Monday, August 4, 2014

Week ending 8/1/2014: OCN, HLSS, and managed care

I have been all over the place the past 3 weeks due to the earning season and because I’m trying to expand my circle of competence. Here I will comment on OCN, HLSS, and managed care.

Ocwen (OCN)

lawsky and NYDFS probes ocwen
Lawsky probes Erbey

Fundamentally, earnings (and expenses) actually came in better than I projected. 1Q14 already saw big expense increases so I’m not sure why the market was surprised by that. Still no news on the WellsFargo MSR transfer but that’s actually not too material to the long term thesis.

What is this “long term thesis” then? As in any business: 1) sustainable volume and 2) price/margins. In my Seeking Alpha article earlier this year, I envisioned a scenario where banks get in the habit of transferring delinquent loans to handful of special servicers (OCN/NSM/WAC). The development of a consistent “flow” mechanism is what drives sustainable value in my “normalized” scenario. The second thing is this “delinquent flow” needs to provide a sufficient margin – this will be a function of industry structure. In the 2Q14 call management explicitly referred to this vision as well.

The problem is getting a steady flow of delinquent loan business requires better customer service, reputation, compliance, and generally business goodwill. Frankly, as a shareholder I have been frustrated with the lack of progress here. The customer service topic deserves its own article so I won’t get into that here. But suffice to say improving service will require higher cost (at least in the short term).

I think the stock market is being short sighted here. Institutional shareholders should be holding management accountable for better customer service and compliance, even at the expense of lower margins. Only then can OCN achieve its vision and upside.

Note 1: At 26.7 per share this is a bargain! Now, investing in OCN requires some faith on how the entire industry is going to change. No matter how much sense this idea of delinquency flow transactions seems to make, the industry is just not there yet, so there’s definitely an element of speculation.

Note 2:  OCN talked about exercising their clean up calls, which coincidentally is the name of this blog. I need to dig deeper here but I would think the value of those calls are already priced in when they paid for the MSRs. 

Home Loan Servicing Solutions (HLSS)

This has very much moved in sync with OCN, which makes me wonder if the market understands what the company does. HLSS is a liquidating asset by nature so the best way is to model cash flows in a runoff scenario, assume it hit 0 one day and calculate the IRR. In my analysis I got a nice single digit IRR. Yes, additional MSR transfers from Ocwen can provide some bonus but I’d be surprised if many institutional investors counted on that to begin with. I also don’t get the high short interest in this name (short interest 8% of float and 16 days to cover). At this price shorts are paying out 8-9% in dividend yield, clearly there are better ways to short mortgage servicers (assuming that’s what shorts are trying to do)?

The biggest risk here is management getting adventurous with non-traditional assets. The latest creativity came from reperforming loans (RPL) where HLSS takes a small amount of credit risk. This is still a small portion of the overall portfolio but will likely increase as OCN exercise its clean up calls. Until then, the vast majority of HLSS’s assets still consist of servicing advances which have zero credit risk and very low interest rate risk.

Managed Care companies

Managed care organizations (“MCO”) stocks took a real beating last week despite solid earnings and guidance outlooks. The pressure actually started building a week earlier when WellCare slashed its guidance by half (on Florida MMA, negative reserve development and other charges). On 7/29/2014, Aetna beat consensus earnings but its commercial medical loss ratio (MLR) came in at 80.6%. Apparently this is worse than expected (market expected MLR to improve yoy instead of deteriorate) and managed care stocks tanked.

The market is worried about utilization trend deteriorating, given the strong numbers seen in hospital volumes and prescription drug trends. Wellcare’s guidance cut and AET’s higher commercial loss ratio were seen as a potential inflection point. The sentiment on managed care got so negative that when Wellpoint reported the next day with a “beat and raise” plus solid loss ratio, its stock fell more than 4% before recovering!

Does this make sense? My problem with the increased utilization theory is this: even if there is increased utilization and higher costs, why wouldn’t MCOs build that into the next round of price increases? Longer term profitability does not depend on cost trends, but rather pricing power, which is in turn based on industry structure, availability of industry capital and competitive rivalry, none of which have seen observable changes. Yes re-pricing to higher cost trends will suffer from lags that could impact the next year, leading to lower guidance and EPS estimates. But for investors with long time horizon, higher cost trends should not be a worry.

I also heard that empirical/historical data shows that we’re at a point in the economic recovery cycle where cost trend accelerates. Well if the pattern is so well known, does this not in fact help managed care companies argue for higher prices?

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