Description

Lender Processing Services (LPS) is the country’s largest processor of home mortgages. The company is trading at a discount to its intrinsic value as analysts have struggled to understand its business in what has been extremely hectic environment after LPS was spun-out in July. Historical financials by segment were recently released, and in the interim, a number of regulatory and macro fears have overshadowed fundamental economic reality. Despite a strong affiliation with the mortgage industry, LPS’s earnings are actually positively correlated with default activity. This has enabled LPS to deliver strong results in 2008 and the company is likely to outperform expectations in 2009 and 2010. Shares are currently trading for 10x 2009E FCF while a more appropriate valuation would put the stock closer to $40, offering 33% upside over the next year.

Capital Structure

The company’s debt does not mature until 2013-2015 and has been predominantly locked in at an interest rate of 6%.  Free cash flow will be used to paydown $140MM in debt annually, distribute a $38MM dividend, and then the excess will be used to either buyback stock, retire debt at a discount, or make small acquisitions. LPS did approve a small $75MM buyback in October, but this amount was only designed to offset the non-cash compensation expense that will be incurred through 2009.

Business Segments

Loan Facilitation: When a new mortgage is originated, LPS provides settlement, appraisal, and other related services. The company has roughly a 25% market share of these activities. This sales have obviously been under pressure as lower sales have caused margins to contract but Management expects business to stabilize by Q1 2009.

While things have been fairly dire, there is room for some positive surprise that has largely went unnoticed on the sell-side due to Land America (LFG) filing for bankruptcy in November.  LFG generated $61MM in revenues in Q3 from its Lender Services segment which competes directly with LPS’s Loan Facilitation segment. LFG is in the process of being bought by FNF and since FNF no longer has any mortgage processing business (it spun-out these businesses originally create to LPS), many of LFG’s customers are likely to switch to LPS. LPS’s CEO recently confirmed that the company was receiving a significant amount of calls from LFG’s customers.

Mortgage Processing: LPS has a mortgage servicing platform which handles all areas of the loan servicing process including loan setup, ongoing processing, customer service, accounting, and reporting. Of the roughly 50MM mortgages in the country, LPS processes 27MM on its platform under long-term contracts. Revenue is approximately $1 per month per loan and carries a near 50% margin.

Given that it can take years to transition off of a platform, this is a highly recurring business model, evidenced by the fact that all of the top 10 customers have had relationships with LPS for nearly 20 years.

LPS processes the mortgages of virtually every major mortgage originator in the country save for Bank of America, which recently decided to attempt to use Countrywide’s platform and transition off of LPS’s platform in 2010. Management is still trying to reverse this decision and has pointed out that given LPs’s superior scale, it will cost Bank of America $50MM more a year to bring these capabilities in house. Regardless of what Bank of America ultimately decides, LPS’s management is confident that they can offset any loss of revenue with the sale of other services to Bank of America. More importantly, it’s unlikely that LPS loses any other customers given that none of the other top 100 lenders have in-house mortgage processing systems.

On the positive side, the company continues to win new business as banks look for cheaper and more effective ways of managing the mortgage process. Chase is converting their prime portfolio over to LPS in 2009 and Wachovia is converting their HELOC platform to LPS in 2010. The 15-20MM HELOC loan market represent a long-term growth opportunity for the company. Traditionally, these loans were $15,000 and were treated as credit card debt by lenders, but with sizes as high as $100,000, these loans are effectively real estate loans and banks are finding that the internal platforms they have been using are not robust enough to handle necessary loss mitigation activities.

Default: After a loan defaults, LPS provides attorney referrals, title work, publishing, posting, and inspections. If the mortgage is taken over by the bank LPS will manage the asset sale, get the property ready for sale, or find a broker to sell the property. The company has been taking substantial market share and still has ample room to grow. Management currently estimates its share of these various services at 17%. LPS is paid a fee per default based on the services used. While some fees are paid up front, a number of fees are not collected until the home is resold such that on average revenues are recognized over the default period which can be as long as two years.  This can be a slight negative as LPS has had to invest considerable working capital in order to grow the business.

Historically, the peak in foreclosure activity has occurred after the bottom in housing prices and more importantly, heighted foreclosure activity lasted for years after the peak in foreclosures.  Management should have a pretty good sense of the state of mortgages, given that they process half of them, and they believe default activity will be strong through 2011.  

RealtyTrac puts out a monthly foreclosure statistic. While it’s likely that LPS has superior data, these numbers suggest a strong correlation between quarterly default revenue and quarterly default filings. However, if one was to assume that default filings each quarter create a 18 month revenue stream, there revenue numbers will be much higher than a number of sell-side models leading to a $0.25-0.50/share upside in earnings depending on how long of a lag effect one is willing to apply. Even more compelling is that if the market starts to clear sometime in 2010, there could be substantial origination activity while default revenues would continue to be recognized, allowing LPS to materially outperform sell-side models in 2010.

Other Technology, Data & Analytics: LPS sells software to customers to assists with the property valuation, recordkeeping, and analytic services associated with loan marketing and loss mitigation. This segment is the hardest to model of the four as it is largely dependent on a mix of new software purchases and long-term contracts. This business has generated $210-230MM in revenues per year since 2005 and management, which has decent visibility into the pipeline, expects it to grow slightly next year.

Valuation

Management has guided towards strong growth in sales and margins over the next few years but the street has remained skeptical. As an example, Morgan Stanley valued LPS at $32 in a reported dated November 3. The analyst’s bull case values the shares at $50, but he was careful to warn investors not to overpay for what would likely be peak earnings:

“Management’s long-term annual growth outlook for 6-9% total company revenue growth and 50 basis points of operating margin expansion assume default volumes will continue to rise through late 2010/early 2011, which we do not. If LPS’s internal forecast is correct, our 2010 and 2011 estimates may be conservative.”

On July 10^th Goldman had run a DCF analysis on LPS an arrived at a $53 stock price yet Morgan Stanley’s DCF yielded a value of $32. It’s interesting to note that a key difference diving Morgan Stanley’s model is the analyst’s disbelief in guidance:

“From 2008 to 2012, revenue and EBITDA CAGR of -3% and -4% (versus the company’s long-term revenue forecast of 6-9% annual growth)”

While Goldman had modeled default revenues in line with what we believe to be closer to economic reality, a number of other sell-side analyst have failed to realize that default activity creates a stream of revenues for LPS that can last as long as the home remains in default rather than a one-time fee. Management has indicated multiple times that this tends to be 18 months and that revenue is spread roughly equally over this period.

Given that LPS has an incredibly resilient and balanced model, very healthy margins, was able to grow throughout 2008 with considerable room for future growth, a management team filled with executives who have all been with the company for nearly two decades, and earnings that are now (thanks to the large growth in default) inversely related to the economy, by the end of 2009 the stock could easily trade for $40/share or 13x the more than $3/share in FCF that the company will generate in 2010.

Risks

LPS gets paid every time a loan originates or defaults and so a wave of defaults would likely be followed by a wave of originations. Unless those properties sit on the market indefinitely or are purchased with cash, new mortgages will have to be created, which also benefits LPS through origination volumes. Despite the fact that it would probably be best for the economy to let this market clearing process occur, a number of proposals have caught a lot of attention in the press. These issues have caused investors to doubt whether or not the mortgage market will clear through defaults and new loans to qualified homeowners (positive impact to EPS) or through direct government intervention that prevents any foreclosure and origination activity (negative impact to EPS). These headlines have sidelined a number of investors who would decided that it would be safer to sell their shares in 2008 and buy them back in 2009 in order to avoid the headline risk. The major news items that have dominated sell-side research are below:  

Home Valuation Code of Conduct: In March 2008, Freddie Mac and Fannie Mae agreed only to buy loans from banks that follow new appraisal standards set by the New York Attorney General. The new standards appear to prohibit lenders from using internal appraisers or appraisers that are employed by a settlement service provider. A considerable amount of sell-side research has been dedicated to the risk embedded in LPS’s ownership of a settlement services provider. A lot of the fear here is misplaced as LPS uses independent contracts for appraisal and in the event that the law required all appraisals to be performed by a completely independent third-party. In a worst case senario, a spin-off of this division would result in the only national and fully independent provider of appraisals with massive scale and a strong competitive advantage due to its relationship with LPS’s processing platform.

FDIC Loan Guarantee Proposal: In October the FDIC stated that it was working on a plan to help banks renegotiate mortgages rather than foreclose on a home. Under this proposal, loans modified would qualify for government guarantees. The FDIC proposal is not going to save the bulk of loans with negative equity, but it might save a few good ones. Unfortunately, whenever a government guarantee is involved, adverse selection is soon to follow. Fortunately, the Treasury has shown far more willingness to support the lending process by purchasing groups of MBS rather than individual loans. More importantly, any guarantee activity on behalf of the government would require a large third-party to provide valuation services, and LPS is one of the few likely candidates. As an example, the company is the current provider of mortgage information to the Hope Now program.

Foreclosure Moratorium: In late October, JP Morgan said that it would not foreclose on any mortgages for 90 days. Banning foreclosure is a rosy concept with one big problem, it does not work. In Massachusetts a 90 day moratorium in June was followed by a huge jump in foreclosure activity when it expired in September. Historically, moratoriums of defaults have only caused a significant ramp up in the number of defaults after the moratorium expires. If everyone who can afford a $200,000 house bought a $400,000 house it may seem like a simple solution to force banks to write the mortgage down to $200,000 and have the bank (read government) take the hit. However, what about the people with $400,000 homes who CAN afford to pay their mortgages…won’t they want to lower their mortgage by $200,000 as well? When a moratorium occurs, virtually anyone with negative equity in their home based on market prices stops paying their mortgage with the hope of renegotiating. The end result is that the problem only really gets worse.

“We have seen aggressive loan modification programs implemented by the FDIC on financial institutions that have gone into conservatorship. As the processor for these financial institutions, we did not see a material change in the foreclosure volumes once the more aggressive programs were put in place. Similarly, when top level financial institutions implemented a principal balance reduction focused program, the success rate was very low.” – Q3 Conference Call

While the government can certainly delay it, it is highly unlikely that they can prevent the market from ultimately clearing as home prices decline and homeowners filter back into homes that they can afford.

A final risk that has been mentioned is that LPS has a rapidly consolidating customer base which usually leads to pricing pressure. Much of this is mitigated by the fact that there really isn’t an effective alternative provider for mortgage processing and that the company has renewed over half of its MSP revenue without having to lower prices. Most banks are currently focused on large recapitalizations and survival rather than saving a few pennies on lower processing fees.

“The last market development I would like to discuss is customer consolidation. As we have stated in the past, customer consolidation generally is neutral to positive to our business. Recent acquisition activity provides good examples as the transactions between Wells Fargo and Wachovia and between Chase and Washington Mutual were probably the most favorable outcomes for our business going forward. All four of these financial institutions are major customers who already use or are in the process of converting to our MSP platform.” – Q3 Conference Call

Catalyst