Description

OCN: Ocwen Financial Corporation- Long Thesis

We are proposing a long position in Ocwen Financial, a forgotten and overlooked non-bank mortgage servicer and originator with a long history of regulatory and operational struggles that we believe has now turned the corner and is in a period of stabilization that will ultimately lead to growth beginning in 2021.  Because of the company’s embattled past and operational mishaps, OCN trades at just 48% of what we believe will soon be a growing book value.  We see 100% upside to $49 as the company resolves legacy CFPB matters, gains more traction in originations, continues to meet cost reduction goals, and ultimately achieves profitability and book value growth in 2021. 

OCN History:

Ocwen was formerly run by embattled mortgage servicing pioneer Bill Erbey from 1988-2010.  In 2010 Erbey tapped Ron Faris to be his successor and the company went on an acquisition spree and Ocwen ultimately serviced loans with a UPB of over $467b at its peak in 2013.  By 2017 it was evident that OCN was struggling to properly and adequately service their mortgages.  In April 2017 the CFPB + 30 states sued Ocwen for “failing borrowers at every stage of the mortgage servicing process”, alleging that Ocwen had years of widespread errors, shortcuts, and runarounds that cost some borrowers money and others their homes.  The result of the suit was that the company was temporarily restricted from acquiring mortgage servicing rights (MSRs), which caused the company to effectively be in runoff for nearly two years.  The result was a difficult time for OCN operationally and for OCN shareholders. Ultimately OCN was able to settle with all 30 states, integrate a best-in-class mortgage servicing platform acquired with acquisition of PHH in 2018, and begin to once again acquire MSRs in the market in 2020.  Glenn Messina, the PHH CEO, was also named CEO of OCN subsequent to the closing of the acquisition and has done a phenomenal job integrating PHH/OCN, navigating the legacy legal and regulatory matters, and cutting costs in order to position OCN for a return to growth.

Business Summary

Ocwen earns servicing revenue based on the UPB of its loans. OCN’s core competency is sub-prime servicing, but the company also services conventional (agency), government-insured (guaranteed by FHA and VA), and non-agency (sub-prime) loans.  Ocwen earns fees by collecting payments from borrowers, forwarding P&I to investors in securitized loans, remitting taxes and insurance premiums from escrow accounts, and performing collection, loss prevention, and foreclosure activities for delinquent loans. Ocwen also originates loans through its lending segment. After origination, OCN can retain the servicing rights or sell the rights to other servicers.  Retaining servicing rights adds to the company’s UPB, whereas selling the rights results in a gain on sale of the associated rights.  For more information on OCN’s business model, the PHH acquisition, and history, see Rizzo's excellent write-up from early 2019.  We will focus on developments since this write-up and the current outlook/environment.

Cost Cutting:

Glenn Messina took over the reigns as CEO in October of 2018 when he came over in the PHH acquisition, where he had been CEO for 5.5 years.  His first order of business was to institute and oversee a massive cost cutting initiative while transitioning the mortgage servicing platform to Black Knight and cleaning up OCN’s legacy compliance issues.  He immediately upped the cost synergies goal from $100m to $145m in Dec 2018 while targeting a total of $200m in overall cost savings.  Ultimately the OCN team upped this goal again to $300m and has executed well in achieving it.  As of 3Q2020 OCN has taken a total of $394m of run-rate costs out of the business since 2Q2018.

Resolving the Final Legacy Regulatory Issues

Another area where Ocwen has made headway has been in resolving the legacy regulatory issues inherited from the previous management team.  The company resolved their regulatory issue with Florida on October 15th, the final outstanding state issue.  OCN also completed their final data integrity audit and report for the state of New York, who has been monitoring OCN for the past three years.  Additionally, Ocwen issued their escrow review report and submitted their action plans to participating states during the third quarter as well.  The bottom line is that, after a long period of multiple major regulatory proceedings against OCN, the company is on the cusp of putting the last of their issues behind them.  The final major hurdle is the CFPB mediation, which commenced on Oct 23rd. We expect this mediation to have a favorable outcome and the stock to react positively as the last major legal overhang for OCN is resolved.

Originations Growth

Historically OCN’s primary engine for growth was the acquisition of MSRs, particularly in the subprime space where the goal is to reduce delinquencies through high-touch servicing, generating ancillary fees in the process. However, for the period of time where OCN was restricted from acquiring MSRs, Ocwen began to focus more intently on building up an originations network and attempt to gain more of a foothold in originations. This provided another avenue to replace UPB as it ran off and diversified the means by which the company could return to growth.  In 2020 the environment for originations has been favorable, allowing the focus in late 2019 on originations capabilities to pay off during 2020.  As seen below, subservicing additions have seen growth accelerate somewhat, while servicing has exploded.

Going forward it will be important to monitor this originations growth at OCN as a key sign of the health of the business.

Return to Growth and Profitability

Another primary objective of the PHH acquisition was to transition Ocwen’s legacy mortgage servicing platform (MSP) to PHH’s Black Knight MSP in order to achieve regulatory compliance and allow the company to transition from runoff back to MSR growth.  OCN was able to onboard the lion’s share of their legacy assets to the new MSP by 4Q19, with the remaining being onboarded in 1Q20.  OCN is now able to focus on growing their servicing and is in regulatory compliance to do so.  OCN grew their non-NRZ servicing by $3b q/q in the third quarter.

We expect OCN to achieve their stated goal of positive adjusted pretax income for this year and positive earnings for 2021 and low double-digit to mid-teens after-tax ROEs by mid-2021.  

Valuation 

Ocwen has made solid progress on regulatory issues, cost cutting, and operational execution over the past two years.  However, due to the aforementioned legacy issues, OCN currently trades at just 47% of book value despite the evidence of progress being made. The closest comp, Mr Cooper Group (COOP), trades at 0.95x book.  While we do think COOP deserves a valuation premium (we also own COOP which we think will continue to grow book value and ultimately trade at a premium to BV) as they continue to execute well and are the industry standard, we expect the valuation gap to close over time as OCN continues to prove to the market that they have successfully returned to growth.

Within 18-24 months, we expect OCN to double in a base case:

Base Case: $49 (+100%) or ~0.9x a growing $54 book value

Bull Case: $60 (+150%) or 1x a growing $60 book value

Bear Case: $22 (-10%) or 0.5x $44 book value

In our base case, management achieves their goals for 2021 and sees book value grow from $49 currently to $53.  In our bull case, originations volumes come in higher than expected and after-tax ROEs come in at the mid to high teens.  In our bear case, market conditions cause originations to falter and the company is unable to replenish UPB runoff, causing BV to not achieve growth. 

Another possible outcome is that OCN could be acquired in the short term at a premium to its current depressed multiple to BV. The industry is ripe for continued consolidation and the recent progress OCN has made from a regulatory and operational perspective make it an attractive acquisition. 

Catalyst

• After a multi-year bleed on book value and cash during a period of runoff, the stabilization in book value achieved in 2020 will finally give way to a return to growth in UPB, originations, and book value and cause the stock to rerate.

• Resolution of the final remaining major legacy regulatory matter with the CFPB. Mediation commenced on October 23rd and a a resolution will likely be positive and finally put to rest a long-lived overhang on the stock.

• Continued achievement of cost cutting goals by CEO Glenn Messina and team.

• Though it is not core to our thesis, we believe OCN could also be an acquisition target in an industry that will likely continue to consolidate.