Description

Like NCEN (recently submitted to VIC), Saxon is involved in the sub prime mortgage market. The company was spun out in a private transaction by Dominion Resources in July of 2001, and began publicly trading in January 2002 under the symbol SAXN. The main points regarding Saxon are the following:

Strong Franchise

Formed in the late 80’s as a non-conforming mortgage conduit for Ryland Mortgage and Dynex Capital, Saxon has grown into one of the most respected players in the sub prime field. While following the same gain-on-sale accounting rules that plagued the industry and led to its demise, Saxon operated much more conservatively than most of its competitors, focusing mostly on the higher quality markets and putting special emphasis on the life of the loan. Due to this more conservative nature, Saxon, over the years, generated one of the strongest track records in the ABS markets. Since 1996, the company has been involved in ABS transactions accounting for roughly $11 billion in mortgages, and has managed to create a strong base of buyers for its product. This track record allowed Saxon to price two securitization transactions since the spin out in line with Chase Financial. The result of this conservative nature and strong performance in the ABS market has made Saxon one the strongest franchises in the sub prime market.

And, it is the franchise, not a loan portfolio, that you are currently buying when you buy SAXN. This is because upon the spin out from Dominion last year, Saxon went through a “cleansing” process. That is, as part of the transaction, Saxon’s residuals stayed with Dominion. In effect, the spin out was of the Saxon platform, ABS track record and management expertise, but not of Saxon’s loan book. Hence, the current Saxon is a company with an industry-leading track record and reputation, with access to cheap capital, but without a large loan portfolio. Because of this, Saxon’s current strategy is to use its franchise to build up a portfolio.

Disciplined Approach

The strong reputation Saxon enjoys in the ABS market stems from its conservative underwriting approach. Unlike some competitors, Saxon underwrites 100% of the files from all production channels prior to origination or purchase. The company also re-underwrites 10-15% of funded loans on a random and adverse basis. And, Saxon strives to be geographically diverse, with account executives in 49 states. The demise of the industry stemmed from, among other things, an aggressive and irrational underwriting market. Saxon’s disciplined approach, proven by its ABS market reputation, separates it from its previous, now bankrupt, competitors.

Limited Competition

Due to the collapse of the industry, and the numerous bankruptcies, acquisitions and exits (notably Bank of America in 2001), competition in the industry has diminished. While the diminished competition will help all current market participants, it will be especially beneficial to Saxon due to its need to grow its loan portfolio. At a time when Saxon must grow to prosper it finds itself in one of the most benign competitive environments in years. With former aggressive and irrational competition eradicated, Saxon should be able to grow its loan portfolio relatively quickly and profitably. (This is the same macro environment that is benefiting NCEN. It just helps SAXN even more.)

New Accounting

Saxon took advantage of its balance sheet “cleansing” at the time of the spin to switch from gain-on-sale accounting to “portfolio accounting”. Instead of booking gains on securitizations, the company structures its securitizations as financings. This change makes Saxon’s income statement and balance sheet look like that of a bank’s. That is, the company’s loans and asset-backed securities remain on the balance sheet, a loan loss provision hits the income statement and a loan loss reserve is placed on the balance sheet as well. So, the newly independent Saxon’s GAAP income will be generated from the spread it earns on its loans rather than from one-time gains from the securitization of loans. This allows the company’s reported income to be much more consistent and much more in-line with its cash flows.

Bottom Line

In Saxon, you are buying an industry leading franchise cleansed of prior industry accounting issues building a loan portfolio conservatively in a market with substantially reduced competition. The cleansing process and subsequent rebuilding of the portfolio should lead to tremendous earnings and book growth over the next few years. Combined with a disciplined lending approach and industry leading spreads, Saxon should be an investment to hold onto for years to come.

Valuation:

In my opinion, SAXN is incredibly cheap (obviously, since I decided to submit it). A quality lender, as evidenced by where its ABS trade in the market (i.e. in line with Chase), should command a premium valuation. Hence, even though Saxon is a smaller financial company and therefore considered more risky, I believe it should trade at a premium to comparable capitalized companies, somewhere around 2.0 to 2.5 times book, if not higher. With a current book value of $8.98 per share, those multiples would equate to a stock price of roughly $18.00 to $22.50, up from the current price of $12.00. Of course, as discussed above, the company is in the process of growing its book. Hence, the book value should grow substantially going forward, implying an even higher stock price. (Of note, after its recent nice run, NCEN trades at 1.8X book. Using that multiple, you arrive at a stock price of $16.16 per share for SAXN.)

Risks:

Saxon faces general risks that affect the entire sub prime market including extended economic weakness, increasing interest rates and a possible changing regulatory environment. On top of those, Saxon faces some more company specific risks, including:

Undisciplined Underwriting Practices

A large part of my thesis stems from the company’s conservative underwriting practices. Due to Saxon’s strategy to hold the majority of its loans through maturity, unexpectedly poor loan quality would severely impact the company. If the company becomes more aggressive, if it succumbs to the Sirens of Wall St., then my thesis would be wrong. However, this risk is somewhat mitigated by the company’s change in accounting practices, practices that would not reward aggressive loan underwriting that much.

Cash Flow

Saxon will not be cash flow positive until late 2003 at the earliest due to its current growth mode. While this should not be a problem for the company, a delay of positive fcf much beyond 2003 could limit the ability for Saxon to further expand origination volumes.

Catalyst

Increased Awareness
SAXN began trading in January 2002 with little fanfare. As investors begin to recognize the company’s franchise value and new accounting practices, SAXN should start to trade closer to a more reasonable valuation.

Growth of Book/Earnings
With the company focused on rebuilding its loan portfolio, its book and earnings should grow substantially over the next few years providing a higher valuation on its own.