Description

Company:                Mr. Cooper Group

Security:                  Equity

Recommendation:   Long

Executive Summary

After the recent transformative acquisition of Nationstar Mortgage Holdings Inc. (‘NSM’), which closed on July 31, 2018, I believe Mr. Cooper Group (“COOP” or “the Company”) is significantly undervalued and has 35-40% upside for the following reasons:

• Fundamental outlook: Positive given the rising rate environment

• Cash flow generation: improving due to COOP’s $6bn NOL which is available through 2032

• ‘Platform Value’: cheap optionality on KKR’s ‘platform’ value to grow balances faster via additional bulk/platform acquisitions, increase operating leverage and accelerate the use of the tax asset – the Company has already announced two acquisitions in recent months.

Prior to the NSM deal, COOP (formerly known as WMIH) was essentially an NOL shell. Today it is a very different company. For a more detailed background on WMIH prior to the acquisition, please review AAMD’s post from earlier this year on February 12.

Capital Structure

($MM)

Transaction Background

On February 13, COOP announced an agreement to acquire NSM for an aggregate consideration of ~$3.8bn comprised of: (i) $1.2bn in cash, (ii) 36% of COOP pf ownership, and (iii) $1.9bn of debt. NSM shareholders could elect $18/share in cash or 12.7793 shares of COOP subject to a predetermined proration. Following the closing of the transaction, Fortress, the largest NSM shareholder, holds 5.1% (reflecting a 70% reduction in their ownership) and KKR, the largest WMIH shareholder, has a 17% stake in COOP (down from 24% of WMIH prior to the transaction). Jay Bray, NSM’s CEO, is now the CEO of the combined company. COOP’s tax rate will be sub 5% compared to NSM’s 24%.

Company Description

COOP is a non-bank residential mortgage servicer that earns fees by providing servicing, origination and real-estate transaction-based services primarily to single-family residences in the US. The Company has three distinct but interrelated business segments:

• Servicing: the Company acquires mortgage servicing rights (MSRs) on loans with unpaid principal balances (UPBs) and services those loans; COOP is now the largest non-bank mortgage servicer and 3rd largest in the US.

• Origination: 15th largest mortgage originator with $21BN in annual originations (soon to be ~$30bn pf for the recently announced acquisition of Pacific Union Financial).

• Xome: real estate services including “auction”, title, collateral valuation and property disposition.

Servicing:

Business Overview

Servicing is the core of the three segments that accounts for 57% of revenue and 61% of Pre-Tax Income. The Company provides servicing to ~3.3MM customers with an aggregate unpaid principal balance (UPB) of +$500BN. The majority of the Company’s loans are serviced for the GSEs (Fannie and Freddie), followed by Ginnie Mae and private-label investors in mortgage securitizations. While COOP owns the MSRs for most of the loans, COOP also acts as a master servicer on certain portfolios and a subservicer where the servicing rights are owned by a third party. The servicing portfolio is subject to natural “run off”, which means that the mortgage loans serviced by COOP may be prepaid prior to maturity or repaid through standard amortization of principal. As a result, the Company’s growth profile is largely dependent on its ability to acquire additional MSRs, enter into additional subservicing agreements and originate new mortgages (where it retains the MSR). The Company has guided to 5% growth in UPB in 2018 and has visibility on at least 7% growth in 2019.

Note: 2019E includes $25BN from Pacific Union acquisition

The unit economics of the business model are pretty straightforward:

• Owned-Servicing: COOP is responsible for collecting and recording mortgage payments, administration of mortgage escrow accounts, negotiating workouts and modifications, and managing foreclosures if necessary. The Company collects servicing fees (expressed as basis points of outstanding UPB) and ancillary revenues (late fees, modification fees) which are intended to cover the operating costs and risks of MSR ownership. Servicing profitability is in the 8-10bps range (of UPB).

• Subservicing: includes collecting mortgage payments and related activities on behalf of other institutions that own the MSRs. While the fees are less than owned-servicing (in the 2-3bps range), the costs incurred and capital requirements are also lower. It’s essentially a fee-for-service business which doesn’t require an investment commitment.

Segment Metrics:

The split between owned-servicing and subservicing has evolved from 85%/15% in 2015 to about 60%/40% today. Despite the increased contribution from subservicing, which carries lower fees (3bps vs 8bps for owned MSRs), servicing profitability has improved in the last few years largely due to lower amortization expense resulting from higher interest rates. In 2018 alone, profitability has increased from 5.5bps in Q1 to 6.5bps in Q3. Servicing outperforms when rates rise as the run-off (I.e. amortization) slows due to lower refinancing activity (at higher interest rates).  Interest rates are up 140bps in the last two years and annual amortization expense has declined from 8bps/UPB in 2015 to 4.8bps/UPB in 2017 as a result. Amortization expense is expected to decrease further to ~3.5bps in the 2018-’20 period.

Growth Drivers

The Company has guided to 6bps of (adjusted) servicing profitability for 2018, which would imply 6-6.5bps in Q4, and compares to 5.8bps in Q4-2017.

Management has also indicated that servicing profitability should be +6bps beyond 2018 and the growth is largely driven by higher revenue from portfolio onboarding/acquisitions and lower costs from operating efficiencies. Slowing prepays from higher rates are not baked into the unofficial forecasts (one CPR equates to ~$80 impact on book value and ~$20MM in earnings).  

• Portfolio Onboarding/Acquisitions: After onboarding $175bn UPB of loans in 2017, there is visibility that growth in 2018/19 should be in the MSD-HSD range and a large position of that growth is driven by the Company’s push into subservicing given the minimal upfront investment and the high returns on capital. COOP has said that it is targeting larger customers that have origination platforms and an appetite to grow. The strategy seems logical from a cost of customer acquisition standpoint in that it should enable COOP to grow its subservicing revenue with these larger clients as opposed to onboarding 50-100 separate clients that park servicing for a short while and provide little longer term visibility (as clients may take servicing in-house or sell the MSR outright).  With ~$60bn of the portfolio running off every year from current prepayments, subservicing growth just from its two largest customers is expected to be in the $25-30bn range. In terms of owned-MSRs, the tax asset improves COOP’s position as an acquirer in two main ways: 1) it is no longer a disadvantaged buyer vs the REIT buyers, and 2) at $86 direct expense per loan, the Company is now generally considered the lowest cost servicer by several 3rd party metrics. As such, COOP can be more competitive while maintaining its return threshold.  The reality is between subservicing growth, the Company’s origination platform (which is the $20-25bn per annum range largely in recapture business – more detail below) and some small bolt-on deals, COOP is largely in self-sustaining mode without incurring significant capex on bulk acquisitions (which I view as cheap upside optionality). While management has emphatically stated that it has a consistent (mid-teens) return threshold on an MSR investment and “will remain disciplined through the cycle”, one legitimate concern is that the Company may compete away its tax advantage and chase bad deals. It was therefore positive to see management refrain from bidding on recently issued Fannie and Freddie product which appeared too frothy. The Company did recently announce the acquisition of Pacific Union Financial, which will add $25BN to the servicing portfolio, and said it believed it was “market price for the assets”. What appears attractive about the portfolio is that it was recently originated (last two years) and is government insured, so the MSR is relatively new and the CPR is presumably quite low. It appears that the Company has been even more selective on the subservicing side – management could lower its pricing (to sub 2bps where some deals are getting done) and get many more subservicing contracts but has refrained from doing so.

• Operating Efficiencies: Historically one of the criticisms of the Company was that higher UPB balances never translated into operating leverage. Compliance costs and changing regulation posed an incessant drag on earnings. Since 2015, servicing rules have eased and COOP has been able to deliver scale benefits with growing UPB balances. The Company is currently targeting another $15MM in cost reduction by yearend 2018 and expects to continue cost reductions in 2019.

Origination:

The Company originates ~$21bn in loans annually primarily through the direct-to-consumer and correspondent channels. Most of the profitability comes through the consumer channel where the primary source of originations is the recapture of refinancing activity from existing customers in the servicing portfolio. The origination business is essentially designed to create servicing assets at attractive margins through recapture. Given the upward move in rates in recent years, however, the origination industry has seen a significant decline in repayment and refinancing activity, and COOP is no exception. Given this dynamic, on the Q3 call, management reduced its Pre-Tax Income expectations for the Origination segment to $115MM (from $120MM in Q2 and $140MM at the beginning of the year).

Growth:

• Home Intelligence: new product to help customers navigate their balance sheets and provide “debt consolidation” services. Given that housing is in reasonably good shape today, the product is designed to enable customers to view the home as a “center, not just a loan” and focused on driving more home-centric transactions.

• Leveraging the Channel: The Company has offset some of the refinancing volume decline by expanding volume from the correspondent channel and new (home) purchase recapture from the consumer channel. COOP is also investing in acquiring new customers to drive incremental volume and margins. The origination business is clearly the weak link – while correspondent margins are significantly lower than consumer direct, correspondent volumes have been effective in replenishing the portfolio. The recently announced acquisition of Pacific Union should be additive to the franchise with ~$10bn of incremental volume (in addition to the ~$21bn, largely in the correspondent channel) in 2019 and also supports the Company’s expansion into non-Qualified Mortgage (Non-QM) which is a high growth area for non-bank originators given the tight bank underwriting standards.

Segment Metrics:

Xome:

Real estate services business with a focus on property sales and asset management. The fee-for-service business was started in 2012 initially to capture a lot of the spend out of the MSR portfolio. The Company spends money on property preservation, title, appraisal, closing services and asset disposition. The Company first offered “exchange” or “auction” technology-enabled platform (via Xome.com) to enable management and sale of residential properties in foreclosure. COOP’s services have since expanded to include title, escrow and collateral valuation, and most recently preservation. “Steady-state” Pre-Tax Income is in the $55-65MM, and with preservation it is closer to $70MM. The main pushback on Xome has been the stability of its earning profile (particularly on the exchange/auction side) given the steady decline of foreclosure volume since 2015. Over the last several quarters, however, the Company has done a good job stabilizing its inventory of total homes for sale with 3rd party inflows (including one of the large GSEs) which are now offsetting declining volume from the Company’s portfolio. With the Assurant acquisition that closed in August, 3rd party revenue has increased to 49%.

Growth:

• Organic: Pathway to higher earnings include (1) increased 3rd party business and (2) higher share of internal services - management’s goal is to move much more of the Company’s business to Xome, which could be $100MM in overall revenue per annum at a ~20% EBITDA margin.

• Acquisitions: COOP is opportunistically looking at platforms that offer different products, better technology and more 3rd party business. The industry is reasonably fragmented so there is an opportunity to consolidate.

• Transition: With the recent acquisition of Assurant, the Company is transforming itself and should be fully ramped by mid-2019. The Company had incurred expense to enhance field services (title and appraisal throughout the servicing book) but decided to abandon the project after the acquisition given Assurant’s superior platform. COOP is making a meaningful investment in Xome and has also hired a new CEO for the business. In the near-term, margins will be invariably below historical levels but should revert in the next 6-9 months as the Assurant is fully integrated.

Segment Metrics:

Valuation:

Additional considerations:

• Tax Asset: A large part of the value proposition is the tax asset: $1.26bn FV of the NOL less $326MM valuation allowance = $934MM DTA; my estimate of NPV is ~$650MM.

• Acquisition of Pacific Union: I assume they paid a point on the $25bn MSR pool, so ~$250MM, and commentary is that a capital provider (presumably KKR) will pay for the “excess” above cash.

• Guidance: For 2018, management has guided to 5% UPB growth (to $535BN), +6bps of servicing profitability per UPB, $115MM Pre-Tax Income in Origination and $60MM Pre-Tax Income for Xome. For 2019, there is visibility to 7% UPB growth, more correspondent volume (lower margins) in Origination and a turnaround in Xome.

On June 29th, the Company released the following projections in a proxy (which I view as the bull case):

Using more conservative assumptions, I believe the stock is worth ~$20/share or 35-40% upside:

1) Sum of the Parts:

2) Liquidation (Adj. Book) Value:

Risks:

• Regulation: The Company is regulated in every state by the CFPB. Over the last three years the Company has had over 20 exams and has been rated 1 or 2 which is very favorable. As the Company looks to grow/make portfolio acquisitions, the regulators could certainly intervene if they don’t think it is in the best interest of the customer. The reality is that COOP has been endorsed by the larger subservicing clients like USAA that care deeply about regulatory standing.

• Xome: The segment is going through a period of transition and my expectation is that performance will rebound in the next 6-9 months but it could certainly take longer.

Catalysts:

• Interest Rates: Consensus is for rates to continue to move higher which will increase the value of the MSR portfolio. The partial offset is that refinancing origination volumes will be softer.

• Acquisitions: The industry is ripe for consolidation and I believe COOP has the resources and discipline to do accretive deals. Acquisitions will not only serve to replenish the run-off in the servicing portfolio, leverage the origination infrastructure and increase 3rd party business for Xome but also accelerate the use of the NOL.

Catalyst

• Interest Rates: Consensus is for rates to continue to move higher which will increase the value of the MSR portfolio. The partial offset is that refinancing origination volumes will be softer.

• Acquisitions: The industry is ripe for consolidation and I believe COOP has the resources and discipline to do accretive deals. Acquisitions will not only serve to replenish the run-off in the servicing portfolio, leverage the origination infrastructure and increase 3rd party business for Xome but also accelerate the use of the NOL.