Description

Amnet Mortgage
Introduction:
Amnet Mortgage, currently has 78% of market cap in cash, is trading 1.2 ev/earnings, mid teens ROE over the next 3 quarters, a discount to tangible book, insider buying, company recently announced 5% buyback, and Nasdaq listing later this month (moving from AMEX). Amnet is DIRT cheap, $74mm mkt cap with $54.7mm in cash, investors are paying a paltry $20mm for a company that should earn about $12.7mm over next 3 quarters, and estimated $17mm for 2005. The market is ascribes a -0- for the business after collecting earnings over the next 4 quarters. I believe the company will earn $.93 this year (guidance is $.75-$1, -.72 1Q04, 2-4Q04E $1.65) and $2-$2.10 for 2005. D3 filed as a 12% owner of the company in March paying $9.50 a share and has a board seat (great track record of success in small caps). Here D3 comments on why they made an investment in Amnet:

http://www.sec.gov/Archives/edgar/data/1035744/000120095204000162/dn_13d40304.txt

Amnet is a hybrid wholesale mortgage banking company, that does not take prepayment, interest rate risk (100% hedged), impairment risk (unless fraud) and sells off more capital intensive mortgage servicing rights. Amnet holds mortgage for approximately 18 days.

Last time management (top 10 employees now at INV) did this in 1990 they made investors 8x their money in 4 years before selling to Chase Manhattan (growing into a top 5 Wholesale Mortgage Bank).

I believe the business is worth about 1.7x year end tangible book ($19.25 a share) and about 7x operating earnings (next 3 quarters) plus cash ($18 a share) with downside I think of $8.25 +/- a share. I base this on several factors but mainly in 10Q, company says they will buy back stock up to 85% of book value (I checked with mgt and it is book based on current outstanding shares) or $9.19 per share (and this moves up month by month based on earnings inside the company).

Conventional Wisdom: a company like Amnet will get crushed in rising rate environment, I believe this is very clearly not the case as I will explain below.

A) Account executive growth:

Avg /year end account executives avg origination per qtr AE Total Originations
72/96 $35.4/$26.6 million $10.2 Billion
165/200 $17/$14 million $11.3 Billion
250/300 $12/$10 million $12 Billion

So Originations should +10.78%, and +6.19% due to account executive head count growth of +129%, and 51.5%, while originations per AE will fall 50% and 29%. In addition, margins will begin to expand as consumers want less 30 year fixed and demand for other higher margin products begins to pick up (30 year fixed bulk of business, lowest margin).

B) Monthly Loan Production

2002 first complete year company originated $4.135bn
2003 originated $10.1bn
2004E originations $11.3bn
INV +11.8% in originations when market will be -37% I believe this is possible given:
INV has originated $3.83BN in first 5 months of 2004 implies run rate of $9.34bn dividing by .417
This does not include:
1) additional account executives of 108/140 (end of 1Q04 and estimated 2Q04) to 200 year end
2) Increased productivity from account executives from 2003, start to have bigger impact after one year.

C) Small town America strategy

INV is rolling out its “Small Town America” augmenting its field office strategy with remote AE’s which work out of their home.
• Classically underserved market includes 1000 cities/towns with a population 25-150k, where typically sales penetration has been more difficult.
• By having remote AE’s with a low expense structure call on various MB’s in smaller towns, INV believes they will be very effective in tapping smaller markets.
• Significantly cuts cost to originate loan and margins are better due to less competition



History:
• 1997 Company was founded in 1997 as a REIT- which acquired mortgages for investment.
• Mid 2001 – it pursued a fundamental change in course when it decided mortgage banking business has more opportunity to monetize 100% of the value chain on the loans it funds.
• April 2004 changed name to Amnet Mortgage to reflect new business model. Mortgage banking offers greater value to shareholders than trying to compete with already well capitalized REITS (I.E. INV had no real competitive advantage as a REIT). As INV declared its strategy to switch over from its REIT status, shareholders holding for dividends became motivated sellers and dropped the stock, especially after seeing .72 loss in 1Q04 mainly due to change from “held for investment” to “held for sale” on former REIT loan portfolio.


INV’s Business Model:
INV is a hybrid wholesale mortgage banker which underwrites, funds and then within 18 days sells loans to major lender / servicer.
• Top purchasers of INV loans in the secondary market are Countrywide, Wells Fargo and JPMorgan Chase.

• All of INV’s business is generated through mortgage brokers, who originate the loans.

• Nationwide, mortgage brokers (MBs) control about 60% - 70% of all residential mortgage originations. INV’s relationship with mortgage brokers, effectively INV’s customer, is critical.

• INV has already approved 5000 MB’s nationwide with a remaining target universe of 16,000. To that end, INV currently has 26 field offices staffed with about 108 (end 1Q04) account executives who promote loan products and educate MB’s about INV’s full product line-up.

• INV has been ramping up the number of field offices and expects to end ‘04 with 31 offices (200 AE’s) and ’05 with about 40 offices (300 AE’s) respectively.

• Only 9 offices of the 26 offices are considered “mature,” meaning fully staffed and producing up to their potential. Mature offices have 10-11 AE’s, while newer offices have only 2-3 AE’s. New offices take about $500K to start up, but the AE’s are ultimately a sales rep and therefore compensated by commission. For every $10,000,000 in originations the AE makes about $12,000.

• Branch management incentive compensation aligned with risk and profit metrics

• Sub Prime is less than 2% should be less than revenues ‘04E, but management sees this becoming up to 20% for 2005E.


Business Model
As a mortgage banker INV monetizes 100% of its part of the value chain of the loans it funds. There are 5 steps in the value chain for mortgage loans: Originating, underwriting, funding, sale of loan and servicing. INV receives revenues from Underwriting / documentation fees (25 bps), funding (15bps) (earns spread over its cost of funds while holding loan - avg. holding period is 18 days), and sale of loan for premium (160 bps) in secondary market.

INV Revenue generation:
Consumer Acquires $200K loan at par: $ bps
Underwriting / doc fee $500 (25 bps)
MB funds loan (pays MB commission) ($2000) (100 bps)
INV holds loan for approx 20 days $ 300 (15 bps)
Sale of loan to servicer $ 3,200 (160 bps)
Gross Rev / Margin Bps $ 2,000 (100bps)


Mortgage servicing release eliminates capital intensive aspect of business. The company believes that non-servicing competitors are low volume, privately owned regional hybrid mortgage banks that lack the equity capital for national execution while strongly capitalized companies follow traditional model (of retaining servicing rights).



INV has plenty of funding capacity with a $1.4bn warehouse line, while doing $751mm in loans in May. Servicing release also mitigates credit, prepayment and long term interest rate risk impairment. There is no interest rate risk because all loans are fully hedged during holding period before their sale.

What will increase margins: Currently INV has typically funded “A paper” or prime. The company is moving into Subprime (mainly in 2005) and Alt + A products. Alt + A are loans to consumers that have no income verification (typically own a business that generates lots of cash). Because sub-prime and Alt + A are higher interest rate products, it will add margin during holding period - when INV is earning the spread over its cost of funds.

Catalyst

Catalysts:
• 73% earnings yield for ’04, Cash plus next 4-5 quarters EPS = current share price
• Tangible Book should be over $11.25 by year end, mid teens ROE next 3Q’s
• Highly successful CEO/top management with extensive industry experience
• Company buying back 5% (400k) + Director buying
• 75% market cap cash
• Stock trading at .85x tangible book, 1.75x ev/net earnings next 3 quarters
• Differentiated strategy that makes them well situated to roll out offices across US
• No interest rate risk – hedge 100% of loans they make, bundle and sell off all loans within 20 days.
• Strategy to grow loan portfolio and increase gross margins
• Possible take-out candidate down the line – Mgt previously grew and sold ARMC