of the general business information for the reader to learn through the 10-Qs, Form 10 and 8-Ks available here (http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0001462418&owner=exclude&count=40) and the website available here (http://ir.altisource.com/index.cfm). The main reason is that I feel these are well written documents and my value-add is nil.

In summary, a P/E multiple of 8.9 is a bargain for a strong cash generator that may increase its earnings power by 60% or more in the next few years.

Catalyst

Catalysts:
-Servicing portfolio acquisition(s) by Ocwen
-Investor presentations
-Earnings announcements revealing the growing EPS run-rate
-New business wins in 2010 and on
-Time