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.

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