Value Investors Club / WALKER & DUNLOP INC (WD)

Description

Summary and Thesis:

At current levels, we believe that Walker & Dunlop (NYSE:WD) represents an attractive risk / reward profile. In our view, WD remains underfollowed, its business model largely misunderstood, and its investment merits underappreciated. Summary points include:

- WD possesses strong downside protection and trades at an undeservedly low valuation.

- WD possesses significant business structure optionality and capital light growth prospects.

- Management is first-rate with proven ability to drive value across cycles, is highly aligned with shareholders, and has a demonstrated history of highly accretive and shareholder friendly capital allocation.

WD is a commercial real estate lender focused on multi-family assets, but also has a meaningful and growing presence in other CRE verticals. WD operates primarily as a non-balance sheet lender and loan servicer whereby it generates upfront cash origination fees and books mortgage servicing rights (MSRs). The MSRs, which are held at their capitalized value on WD’s balance sheet, provide the Company with long-term contractual cash flows immune to the vagaries of the origination environment.

The majority of WD’s business is originating for the government sponsored entity programs that facilitate multi-family lending. WD has strong positions across the GSEs as one of the top lenders for both Fannie Mae and Freddie Mac.[1] In addition to its GSE lending platform, WD brokers and services loans for life insurance companies, commercial banks, commercial mortgage backed securities (CMBS) and other institutional investors. WD also brokers property sales and originates/holds direct loans on its balance sheet.

We recognize the obvious issues in pitching a commercial real estate finance company at this point in the cycle. Concerns around the health and sustainability of the current CRE cycle are well known. We believe that those concerns have helped create the opportunity in WD and that WD’s valuation more than compensates shareholders for the known risks.

On a headline basis, WD trades at ≈8x our estimate of 2016/17 earnings. WD trades at ≈10x our conservative estimate of normalized earnings, a figure which assumes CRE transaction volumes retrench significantly from current levels, WD does not recalibrate its fixed expense base for a weaker environment, and WD does not execute on its growth prospects. If we isolate WD’s balance sheet assets from the Company’s origination platform, shares trade at an implied residual value of ≈2.5x our estimate of 2016/17 PT earnings from the Company’s origination platform and ≈4.5x our conservative estimate of normalized earnings.

We believe WD valuation is far too cheap for a growing and extremely well managed Company. Using various data points, we believe fair value is north of $40/share, or 50%+ above current levels.

Commentary on MSRs, valuation, etc.:

If we strip out the matching assets and liabilities on WD’s balance sheet, [2] almost all of WD’s equity value is represented by the book value of the Company’s MSRs.[3]

Over the last few years, MSR has become a dirty word in the investment universe as a result of the lackluster performances and near collapses of almost all public companies involved in the origination, servicing, or ownership of single-family MSRs.

WD’s multi-family MSRs are extremely high quality servicing assets and are fundamentally different from single-family MSRs.

Two basic distinctions explain why WD’s multi-family MSRs generate consistent and predictable cash flows and are substantially higher quality assets than single-family MSRs:

1) Unlike single-family mortgages, the substantial majority of WD’s mortgages contain significant prepayment penalties. 87% of WD’s servicing fees are prepayment protected, meaning that in the case of prepayment WD is made whole on the value of its MSRs.[4] Of the remaining, the majority contain certain prepayment disincentives.

2) The operating expenses associated with WD’s MSRs are much lower and far less volatile than the operating expenses associated with single-family MSRs. That is a result of WD servicing far fewer but much larger mortgages and the nature of collecting payments from commercial landlords vs. residential homeowners.

Over the life of the assets, WD’s existing MSRs should generate ≈$1bn in pre-tax income, and we believe that WD’s MSR portfolio will continue to grow.

Presented below is a summary snapshot of WD’s servicing fees over time. We believe margins have been consistently maintained at 95%+.

For three reasons WD’s reported book value understates the intrinsic value of its MSRs:

1) WD employs an accounting method with causes WD to over amortize its MSRs.

2) WD takes a highly conservative stance towards the capitalization of servicing fees that do not possess contractual prepayment penalties.

3) WD uses an unreasonably high discount rate of ≈12%.

As a result, there is a $94mm positive delta between a third party fair value of WD’s MSRs (cited in WD’s filings) and WD’s reported book value of its MSRs. Moreover, WD’s over amortization of its MSRs result in an under reporting of economic earnings. Our analysis indicates that WD over amortizes its MSRs by ≈$10.0mm on a pre-tax basis, representing ≈$.20/share in fully taxed EPS.

In our view, WD’s balance sheet and its associated earnings stream could be separated from WD’s origination platform. From a conceptual level, we can separate the two for valuation purposes. To separate the businesses, we bucket the entirety of WD’s tangible book value and all balance sheet associated earnings separately from all earnings associated with WD’s origination platform. If we value WD’s balance sheet assets at 1x economic tangible book value, shares currently trade at an implied residual value of ≈2.5x 2016/17 pre-tax earnings for the Company’s origination platform.

To comment on WD’s cyclicality. WD is a cyclical business – all else being equal, WD will perform better when CRE originations/refinancing are higher, the hallmark of a buoyant RE market. However, we believe the market fails to appreciate the significant counter-cyclical elements WD possesses:

1) As previously highlighted, WD’s MSRs will generate robust cash flow regardless of the origination environment.

2) The GSEs are counter cyclical lenders. In periods of market stress, the GSEs’ competitive position significantly strengthens, yielding benefits for WD. The GSEs take market share – boosting WD’s revenue – and the GSEs lending spreads increase – boosting WD’s margins. The dynamic is manifest in WD’s performance through and after the financial crisis.

Separately, WD is positioned to benefit from higher interest rates as a result of ≈$1.3bn of escrow balances associated with the Company’s servicing portfolio. Insofar as higher interest rates will likely slow originations/refinancings, WD should be able to meaningfully offset the negative impact with higher escrow earnings.

WD’s best comps are the various commercial real estate finance service companies such as MMI, HFF, CBG, JLL, and TSX:CIG. Amongst the peer group, there are various puts and takes regarding relative business attractiveness, management quality, capital structure, etc. The peer group trades at median EV / EBIT of 11x / 9.5x on 2016 / 2017 and median P/E of 14x / 13x. For the reasons discussed in this memo, we do not believe WD should trade at the back of the pack.

Based on our analysis, WD is likely to earn ≈$3.30 in 2016/17. Valuing the Company at a consolidated P/E in line with peers yields a $40+ stock. Alternatively, valuing the balance sheet assets at TBV and applying a 10x PT multiple to a conservative estimate of normalized origination earnings also yields a $40+ stock.

Management, Growth, Capital Allocation, etc.

We believe that WD’s attractiveness is significantly enhanced by the quality of its management team. In our view, WD has the best management team in its industry. We have followed WD since its 2010 IPO and have been consistently impressed with the stewardship of CEO Willy Walker. Willy rates amongst the most consistently thoughtful CEOs we’ve encountered at any company. We highly recommend that potentially interested investors listen to a handful of conference calls / presentations. Countless industry checks – amongst competitors, clients, former employees, GSE participants, etc. – have confirmed the strong reputation of WD and its management.

Under Willy’s leadership WD has achieved significant growth both organically and through M&A. Prospectively, we expect the Company to continue to grow within its existing verticals and capabilities, as well as add new ones. Additionally, two specific structural and growth opportunities bear mentioning (note: the two are potentially related insofar as item 2 may be an early step of item 1):

1) The Company has plans to establish an asset management business with the goal of raising $8bn-$10bn over the next few years. Willy’s commentary on the establishment of the asset management business from the Company’s 2Q16 CC is a worthwhile read.[5]

2) The Company is exploring creating a mortgage REIT which could house both its on balance sheet interim loan program and possibly a portion of the Company’s MSRs. If the REIT happens, WD could accrue a number of benefits:

a. reduce the real/perceived capital intensity of the consolidated business

b. allow the Company to grow faster and more efficiently

c. highlight the profile and value of the Company’s distinct income streams

d. materially improve the Company’s tax efficiency

Willy owns 5.6% of the Company and total insider ownership stands at ≈11.6%. Over the last few years the Company has taken advantage of opportunities to repurchase meaningful amount of shares, underscoring the Company’s history of highly accretive and shareholder friendly capital allocation:

- March 2014: the Company repurchased 2.4mm shares (7% of shares outstanding) at $14.50/share from Column Guarantee (an affiliate of Credit Suisse), which owned the shares as a result of a previous transaction with WD

- March 2015: the Company repurchased 3.0mm shares (9% of shares outstanding) at $16.00/share from Fortress, which owned the shares as a result of a previous transaction with WD

- February 2016: the Company announced a $75mm (11% of shares outstanding) repurchase authorization

Catalysts:

- See write-up

Risks:

- Cyclicality of real estate markets

- Competitive pressures

- Adverse GSE reform

[1] Two points of note: 1) the debate surrounding GSE reform is essentially wholly focused on the single-family platforms of Fannie Mae and Freddie Mac. The GSE’s multi-family platforms performed admirably through the GFC and legislators on both sides of the aisle recognize the distinctions between the single family and multi-family platforms and the value the latter has generated for public and private interests alike. We are highly confident in the future of the GSE multi-family platforms; 2) for loans WD originates through Fannie Mae, WD retains risk sharing responsibilities for a portion of the loan. Our highly stressed analysis and WD’s own experience during the GFC provide strong support to our view that the risk of material capital loss to WD is small.

[2] The largest asset being ‘Loans held for sale, at fair value’ and the largest liability being ‘Warehouse notes payable’.

[3] WD does have a small amount of equity invested in its on balance sheet interim loan program and its CMBS conduit JV.

[4] In fact, prepayments are an economic net positive because a stream of future cash flows (which are discounted on WD’s balance sheet at ≈12%) are paid out in a lump sum discounted to the present at the current risk free rate for the relevant duration.

[5] “Finally, we established the goal of creating a scaled asset management business at Walker & Dunlop. I would like to take a few moments to explain what that goal means for us and our investors. In 2007, when our company turned 70 years old, we established a 5-year growth plan called the drive to 75, where we aim to increase revenues and earnings by 5x in 5 years. We accomplished that goal in 2012. That same year, when W&D turned 75, we established another 5-year growth plan called onward to 80. That plan set a goal of expanding our loan origination sales force to capture as much deal flow as possible and, once established, to raise third party capital so Walker & Dunlop controlled the underwriting and investment decision to lend on commercial real estate. The onward to 80 strategy was launched in November of 2012. That same year we acquired CWCapital, which increased our loan origination sales force to 72 professionals, who originated $7.1 billion of mortgages. Since then, we have added 5 offices, 32 loan originators and increased our annual transaction volume 150% to $17.8 billion at the end of 2015. As we were dramatically expanding our loan origination network, we also began lending off our balance sheet, and have originated almost $1 billion of loans over the past 4 years, achieving low teens returns on our equity and having not a single delinquency. Our goal now is to expand this lending operation off balance sheet by raising debt funds in the form of a separate account or commingled funds or acquiring the manager of a mortgage REIT. Whether it be in the form of funds or a mortgage REIT, it is our goal to build a business with between $8 billion and $10 billion dollars in assets under management over the next several years. That kind of scale will do several things. First, it will provide our loan originators with capital we control to meet almost any financing need of their clients: first trust debt, mezzanine debt, interim debt, preferred equity and joint venture equity. With this breath of capital, we are certain that Walker & Dunlop will continue to be viewed as one of the very best financing platforms for commercial real estate. Second, by controlling the capital and earning origination fees, exit fees, servicing fees and asset management fees, we will enhance the margins of our lending business. And finally, with $8 billion to $10 billion in assets under management, coupled with the ever increasing revenue off of our servicing portfolio, we believe we will generate over 50% of our revenues from long-term stable revenue streams, causing investors to classify Walker & Dunlop as an alternative asset manager, which will expand our earnings multiple accordingly. With our scaled access to deal flow, long-standing underwriting track record and 191% shareholder return in our first 5 years as a public company, we believe raising capital around this initiative will be achievable and scalable. We made great progress during Q2 at vetting potential partners, meeting with institutional investors and determining our long-term fundraising and asset management strategy.”

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

See write-up

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			2016	2017
Price:	26.80	EPS	3.3	3.3
Shares Out. (in M):	31	P/E	8	8
Market Cap (in $M):	817	P/FCF	8	8
Net Debt (in $M):	103	EBIT	165	165
TEV (in $M):	920	TEV/EBIT	5.5	5.5