Thursday, January 15, 2015

Week Ending 1/16/2015: Wrapping up on Ocwen, Moving on to Other Names (SERV)

I closed out of a short position on OCN first thing this morning. It was a small but material position that protected my portfolio from the tough markets the past 2 weeks. I closed out of the short because OCN is basically trading around liquidation value, as if the company is in bankruptcy already. So why not turn around and go long? 1) the valuation range I came up with is wide, and 2) I think more bad news are likely on the way. Even if Ocwen muddles through, there’s not much upside in terms of business growth. More on each of these as follows:

1. Liquidation value. I did a liquidation scenario assuming OCN hits bankruptcy, and came up with a $4.5 – $13 per share. This is the floor value assuming no further legal issues. The valuation is very sensitive to how you value the MSRs, as well as how much you haircut the advances (Some people would say advances should be valued at par, but I disagree. This is a 0% interest receivable that requires financing cost –i.e. negative carry. There’s an operating cost to collect those advances, and it takes time to get them all back. So I think a smallish haircut is certainly warranted in a bankruptcy scenario. Note that a 5% haircut =~$1.3 per share)

2. More bad news likely and no growth outlook. (Warning, I’ll get a little philosophical here). In my mind there’s 2 basic ways to profit off discrepancies between fundamental vs market prices. First is the traditional value investing concept: there’s an intrinsic value that’s not reflected in market value. If the intrinsic value is much higher, buy the stock and ignore market fluctuations. If the stock drops 30% on no fundamental changes, I’ll buy more. Call this “reversion to the mean”, classic value investing, or the Warrant Buffett/Seth Klarman way.

The second way is George Soros’ “reflexivity” feedback loop. In this model, market prices actually change the “fundamentals”. How does that happen? Soros has his examples but one way is this: when stock prices go down and negative media attention, regulators are emboldened to, even pressured to take legal actions. Rating agencies / bankers / analysts all toughen up on the company. Customers may stop doing business with you. Working capital terms deteriorate. Basically everyone’s trying to cover their own ass. This leads to more lawsuits, less future business, working capital deterioration, liquidity/capital stress -> even lower market prices, and the cycle repeats. Call this “trending market”, or “Reflexive feedback loop”

Successful investing requires one to recognize which of the 2 situations we’re in. When I first wrote about Ocwen almost a year ago here, I was working under a Buffett/Klarman framework, insisted on a long term, “normalized” view and ignored the price actions. Somewhere down the line, I (slowly and belatedly) realized that Ocwen became a Soros “reflexive spiral” situation, where declining prices actually does influence the fundamentals. Recognizing that has been very helpful the past 2 months. More concretely, Ocwen is not likely to get through its regulatory troubles before July this year, thus giving more time for bad news to pop up. Even if it survives through this whole thing, fundamental upside is shot because 1) who dares to give new businesses to Ocwen? 2) what consumer wants Ocwen as a lender? (I say “fundamental upside” because speculation can certainly get this stock much higher)

Taking a Break from Mortgage Servicing

I plan to take a mental break from mortgage servicing the next 2 months. At this point, my only position in that subsector is PennyMac (PFSI), which 1) unlike its peers, PFSI already has an origination segment that more than offsets servicing runoffs. 2) can benefit from FHA lowering its premium, 3) has good upside participation if the regulatory overhang in the sector improves, 4) downside protection in the sense that PFSI has potential to take over MSRs if Ocwen gets fired (note that HLSS already does business with PennyMac). 5) Ocwen will likely vacate the Ginnie Mae space and PFSI is a strong player there.

I might also get into NationStar (NSM) at some point (I got stopped out of my position on Walter Investment (WAC), put that money into NSM and then got stopped out of that one too). At some point, someone is going to justify a high price for NSM, probably with a flawed valuation method (using EBITDA multiples for servicing and P/E multiples for originations). If the market falls for that I want to be along for the ride..

Onto Other Things (ServiceMaster)

One of the ideas I’m looking at is ServiceMaster (SERV). The company’s largest segment is Terminix (pest & termite business), which is a direct competitor to Orkin, owned by Rollins (ROL). Rollins trades at 30x forward PE and 18x LTM EBITDA. ServiceMaster is much cheaper at 20x forward P/E and 12.3x EBITDA.

ServiceMaster can achieve a higher valuation (10-30% upside) with the following transaction. They can sell their home warranty business, and use the proceeds to pay down debt. This would deleverage the company, and leave the Terminix segment to be compared directly to Rollins, which of course trades much higher.

I know people will say Rollins is overvalued, but I actually think it’s reasonable because: 1) it historically has traded at a rich multiple, 2) 10-15 years of consecutive revenue / earnings growth, 3) large untapped growth potential through further consolidation, 4) stable industry demand. As for the how much American Home Shields (the home warranty business) will fetch, I think 10-15x P/E is reasonable. (First American Financial is a title insurer that owns a home warranty business, and they trade at 15x P/E)

Of course, I can’t tell management what to because I don’t have control. But the biggest owner of SERV is private equity firm Clayton, Dubilier & Rice (“CDR”), and they definitely have control. I think the CDR guys has to be thinking about the transaction I highlighted here. I’m looking for an entry point here.

Sunday, January 11, 2015

HLSS and evolution of tail risks

HLSS stock got killed this week. To me, this is an example of when the market re-prices former “tail risks” as not so “tails”. The market starts out seeing certain risks as a <1% probability event, then re-evaluates that to be a 5% probability event, and then a 20% probability event. How did this happen?? I’m writing this to clarify and record my thoughts. Also, this could be of help to someone looking at HLSS.

Although it’s clear that HLSS’ problems are tied to Ocwen (OCN), how OCN’s issues transmit to HLSS can get pretty esoteric and not well understood –even now. This is not a simple matter of Ocwen no longer adding any more MSRs and thus curtailing HLSS’s growth potential. (In fact, anyone investing in HLSS should have valued it based on a runoff scenario in the first place).

I’ll go over a few risks here. A year from now we may look back and say these concerns are absurd. But what I want to emphasize here is how they changed over time.

Evolution of Risks

1. Risk of forced servicing transfers away from Ocwen. Ocwen’s weak servicer ratings triggered Event of Default (EOD) in certain nonagency MBS, which makes them eligible for servicing transfers. Ying Shen at Deutsche Bank gave an example recently:
“For investors of MSAC 2005-HE3, the Master Servicer, Wells Fargo, sent an EOD notice to all bondholders seeking to vote by the January 5, 2015, deadline as to whether Ocwen shall be terminated as a servicer.”
Just a few months ago, the default reaction is “Impossible! MBS investors won’t terminate Ocwen given lack of alternatives!” But now, firing Ocwen is no longer some unimaginable tail risk, but rather an actual item on the table, being voted on. The probabilities are still low, but not that low. If Ocwen’s troubles keep dragging on (perhaps due to even more lawsuits which Dr. Shen contemplated), then MBS investors will really have to start thinking about plan B. If and when that plan B develops, Ocwen will be in real trouble. How that plays out for HLSS will be left to the lawyers. Keep in mind HLSS never actually owned the legal title to Ocwen serviced MSRs, but is technically more like a secured lender.

2. Cash flows to equity from advance securitizations get shut off (very esoteric). Dr. Shen also commented on HLSS’s servicing advance (SA) deals:
 “We expect extension of distress timelines due to the delay in the foreclosure process…likely result in a slowdown of advance recoveries…Significant reduction of recovery speeds beyond certain thresholds will likely trigger an early amortization event, which will likely result immediately in paydown of the SA notes”.
For equity holders, the implication is cash flows getting funneled to pay down debt instead of going to equity. This would hurt dividend coverage (which are still strong but have deteriorated) and reduce present value of cash flows by pushing them back. I bet not many people thought of this one back in January 2014!

3. Ocwen and HLSS re-negotiate their contracts to the disadvantage of HLSS. This was my main concern back around August. I think the risk actually decreased with the exile of Bill Erbey, because OCN affiliates are now more likely to deal in a true arms-length manner.

My Own Experience in This Name

My investments in HLSS mirrored how these risks evolved. I first bought HLSS in late 2012. It was a major position after a lot research. But honestly, I never even thought of three risks discussed above! Even if I did, I would have considered them extremely low probability to the point of paranoia. It wasn’t until August 2014 that I started worrying about #3 (threat of recontracting) and reduced my positions. October 2014 is when the market really started talking about #1 and #2, and I further cut my position to a minimal amount. By mid-December I exited the remaining stake and actually thought about going short, but the high dividends held me back. Overall HLSS was a slight loss for me.

In each of these gap downs, I was tempted to say “these are super low probabilities, the market is over-reacting, and I should be a contrarian and double down” but decided not to. The reasons are twofold: 1) given my belated recognition of these risks, I wonder if there's even more risks that I have not thought of?  I’m just not close enough to the non-agency MBS market to sense its latest developments. 2) what’s the upside? Why wouldn’t people just move to AGNC which yields a solid 12% without these issues? I think the latter argument will be repeated throughout 2015.

Sunday, January 4, 2015

Bright Horizons: Overvalued Stocks Can Be A Good Thing

Bright Horizons Family Solutions, Inc (BFAM) runs day care center sponsored by employers. The company has a long history and Bain was the sponsor of the recent IPO. Famous Bain alum Mitt Romney even mentioned it in his presidential campaign.

On the surface, valuation has always looked stretched and it just continues to get worse over the past 2 years. At $45.4 per share, BFAM trades at 26x 2015E earnings and 16.5x LTM EBITDA.

When Rich Valuations Can Help the Long Thesis

I decided not to short this for a variety of reasons. The more counterintuitive one (at last to me) is that in BFAM’s case, over-priced stock can actually be a good thing. BFAM is a serial acquirer and they’ve been able to acquire at 5-9x EBITDA (recent acquisitions include kidsunlimited, Childrens Choice…etc). If you can raise money at >16x EBITDA and acquire at 8x EBITDA, you can do this all day and add to shareholder value in the process.

Everyone knows that companies should do buybacks if stock is undervalued. The flip side of that is if your stock is over-valued, you should issue shares and buy something of value with it.

This seems borderline ridiculous. After all, if over-priced stocks could be part of a long-thesis, then when is anything ever too expensive? Clearly there has to be caveats with the “use over-valued stock as cheap currency for accretive acquisitions” argument. There are a couple requirements I can think of, both of which BFAM was able to meet.

  1. Large potential for growth through acquisition, and acquisitions make sense because you can’t simply take business from competitors
  2. Price arbitrage between acquirer and target. 

I think the criteria above should filter out most high P/E stocks. Typical high priced internet companies cannot buy each another cheaply. For disruptive companies, acquisition might not even make sense if you can simply take business away from competitors. For example, TrueCar (a car lead-generation company) can take business from competitor AutoBytel. It would not make sense for TrueCar to buy AutoBytel.

Bright Horizons, on the other hand, meets these criteria. Its market is vast and highly fragmented, with over 100,000 licensed U.S. day care centers (BFAM currently has <900 centers). The day care center business is location dependent, so you have to either build or acquire, instead of simply taking business away from competitors. Finally, the ability to raise money at 16x EBITDA then acquire at 5-9x certainly qualifies as price arbitrage.

Other Reasons AGAINST Shorting BFAM

These are more mundane and should be part of any standard long-thesis for this name. I will just list them out below.

  • This name deserves premium multiple 
    • EPS growth in the high teens or even 20%+
    • Stability of cash flows and track record = lower required returns from investors
    • The company is a bit of a glamour stock and commands glamour valuation. Normal, day to day people actually have heard of Bright Horizons, and would like to brag that they own their kids’ day care center.
  • EBITDA is understated because they're adding new facilities and those have not fully ramped up yet. As children age each year, Bright Horizons’ pricing naturally falls due to lower operating cost. This allowing them to raise prices without customers noticing.