LENDER PROCESSING SERVICES LPS
May 11, 2011 - 3:12pm EST by
399
2011 2012
Price: 28.30 EPS $3.50 $3.54
Shares Out. (in M): 86 P/E 8.0x 8.0x
Market Cap (in $M): 2,450 P/FCF 8.0x 8.0x
Net Debt (in $M): 1,200 EBIT 571 560
TEV ($): 3,650 TEV/EBIT 6.4x 6.5x

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Description

LPS is a cheap and misunderstood company that has high barriers to entry and generates a roughly 20% ROIC.  The stock trades at a 12-13% current year free cash flow yield with a relatively clean balance sheet, and management is deploying virtually all of its free cash to retire shares outstanding.  It’s one of the few companies I have seen buy back shares so aggressively when their stock is actually cheap, rather than wait till it gets expensive first.   The stock is depressed due to the foreclosure controversies that have generated so many headlines, but I believe their role within the space as a processor has been misunderstood.  It’s also cheap because it has moving parts in origination and default, which I believe cause many analysts to miss the forest of a great business with high ROIC/FCF and barriers to entry, in the trees of quarterly earnings visibility and revenue momentum.

 

The Company is a monopoly provider of processing technology to mortgage servicers, with its only real competition being legacy in-house systems used at BAC, C, and GMAC.  With roughly 60% of mortgages in the US serviced on its MSP platform, it enjoys a scale barrier to entry, in that no one could ever match their average unit cost.  So when they invest in platform development, the cost is spread over 30mn units/mortgages.  The Company also provides related origination and default services that are activity based rather than recurring, and in my view their quarterly movements attract too much attention from analysts.  The revenue breakdown in 2010 was 43% default, 31% technology data & analytics, and 26% originations.  The profitability is more heavily weighted toward technology, as it generates low to mid 30s EBIT margins versus low to mid 20s for the transaction related businesses.  By contrast in 2006 before the big spike in mortgage credit issues, the Company’s revenue breakdown was 19% default, 38% technology, and 43% origination.  In theory originations and defaults provide a hedge against each other, as one should be strong when the other is weak, but that obviously may not work perfectly in every quarter.  

 

LPS has been measurably gaining share in its markets.  The chart below shows the growth rate of LPS’s origination revenue versus the change in the MBA reported market origination volumes, as well as LPS’s default revenues versus the change in the Realty Trac reported foreclosure filings.  Neither is a perfect driver of LPS’s revenues, and may not even be the best, but directionally this presents fairly the Company’s consistent outperformance of its markets due to continued share gains and lack of apparent pricing pressure.

 

 

2007

2008

2009

2010

Origination Revenue

5%

-30%

20%

17%

Market Volume

-15%

-30%

25%

-25%

Default Revenue

70%

80%

33%

-7%

Market Volume

75%

43%

25%

-3%

 

Additionally, LPS has been gaining share in its higher margin technology data and analytics business by automating what were previously manual operations such as invoicing attorneys through its Desktop system.  Other TD&A, which includes the Desktop application and does not include MSP, grew by 12.5% in 2010 and by 18.4% in Q1 2011.  This was driven by the conversion of the 3 largest mortgage originators, WFC, BAC, and JPM, onto Desktop starting in the 2nd half of last year.  One of the bear cases last year on LPS was that the foreclosure controversies would cause some of their large customers to back away from them, but the evidence points in the opposite direction.  Going forward I expect the TD&A segment to grow faster than the transaction segment as more processes are automated, increasing the percentage of higher margin recurring revenues in LPS’s mix, which could be a catalyst for a higher share valuation.

 

The primary factor that has weighed on LPS’s valuation is the foreclosure controversy, and the related investigations LPS has been under and delays in foreclosure activity dragging on the Company’s default revenues.  At the beginning of 2010 management guided to 15-20% growth in default revenues in the year, but the actual result was -7% due to the delays.  There is market skepticism on when that might improve.  Default revenues were down 18% in Q1 just reported.  I believe we are closer to the end of the investigations and delays than the market appreciates, and that default volumes should begin to recover in the 2nd half of this year.

 

LPS recently signed a consent order relating to the controversies with the Fed, FDIC, OTS, and OCC, along with 14 major servicers.  The move by the regulators appears to be an attempt to bring to a reasonable close some of the uncertainty caused by the fractious group of state Attorneys General trying to win a harsher settlement, as well as some of the chain of title issues that have been raised that could create a safety and soundness problem if not resolved.  The orders are all worded similarly to the LPS one at the link below, and ask for lots of compliance reviews to be presented within 30-120 days related to the full spectrum of mortgage servicing and default operations.  Once these reports have been submitted and signed off on by these regulators, it will be much more difficult to argue that there is anything inherently unsound about the process, as many consumer advocates and attorneys have.  As reported in the WSJ April 12th:  “It sure looks like [regulators] are setting up the banks to be able to go out and say to the attorneys general, ‘You can’t touch us,’ says Margot Saunders, a lawyer with the National Consumer Law Center.”

 

http://www.federalreserve.gov/newsevents/press/enforcement/enf20110413a11.pdf

 

The OCC examined LPS on-site before these consent orders were announced and does not appear to have found any problems beyond the well-reported notarization issues at its now defunct subsidiary Docx.  This unit has attracted investigations from Florida State and US Attorneys.  Management has never denied what this unit did was wrong, and I have no doubt it will cause the Company to pay a substantial fine.  The consent order left the issue of fines open to the end, as it did with the other banks, leading one to suspect the regulators are looking for a global settlement.  This unit constituted less than 1% of LPS default revenues, so even if they had to disgorge 3 years worth of revenues it would total $30mn.  Treble that and it’s $90mn, roughly equal to one quarter of LPS free cash flow.  Further, the consent order above confirms management’s account that the activities were stopped in February 2010, and contradicts a negative December 2010 Reuters article that claimed they went on longer.

 

The move by the regulators appears to have forced the Attorney Generals to significantly soften their demands and move toward a settlement.  The American Banker reported May 11th that the AGs new offer drops demands for principal writedowns, and “The AGs are considering using whatever money they receive from banks to start a ‘cash for keys’ program to help troubled borrowers move out of their homes and speed the foreclosure process by providing them cash incentives to leave.”  This opens up the substantial “shadow inventory” to finally move through the foreclosure pipeline, and for LPS to finally capture the delayed default revenue.  Further, principal reduction is the only thing likely to substantially reduce the number of foreclosures.  If that’s off the table defaults will have to happen, it’s only a question of when.  (the reason why only principal reductions could work is a separate topic, but for a detailed explanation I refer you to the work of Laurie Goodman of Amherst Securities)

 

For a basic valuation I “normalized” 2010 earnings for origination and default volumes, and set a target valuation of 8x EBITDA in line with other processors.  To do that I took 2006 as a “normal” year for default, certainly not the bottom but well before the worst.  Foreclosure filings were roughly 1/3rd in 2006 what they were in 2010, and 1/3rd of 2010 default revenue totals $353mn.  (LPS default revenue was $278mn in 2006, so this gives them credit for their market share gains)  Then for originations I took $2tn as a normal year.  There is no such thing as a “normal” year for something as volatile as mortgage originations, but the peak was close to $4tn in 2003, and there were only 2 recent years below $2tn, ’08 and ’10.  This market could be depressed for a while with low home turnover and negative equity, but both of those factors should support elevated default revenues.  A $2tn market would be 1/3rd better than the $1.5tn in 2010, so I increased 2010’s reported $647mn to $860mn.  Thus total transaction revenue would have been $1,214mn versus the $1,701mn reported.  Applying a 27% EBITDA margin nets $132mn of excess EBITDA out of the $670mn reported.  At 8x, less $1.2bn net debt, on the current 86mn shares out gets to $36/share.  Then adding the present value of tax-effected excess default earnings for the next few years, which I assumed to be $800mn/yr of revenue for 4 years, gets to $41/share.  That $41 is a base valuation that gives no credit to market share gains, growth in high margin recurring TD&A revenue, or free cash deployment/buybacks.  So a 2 year forward target would be in the $50s.

 

Additionally, management has taken advantage of the cheap stock and its free cash flow to significantly reduce the share count.  Average diluted shares outstanding declined from 96.7mn in 4Q09 to 88.1mn in 1Q11, and actual shares out were 86.3mn.  So when the default revenues finally come through they will do so on a much lower share base.  Additionally, management openly discussed adding leverage to further reduce shares in the last earnings call.  Debt/TTM EBITDA is currently 1.84, and management discussed the possibility of going back to 3x, similar to where the Company was when it spun off from FIS in 2008.  Assuming they added $650mn in debt (TTM EBITDA currently $659mn) at a 7% cost and bought back 20mn shares it would increase this year’s EPS by over $.60/share and could be paid back down with the excess default revenues of the next few years.

Catalyst

 Consent order completion and increase in foreclosure volume, aggressive share repurchase, levered recap, LBO candidate, continued growth in higher margin recurring technology revenue.
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