Description

Walter Investment Management (WAC)

Let me start by heading off most of the interest in this name at the pass: WAC is a Subprime Mortgage REIT. 

The company came public via a spin and reverse merger into a shell, trades at 60% of book value, will be paying a dividend which I estimate to be in the $1.75 range based on available financials. Insiders have been buying. The company is tough to get hold of (they did present at a recent JMP conference) and have yet to issue financials as the new company, leaving only proformas and the financials of the old parent to go on. They have a differentiated business model, the balance sheet is not that levered (assets/equity of 4:1), they have unencumbered cashflowing assets and may be overcapitalized. Finally, they have a business model that would potentially allow them to profit from the cleanup of the real estate and mortgage debacle.

I guess this qualifies this as a "spec" for most people. I wouldn't argue with that.  I think you have a decent margin of safety, the prospect of a decent dividend, and a company which may be able to take advantage of the ongoing mortgage debacle. Then again, I've been very wrong before (see ACMH) so caveat emptor etc. I'll keep this short, and let you judge for yourself.

WAC was formerly the captive financing arm of Jim Walter homes, which was part of Walter (WLT). The homebuilding division built homes for people in the southeastern United States, on land provided by (and improved by) the owner. The financing arm financed the cost of the house, but got security in the land and improvements (driveway, sewage, utilities, etc etc). The loans were deep subprime (average FICO of 600) and had an average LTV of mid-80s, no more than 90% at the outset. The financing arm also purchased some loans on the open market 2006-8. The loans were financed through a mix of equity, warehouse lines and on-balance sheet securitizations. Walter serviced the loans and also sold fire and extended insurance coverage to the homeowners, through a sub called Best Insurors.

In 2006 WLT brought in Mark O'Brien to serve as the building and financing group's chairman and CEO.  From the S-4: Mark J. O'Brien, 65 has been a director of Walter since 2005. In March 2006, Mr. O'Brien was named Chairman and Chief Executive Officer of Spinco. Mr. O'Brien has served as President and Chief Executive Officer of Brier Patch Capital and Management, Inc., a real estate investment firm, since September 2004. Mr. O'Brien served in various capacities at Pulte Homes, Inc. for 21 years, culminating in his appointment as President and Chief Executive Officer. He retired from that position in 2003. Mr. O'Brien is also a director of Mueller Water Products, Inc.

Walter ultimately decided to spin off the financing business (WLT retained the homebuilding business, which has been shut down). The company stopped underwriting new loans May of 2008 and paid down the warehouse lines. The financing business was reverse merged into the remains of Hanover Capital (HCM) a broken prime mortgage REIT, effective April of 2009. The old HCM team is retained, as are Walter's loan servicing and insurance businesses.

So what do we have? The business is to all intents and purposes the old Walter assets, in runoff, with servicing and insurance revenues.

There are about $1.73B of loans yielding about 10.3%. The loans are 98% fixed rate. The vintages are (per the company presentation at the JMP conference) 25% 2006-2008, 48% between 2001-2006, 28% before 2001.

The loans are performing well. Given the age of the loans, better underwriting, the rural southeastern location of most of the houses (see presentation on their website) you'd guess that the average LTV has not taken the kind of impact that other portfolios have. The company also services its own loans. Their staff live in the communities that they service, have responsibility for and are compensated on, their own portfolio of loans. They know their borrowers, and appear to have done a decent job underwriting the loans and verifying income at the outset, as well as managing through the issues that arise over the life of a subprime loan to keep them current.

Delinquencies are running under 5%. NOTE: This is the company definition, and excludes accounts in bankruptcy where payments are current "based upon payments made in accordance with their bankruptcy plan". Last year, the company took some additional charges to allow for losses on ARMs that they had purchased on the open market. These loans are virtually gone now (2% of the total portfolio). Recoveries on defaults are about in the low 80% range, in line with historical experience of "about 85%", and LTM realized losses are under 0.68% through Q109.

The loans are partly financed with $1.35B of match funded non-recourse securitization loans (per WLT's Q1), costing about 6.9%. The balance of the assets are unencumbered.

There are other assets including cash, and houses held for resale which total to about $100mm, and it all nets out to about $476MM on 20.6mm shares or about $23/share of book value.

Modeling the company going forward is a bit of guesswork.

The insurance business is homeowners insurance for their own borrowers, and appears to be nicely profitable - though vulnerable to a good hurricane season. It is unclear to me what HCM will do but the company assures that the rump of HCM (which is small ~3mm of SG&A, $10MM of assets) will run at breakeven. That looks to be in line with historical profitability on the insurance business, net of $3mm of G&A (per the JMP call) and assumes no major hurricanes, and HCM operations at breakeven (per the S-4: HCM currently is focusing on generating fee income by rendering valuations and loan sale advisory and other related services to private companies and government agencies, services it has provided to third parties in the past.).

The following assumptions are from company guidance for the year, also given at the JMP conference) which are in line with recent history and Q1:

• Net interest Income of $80-$85mm
• G&A running at $30-31mm/year (excludes HCM and Insurance)
• Insurance, HCM and other contribution of $4-$5mm net of G&A
• Credit provisions running in line with Q1 at ~ 1%/Q

I get to operating income of around $40mm/year (management $38-$43mm), which is in line with the company's guidance.

With 20.6mm shares outstanding, and assuming a 90% payout, that points to maybe a 14% dividend yield to holders based on current pricing. Goodwill has been charged off, and a one-time increase in allowance for losses was taken in 2008, so that hopefully the full amount will make it to taxable income. This number ignores (as the company points out) any one-time costs related to charges for the spinoff etc.

Of course, this is a shrinking pool of assets, so it behooves us to ask what will happen to the return of capital as the loans pay down. Management has only given hints here, and there are a few possibilities.

Case 1 - return of capital.

I model loans and securitizations paying down running off at ~6.5% of principal/year. If G&A trends down with the portfolio, provisions are taken at 1.20%, and discounting it all at 10% a year, there's about $20 of value.

Case 2 - they invest the capital.

They speak of potentially acquiring assets. They see their core skill as being their loan servicing business which they regard as a unique asset. They are looking to leverage this into other pools of single family housing loans with balances of under $300k. At the JMP conference, they said that they would not pursue "the classic fee-for-service model" but hope to align with owners of whole loan portfolios and service those loans for a percentage of the value created. How soon this might happen, and how much capital it might consume, is open to conjecture.

Initially they believe that they could service another 15-25,000 accounts (vs about 37,000 currently) within their current footprint within 6 months "without growing pains" but expect to potentially expand the model to areas such as CA over time. In an ideal world, they either buy up assets at pennies on the dollar or take no principal risk at all. What will actually happen we will have to see.

The model for upside in this case could be something like RWT, who are perceived to be savvy buyers of mortgage assets (I know, I know, very different business model, established team etc etc.). In this case, we could argue that the business is worth a premium to book value - maybe 1.2x, or $28, which is also the value of subprime servicer Ocwen Financial (OCN).  Again, I realize that these are (to be charitable) imperfect comps, but I'm throwing them in to get an idea of potential upside.

Case 3 - Not much happens

Management owns a touch over 3% of the company. They may be unable to invest the capital, buy businesses or get anyone else to sign up for their servicing. They may also decide that they like being employed. That means we get a divvy starting out at 14% but dwindling over time as G&A eats up the profits from the portfolio. In this case, 50% of book value is probably not unreasonable - see SUAI.

If we take case 1 as the "base case", a liquidating pool of assets with a ~14% dividend yield plus return of capital on top, we have base case around $20, with upside of $28 and downside of $11.50

Upside - management could succeed in leveraging their existing servicing platform. There's a lot of ugly subprime assets out there. They might also be in a position to bid on and add value to assets that fall into their existing servicing territories. You could have yourself an investment in a subprime mortgage and real estate activist vulture

Risks - I think you can fill in a lot of this for yourself.

• Credit/Losses: While probably more than half of the portfolio has aged to where risk is minimal due to low LTVs, anything written post 2004 would have to be a risk, even in areas without a lot of house price appreciation. It hasn't showed up to date the way it has elsewhere but portfolio credit has clearly shown some deterioration, or be it at mild levels.
• Insurance - a good hurricane could ruin the year's results
• Expansion - management may burn the excess capital that the portfolio throws off on ill-advised purchases of businesses, portfolios, or unsuccessful expansions.
• Inactivity - Management could absorb a lot of the potential dividend stream with bloated G&A
• There's a whole lot more in the S-4, which I suggest you read in detail including this tidbit on tax: The IRS has issued a Notice of Proposed Deficiency assessing tax deficiencies in the amount of $82.2 million for the fiscal years ended May 31, 2000, December 31, 2000 and December 31, 2001 with respect to the Walter consolidated group, which includes Spinco. The proposed adjustments relate primarily to its method of recognizing revenue on the sale of homes and recognizing revenue on the instalment note receivables. The items at issue relate primarily to the timing of revenue recognition, and, consequently, should the IRS prevail on its positions, Walter's financial exposure is generally limited to interest and penalties, although it is possible that some portion of the offsetting deductions may be derived by Spinco after the spin-off and could result in a permanent difference to Walter for a portion of the tax liability. In addition, a controversy exists with regard to federal income taxes allegedly owed by the Walter consolidated group for fiscal years 1980 through 1994. Walter estimates that the amount of tax presently claimed by the IRS is approximately $34.0 million for issues currently in dispute in the bankruptcy court. Walter believes that, should the IRS prevail on any such issues, Walter's financial exposure will be generally limited to interest and possible penalties and the amount of tax claimed will be offset by deductions in later years, although it is possible that some portion of the offsetting deductions may be derived by Spinco after the spin-off and could result in a permanent difference to Walter for a portion of the tax liability.

Insider ownership - Management has skin in the game:

The CEO got 2.5% of the equity which vests no earlier than the third anniversary of the merger. In addition, he is entitled to receive dividend equivalents in cash until the end of the deferral period.

The COO gets a similar equity award equal to 0.833%. (bio from S-4: Charles E. Cauthen. will continue to serve as the President and Chief Operating Officer. Charles E. Cauthen, age 50, President and Chief Operating Officer, was appointed Chief Financial Officer of Spinco and President of WMC in November 2006. Prior thereto, he served as President of JWH since August 2005. Previously, he served as Chief Operating Officer JWH since February 2005 and Senior Vice President and Controller of JWH since November 2000. Prior thereto, he was Senior Vice President and Chief Financial Officer-Consumer Products Group, Bank of America, from 1999 to November 2000.).

There have been numerous insider purchases since the spinoff, both from directors and officers since the spin and reverse merger.

So, with management incented, a different and probably misunderstood business with a superior track record of servicing, a portfolio of what appear to be performing assets trading below book, the chance to leverage their servicing platform in the middle of a subprime firesale, and the potential for a nice dividend on top, WAC looks like an interesting spec at these levels.

Catalyst

Release of first quarter as a merged entity Q2, first dividend in Q3.

Management laying out their plans for the excess cash flows and capital.

Potential for announcing new servicing deals to leverage their platform