Description

Stonegate Mortgage Corporation is a small cap player in the nonbank mortgage market. It is a relatively simple business and we like it for the following reasons:

Because of regulatory pressure, capital management, and business refocusing, many banks are de-emphasizing their mortgage operations. This has made the market less competitive and left an opening for nonbank players like Stonegate, Ocwen, PennyMac, and PHH among others.

Stonegate is focused primarily on purchase mortgages. As such, the company is less dependent the more volatile and rate dependent refinance market. In addition, purchase mortgages tend to be longer lived and hence have more valuable mortgage servicing rights.

Recent negativity in the space driven by rising interest rates, reduced mortgage activity, and the possibility of unhelpful regulatory changes being imposed on servicers has made valuations of some of the companies, including Stonegate, more attractive.

Many investors have been concerned that Stonegate’s assumptions regarding future mortgage production were totally unrealistic. We think this is now priced into the stock given that the post IPO performance has been disappointing and the 4Q results were a bit of a let down on top of that.

With Stonegate now trading at some 11x 2013 earnings that include only small contributions from recently acquired operations (although share count changes and acquisitions make the relevance of this low), and 7x conservative (below consensus) 2014 earnings, we think downside in the shares should be limited. Should the company actually deliver on expectations then the upside could be considerable. We like this skewed to the upside range of possibilities.

Business

Stonegate originates, finances, and services conforming loans.

On the origination side, Stonegate earns revenues from fees and gains from selling loans. These loans may be sourced from (a) correspondents, who are typically mortgage brokers large enough to have their own warehouse line; (b) the wholesale channel, which is typically comprised of brokers who don’t fund their loans, essentially submitting loan applications to Stonegate; and (c) Stonegate’s retail operations which are comprised of loan officers that work in a call center or physical retail location. Stonegate has developed its own technology and credit evaluation software to facilitate origination of loans through its various channels. Ultimately, Stonegate’s objective is to use the skills that it has developed underwriting conforming product in the future in the non-Agency market that should develop (or re-develop) as GSE reform is implemented over the coming years.

On the financing side, Stonegate provides warehouse financing with a view to earning fees, interest income, and retaining servicing rights. Note that the overall goal is ultimately to acquire and retain servicing rights. Stonegate actually retains very little loan exposure.

Where is Stonegate’s growth going to come from?

Stonegate is in the process of licensing in a number of additional states which will allow the company to pursue activities in new territories. Through new licenses, Stonegate should add 15% of the US market in 2014. In addition, the full annualized effect of the 30% of the market that Stonegate added in the second half of2013 should be reflected in prospective results.

Also, the impact of Stonegate’s recent acquisitions has yet to fully impact the company’s numbers. With respect to Crossline, which was acquired in December, costs related to the acquisition impacted 4Q results, however, the full benefit of Crossline’s brokers generating loans under the Stonegate platform will not be felt until the end of the first quarter. With respect to the Nationstar acquisition (of certain retail and wholesale assets), in November 2013, Stonegate simply hired employees which had an immediate negative income statement impact although the future impact of origination fees, interest income and servicing has yet to come online.

Stonegate is to a certain extent a roll up play in that the company intends to acquire or hire small operators in what is a very fragmented market. According to Stonegate’s filings “of the over 15,000 mortgage companies that are currently licensed to originate mortgage loans in the US, 81% have a presence in only one state and 75% have five or fewer mortgage loan officers”. Stonegate believes that it can hire or acquire these operations for very low effective multiples. Crossline’s pro forma purchase multiple was 2.5x projected 2014 net income. In general, Stonegate anticipates making these types of “roll up” acquisitions at multiples of 2x to 4x earnings. With multiple expansion, these types of deals should be accretive to the share price.

Earnings, trading and valuation

Stonegate’s 4Q results were disappointing in part because of lower than anticipated gain on sale revenues. In addition, the outlook for new mortgage volumes has declined. As a result, and because of lofty expectations (perceived unattainable) for future volumes, Stonegate’s stock price performance from its October 2013 has been awful. We think that most of the IPO investors who might have got involved and been disappointed have probably moved on and that Stonegate is more of a value (or GARP) type of play. The Street is now calling for 2014 earnings of $2.25 to $2.75 per share (round numbers). If one is conservative and uses a number below the range of $2 per share then at 7x, we think Stonegate has limited downside from its recent $14 range. Estimates for 2015 are along the lines of $4 to $6 per share implying low single digit multiples. It would seem that few have any faith that those numbers can be met. If you use a $3 per share earnings number for 2015 and assume that investors will get comfortable with that then apply today’s 7x multiple that gives a $21 stock in a year, an upside of 50%.

The principal risks to the story are: lower than expected mortgage volumes, increased regulatory burdens, and poor execution by Stonegate management. We think most of these concerns are priced in.

Catalyst