|Shares Out. (in M):||85||P/E||10.0x||9.0x|
|Market Cap (in $M):||2,090||P/FCF||6.0x||5.0x|
|Net Debt (in $M):||1,029||EBIT||375||400|
I am recommending a long position in Lender Processing Services (LPS). LPS is a high quality business trading at 6x LTM FCF. As legal and regulatory risks subside, I believe that the multiple will expand to 10-12x. Furthermore, the company should benefit from an increase in foreclosure activity over the next couple years and positive secular trends in its origination technology businesses.
LPS was spun out of Fidelity National Information Services (FIS) in 2008. LPS has been written up on VIC as a buy recommendation twice since the spin off, in 2008 and in May 2011. Both are good write-ups, and I suggest reading them in order to obtain background on the company and the industry.
The stock ended 2011 on a low note due to numerous legal and regulatory issues: attorney general complaints, consent order, FDIC complaint, fee splitting allegations, class action litigation, foreclosure moratorium and depressed origination/foreclosure end markets. These concerns pushed the LPS’ valuation to less than 4x free cash flow. The stock is up 65% year to date, but I see significant further upside as these legal concerns are finally put to rest.
In this write up, I’ll focus on addressing these legal issues and highlighting the changes that have occurred since the prior write ups
Summary of legal and regulatory overhang
It has been slow, but LPS has been making progress on the long list of outstanding legal and regulatory issues it has faced over the past few years. The biggest concerns last year were the FDIC complaint and the consent order.
The FDIC alleged breach of contract with WAMU and gross negligence. Gross negligence was the largest risk as bears believed the outcome could result in a terminal situation for LPS based on the alleged losses of $155 mm on 220 appraisals. This was alleviated in November 2011 when the FDIC’s claim was dismissed. The breach of contract is still outstanding but the penalty is significantly less.
The consent order has been discussed extensively on VIC as it relates to banks and service providers like LPS. LPS believes the consent order should be complete by the end of 2012. The third and final phase should take 120 days to complete from the start of work. LPS CEO, Hugh Harris, noted as recently as June 5th, that the “process is going very, very well for us.” This should ultimately be a selling point for LPS as it receives the “stamp of approval” for default/servicing related work. Our conversations with customers support this view, and LPS’ latest investor presentation highlights its market share gains and new customer wins. It is becoming harder and harder for both large and small servicers to meet new regulation and servicing standards economically without improved workflows and technology. Mortgage Technology magazine has written on this issue (http://www.nationalmortgagenews.com/technology/). The requirement of a single point of contact is a good example. In addition, there are other provisions requiring quicker servicer turnaround. For example, servicers will have only five days to respond to written requests from borrowers related to their loans instead of the 20 days currently allowed. The RESPA Amendment also reduces the timeframe for a final response from 60 days to 30 business days. These requirements will drive demand for technology solutions and at the same time, customers are consolidating their vendors which should benefit the largest players. Many servicers are going from 10,000+ vendors to less than 1,000 vendors. The largest should benefit.
Servicing standards required by the national mortgage settlement:
Summary of mortgage related provision of Dodd-Frank:
Second OCC interim report from June 21, 2012:
Class action litigation and fee splitting
The securities class action litigation complaint was dismissed on March 30, 2012 and the shareholder derivative litigation complaint was dismissed on February 14, 2012. Per the company’s February 13, 2012 conference call, 14 of the 15 fee splitting cases have been dismissed.
LPS is in conversations with numerous state AGs. Nevada and Missouri have both filed complaints and LPS has filed motions to dismiss for both complaints. These complaints are relatively well known and any legal costs or penalties should be included in the $78 mm accrued liability LPS set aside as of March 31, 2012.
The motions to dismiss can be found here:
These legal issues will likely take a while to resolve but we believe the worst is behind LPS. Management has set aside a $78 mm reserve for contingent legal and regulatory liabilities as of March 31, 2012. Per the latest 10Q, this accrual includes estimated costs of settlement, damages and associated legal fees and assumes no third party recoveries. The risk is that the company could end up liable for a larger amount. This has been the bears’ main point of contention. Our research suggests that the reserve is adequate or would only be exceeded by tens of millions in a worst case scenario.
Business description and fundamentals
LPS is high quality, cash flow generative business that is trading inexpensively because of the legal and regulatory uncertainty and end market headwinds. LPS has two main segments, Technology, Data and Analytics (TD&A) and Transaction Services, and sub-segments within each. Incidentally, LPS improved its financial reporting classifications in Q1 2012 to provide better visibility into segment revenues.
Technology, Data and Analytics
The TD&A segment includes LPS’ MSP platform which is the dominant mortgage servicing platform in the industry with 50%+ market share. Revenue is based on a monthly fee per loan on file, usage and professional services fees. Revenue per loan per year is around $15 compared to $12 five years ago. This business has pricing power, recurring revenue and high switching costs. This is a relatively stable business that is not entirely dependent on default and origination volumes like the Transaction Services segment.
Longer term opportunities
Citi and BoA are two of the larger servicers not on the MSP platform today and account for around 6% and 15% of the total market, respectively. I think LPS has likely been pushing hard to win this business as Bank of America has had numerous issues with Countrywide’s mortgage servicing platform since the start:
LPS has also improved its relationship with Citi over the past couple years and is doing nearly half of the HARP business at Citi. Citi and BoA represent sizable opportunities, but LPS is also winning business with smaller servicers (less than 50,000 loans). Per an interview in October 2011, recent LPS customer wins were in the 15,000 to 84,000 loan space. The Consent Order will raise the compliance and regulatory requirements of the large servicers, but, over time, we expect the same standards to be applied to small servicers.
The Transactions Sevices segment consists of origination services and default services. Origination services revenue, which has been very depressed, improved in Q1 2012 as refinance volumes increased nearly 40% Y/Y. It’s hard to estimate what a normalized origination market will look like, and what LPS’ origination services revenue will be given the company’s higher exposure to refinance vs. purchase originations. Total mortgage originations are depressed, but refinance originations are arguably elevated given the low rate environment if you look at MBA data over the last 20 years. LPS’ origination services segment has averaged $400 mm to $600 mm in revenue since 2005. I think $500 mm is a normalized revenue number in the near-to-medium term. LPS did $430 mm in 2008 when refinance originations were $777 bn. Since then, LPS has gained market share and new products/services. For example, origination services revenue decreased 14% Y/Y in 2011 while MBA refinance originations decreased 22%. Refinance volume was 10% higher in 2011 vs. 2008 and origination services revenue was 20% higher over the same period. LPS also notes that if a servicer is using all of LPS’ available services on the origination side of the business, the revenue opportunity is around $900 to $1,000 per loan. This is a blended average between purchase and refinance. You can back into a $500 mm to $550 mm revenue number assuming revenue of $800 per loan and a 10-12% market share.
LPS has been facing headwinds in its default services segment over the last couple years. This has caused segment revenue to decline to $886 mm in 2011 from $1.2 bn in 2009 and margins to compress significantly. There are signs foreclosure activity is now just beginning to pick up which should help LPS for the next couple years. The National Mortgage Settlement was filed in March 2012 but foreclosure activity remained depressed for the next couple months. However, foreclosure starts in May increased on an annual basis after 27 consecutive months of year-over-year declines. Foreclosure starts in May increased 12% from April and 16% from the same month last year. RealtyTrac posted its first half 2012 numbers today (7/12) and foreclosure starts for June increased annually for the second consecutive month. 311,010 properties started the foreclosure process in Q2 2012. This was a 6% increase over Q2 2011 and the first year-over-year increase in quarterly foreclosure starts since Q4 2009. The foreclosure process continues to lengthen and is at a record level of 378 days.The best metric to monitor is notices of default (NOD) given LPS’ leverage to front end related work. RealtyTrac publishes NOD data. This data is different from total foreclosure activity. There were 750,00 notices of default in 2011, 1.08 mm in 2010, 1.34 mm in 2009 and 1.29 mm in 2008. Operating margins in this segment are approx. 600 bps below 2009/2010 levels given negative leverage and a negative product mix shift. This segment should see revenue increase over the next few years as servicers work through the pipeline of seriously delinquent loans and then decline to a more normalized level. The seriously delinquent pipeline is around 3.7 mm loans. Modifications are not likely to help these loans. This backlog could take 3-4 years to work through and push default services revenue to near 2009/2010 levels. If notices of default increase to 1 mm, 33% above 2011 levels, revenues could reach $1.1 bn to $1.2 bn for the next few years. Longer term, notices of default could decline to the 400,000 to 600,000 range. This could be roughly half of 2010 levels or $500 to $600 mm in revenue not including market share gains.
We believe LPS has significantly improved its management team. Hugh Harris joined in October 2011. He was formerly at Fidelity National Financial and Fidelity National Information Services. We have received positive checks from customers on his understanding of the issues facing LPS and his long term strategy.
LPS currently trades at 6x trailing twelve month free cash flow of $349 million, equivalent to $4.10 fcf per share. We believe LPS should trade for 10-12x FCF based on peers and a blended multiple based on the characteristics of the TD&A and Transaction Services businesses. We believe these cash flow levels are sustainable even with the eventual decline in default services revenue will be offset by growth from new initiatives in the origination services segment and continued customer wins in the Technology, Data and Analytics segment.