Description

Disclaimer:

This is not a recommendation to buy or sell shares.  Our views are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this recommendation.  The information below is from public sources.  We have not independently verified this information and we make no representations as to the accuracy or correctness of any such information.  We undertake no obligation to update any information below.

Note: For more information on the mortgage servicer industry, see previous VIC write-ups on WAC and OCN. I agree with the analysis in both write-ups and think the entire industry is being undervalued right now. I also think NSM has a few unique features that make it particularly attractive. Also, one should note that with regard to EV, it appears debt is very high but part of this is due to legacy non-recourse debt that NSM is still required to report on its balance sheet.

Recommendation: Long Nationstar Mortgage Holdings (NYSE: NSM) - $50 PT

With depressed valuations in the entire mortgage servicer industry, Nationstar is a particularly attractive investment at these levels because it has several meaningful ways to drive value over the next year. The upcoming spin-off of Solutionstar as well as Nationstar’s significant operating leverage potential will drive an increase in the valuation of the business. Additionally, regulatory scrutiny of the mortgage servicer industry should subside over the next 6-12 months and allow valuations in the sector to return closer to historical norms or even higher. The necessity for many of the larger banks to sell off the servicing rights to their existing loan books due to new Basel regulations will provide a long runway of growth for the entire mortgage servicer industry.

Company Overview

Nationstar Mortgage is one of the largest non-bank mortgage servicers, having grown its MSR portfolio fairly rapidly over the past few years to ~ $384BN in Unpaid Principal Balance as of March 31, 2014. The company also has a large origination platform that it will use to replenish its MSR’s that are rolling off over time, with about ~ $24 BN in origination volume in 2013. Additionally, Nationstar’s Solutionstar segment provides complementary services to mortgage servicing such as appraisal, title, and various other real estate services.

Industry Overview

The mortgage servicer industry is essentially an oligopoly with the main participants being Ocwen, Walter Investment Management, and Nationstar. Given the large operational structures and compliance processes necessary to service mortgages in accordance with the associated rules and regulations, it is difficult for new firms to enter the industry. Servicing mortgages that are higher-risk requires particular expertise in order to avoid foreclosure and mitigate potential losses. The industry is benefitting from the ongoing trend of large banks looking to sell the rights to service their mortgages due to new Basel regulations. However, recently regulators have been scrutinizing the non-bank servicers out of concern that they have grown too much, too fast, and are not treating consumers well. This scrutiny does not reconcile with the fact that the non-bank servicers have been shown to be much more effective and efficient than the large banks, and have fewer complaints and execute more loan modifications. Nevertheless, in what appears to be a largely politically motivated pursuit, Benjamin Lawsky, the NY DFS supervisor, is actively investigating the industry. The ongoing scrutiny has essentially caused new acquisitions of loan portfolio servicing rights to come to a halt. While the main focus of the investigation has thus far been Ocwen due to its status as the largest player in the industry and its various related entities, Lawsky has been investigating Walter and Nationstar as well. It should be quite obvious that the mortgage servicers are better for consumers than the banks because they are more equipped to handle any issues with the mortgages they service and are far more nimble than the large banks. The level of complaints against the larger banks with regard to mortgage servicing is several times higher than it is for any of the non-bank servicers (relative to MSR’s being serviced). Because of this phenomenon, the scrutiny of the non-bank servicers should subside with several small fines being the worst case outcome, and thereby allowing the industry to continue acquiring servicing rights from the large banks.

Reason for Mispricing

As mentioned above, the recent regulatory scrutiny has put tremendous pressure on the entire industry on multiple fronts. Valuations have become compressed due to uncertainty, and purchases of mortgage servicing rights from large banks have been slowed to a standstill, raising concerns about growth opportunities. Thus, the multiples being afforded to the entire industry have come down and the companies are being hindered from growing their earnings power through new acquisitions. Nationstar is currently mispriced due to not only the industry issues, but also because its operating leverage is not evident right now and because the value of its Solutionstar segment is being under-appreciated by the market. In order to grow its UPB very quickly over the past few years, Nationstar had to make significant investments in human capital and other organizational assets, depressing profitability in the short-term. Thus, Nationstar has a significant opportunity to drive efficiencies and increase profitability.

Solutionstar

Solutionstar provides services for mortgage originators and servicers such as real estate valuation, title services, default processing, and real estate sales, among others. Management has indicated that it is considering a spin-off of this unit which should allow the market to value it more accurately and also provide more clarity about the core segments as well. Management has guided to $400MM in revenue for the segment and $215MM of pre-tax income for 2014. Using a 35% tax rate gives roughly $140MM in net income for 2014. Applying an 8x multiple on those earnings, Solutionstar could be worth roughly $12.40 per NSM share. Because this segment could potentially represent a large amount of the value of the business, a spin-off should help highlight the value of Solutionstar as well as the value of the core operating segments.

Management Team

Nationstar’s management team is very experienced in the industry and is receiving a large portion of its compensation in the form of stock and options. The CEO, Jay Bray, spent a number of years at Arthur Andersen and also spent a number of years working in asset-backed securitizations at Bank of America. David C. Hisey, an EVP and the company’s CFO, worked as an EVP and deputy CFO at Fannie Mae from 2008 to 2012. Hisey’s experience at Fannie Mae is very valuable because it should help the company continue to be aware of any changes in the mortgage market and it should also help the company maintain a strong relationship with Fannie Mae and Freddie Mac. Harold Lewis, the company’s President and COO, spent several years at Fannie Mae as well. Overall, the management team has significant experience leading some of the most important players in the mortgage market and should be very qualified to successfully navigate the challenges they are facing right now.

Valuation

Mortgage servicers are commonly valued using P/E multiples because cash flows can get complicated due to various aspects of the business. Additionally, book value is not a very meaningful valuation metric for Nationstar since its mortgage servicing rights are marked to model. The earnings model and valuation summaries can be found below.

Risks

• Regulatory scrutiny – expect that this will subside but any serious enforcement actions by regulators could harm the business significantly and limit growth

• Organizational issues – NSM has grown rapidly so it could have some growing pains as a result – this could also cause exacerbate regulatory issues

• Rapid rise in interest rates – while this actually helps the value of the mortgage servicing rights, it would cause a material slow-down in mortgage originations

• Slow-down in the housing market – would hamper the originations business and may limit NSM’s ability to replace its MSR’s as they roll-off over time

• Accounting of MSR’s – NSM uses fair value accounting whereas competitors use cost accounting – would prefer NSM use cost accounting as it is more conservative

Catalyst