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.

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.

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.

A Rant about Tree.com/LendingTree (TREE)

I'll keep this short because the story is simple. There is a great write up on Seeking Alpha by New Capital: The Beauty of Shorting Tree.com. I will just highlight a few observations here.

• This website asks you a bunch of questions then sell your contact information to strangers.
• The company has been in business for 18 years and still can't make any money.
• Management makes absurd claims that their brand is more recognizable than Citibank.

I tried Tree.com/LendingTree for this research and now I'm flooded with calls from strangers. I've given away my phone number, and there's still no rate quotes - just brokers calling me. Who in the world wants this??

And yes they had the galls to ask for your social security number - again before showing any rate quotes. Who in their right mind does this??

TREE trades at 42x PE, 3x sales. Revenue is growing at a modest ~10% pace, but that is fueled by marketing and advertising spends. There are no operating leverage in this business, so no amount of sales will translate to EBITDA or earnings growth. The company has proven this in its history.

I've looked at other "lead-gen" companies. Most of them trade at sky-high prices but few are as bad as TREE. TrueCar is as least innovative and disruptive, if somewhat easy to copy. Zillow/Trulia both have name recognition and together could be considered a monopoly. Bankrate.com is easy to use and actually have contents. TREE is none of these.

The only sensible thing to do is short the fuck out of this. Unfortunately it's a bull market out there so you have to pick your spots. Check out the LendingTree website, do your research, and short on signs of weakness.

Appendix:

Here's TREE asking for your social security number:







Here they try to sell me a real estate agent – despite having indicated that I’m not interested in one earlier:




And of course, LendingTree is more famous than Citibank:

Musing on Ocwen’s Liquidity Situation

Background

Last Friday (12/12/2014) Ocwen (OCN) announced the purchase of $253mm Ginnie Mae early buyout (EBO) loans. On the surface this looks like good news as it appears that OCN is back on their feet doing business again.

Reading between the lines, I see this as a confession that they lack liquidity.

1) The company was obligated to buy those loans. Barclays’ MBS analysts noted that Ginnie Mae requires servicers to maintain delinquency levels below a 5% threshold, and delinquencies on OCN serviced pools have ran above that threshold for months.

2) In November the scuttlebutt was that Ocwen tried to sell those Ginnie Mae loans but were unsuccessful.

3) Last Friday OCN finally bought what they had to buy all along. But they turned around and sold it to an “unaffiliated third party”. Since Ocwen was already the servicer on these loans, this is not adding to their mortgage servicing rights portfolio.

So here’s the more complete narrative. OCN faced obligations to put up cash for loans. They were delinquent in doing so and tried unsuccessfully to offload that obligation. When they finally bought the loans, they had to bring in a 3rd party to finance it.

Is OCN having cash issues?

Latest Liquidity Situation Uncertain From Filings

At 9/30/2014, Ocwen had almost $300mm of cash on balance sheet but planned to use that for upcoming debt obligations and share repurchases.

Ocwen has to “advance” payments on behalf of delinquent borrowers and raise the money for that through securitization of advance receivables. The advance securitization notes each have their own “amortization date”, which is when OCN has to start paying down those notes and new advances are no longer financed. October 2014 was when the majority of these notes were supposed to start amortizing. In the latest 10Q, Ocwen said they subsequently paid off some of these notes, pushed back the amortization dates of some notes, and issued new notes. The disclosures are vague in terms of dollar sources and uses, so I’m unable judge their current liquidity situation regarding the advance receivables notes. Given the show of weakness on these Ginnie Mae EBO loans, I have to wonder.

Implications

The conventional view is that Ocwen services such a large portion of the subprime market that they’re “too big to fail”. But “too big to fail” does not mean shareholders won’t be wiped out, so investors can’t ignore the tail risk. Still, Ginnie Mae loans are a small subset of OCN’s overall servicing portfolio, so how might this sink Ocwen?

Liquidity issues, like runs on banks, are a bit of circular logic. Confidence (or lack thereof) feeds on itself. It doesn't help that Ocwen may have a large legal settlement coming anytime and capital requirements for servicers are still being discussed. Should Ocwen somehow lose Ginnie Mae’s business or show further signs of liquidity/capital strains, rating agencies may feel intense pressure to downgrade them further (rating agency analysts are people and they have to protect their career risk!) Further rating downgrades could effectively make banks pull their credit facilities - lower advanced rates, higher interest cost, covenant triggers...etc. At that point the issue is no longer confined to advance receivable facilities, but spills over to MSR financing, warehouse lending, corporate debt issues, capital requirements. In short - everything. In fact banks are probably already worried about OCN. No credit access = even less liquidity -> securities price spiral downward -> less confidence -> even less cash access.

Ocwen can try to ease its cash outflows by stop advancing earlier, and quicken the pace of modifications/principal reductions. Keep in mind though, investors have already threated to sue Ocwen due to opaque servicing practices. Any further changes in operations could lead to revolt in the MBS investor base.

In theory, servicing advances and EBO loans are high quality assets with virtually no credit risk, so there should be plenty of hedge funds, insurers…etc willing to provide funding and take these assets off Ocwen’s hands. On the other hand, the corporate high yield market is currently in shambles and liquidity is also scarce there. If I were a hedge fund and OCN desperately seeks my help, I wouldn’t do so without extracting my pound of flesh (perhaps some sort of convertible preferred?)

What If Liquidity Deteriorates

3 Scenarios: 

· Most likely. OCN gets its liquidity at higher funding cost or equity dilution. Ocwen and PennyMac (PFSI) appears to have some sort of alliance going on.

· Possible. Without funding, OCN couldn’t originate loans or acquire MSR. It goes into runoff mode.

· Low probability. Liquidity and confidence evaporates suddenly. Government or a consortium of investors take over OCN on emergency basis and stock goes to 0.


OCN is near the cusp of a tipping point in confidence. It’s possible that capital market goes into raging bull mode, liquidity splashes everywhere, in which case all these issues go away and stock goes back to the 50’s. For now I’m still on the sidelines, viewing Ocwen with a negative bias. If a trend emerges, I’m ready to act either way.

Risk Control and my Mortgage and Housing Portfolio

I mentioned my mortgage/housing portfolio a few months ago and here’s what it looks like now:

• Title insurance: FNF/FAF/STC
• Asset pools: AGNC/MTGE/ HLSS
• Origination and servicing: PFSI/WAC. A short put position in OCN that is fully hedged 
• Builders: UCP
• A tiny position in Freddie Preferred.

Combined, these are more than 20% of my portfolio. My housing exposure is actually more if I count Wells Fargo, Citibank…etc.

Since that last post, I have traded in and out of STC with incredible luck, and it looks like my patience in title insurers are now paying off. I’m not so lucky in OCN however. This one killed my returns this year. Analysts are bound to make wrong fundamental calls at some point, but you have to control your losses with sound portfolio management and this is where I failed. 

Getting Scalped by Gamma

Among the many lessons I learned (and paid for), a more interesting one is the negative convexity of shorting options. I got into OCN with short put positions thinking I can subsequently adjusted my net exposure up and down by going long/short stocks. That turns out to be naïve. A simplified example using fake numbers go like this.

Time 1

Stock trade at $34.
My long position: sold 100 shares of puts strike $35, this is now in the money so I’m net long.
My short position: short 100 shares of stocks.
Net exposure:  zero; I’m hedged right?  right?

Time 2

Stock spikes to $37.
My long position: now 0. That 100 shares of $35 puts is now out-of-the-money
My short position:  still short 100 shares of stocks.
Net exposure:  all the sudden I’m net short, when stock is making a run upward! I close my short stocks to bring net exposure down to 0.

Time 3 

Stock goes back down to $33.
My long position: Those sold puts struck at $35 went In-The-Money again.
My short exposure:  0. I closed my shorts in time 2
Net exposure: long 100 shares, but stock is plummeting.

So basically, that short put positions goes in and out of the money at the worst times. What I thought was a fully hedged position could turn into a net short exposure when stock is making a run upward; and vice versa, it turns to net long when stock is tanking.

People talk about “gamma scalping” by going long call option and shorting stock. With my set up I was short gamma and got scalped instead. 

Controlling Risk with Technical Analysis

FNF, and to some extent FAF, are core positions I plan to hold through the cycles. The rest however are not what most people would consider “quality” companies and my positions in them fluctuate greatly. When the fundamentals are shaky and information dissemination is sparse, I learned to use technicals to control my risk. That means buying things near some technical support level (ideally around 52 week or all-time lows), and cut my losses when they drop below that support level. Since that doesn’t always work (some of these stocks are known for taking a big gap downward), I further control risk by diversify my sector bets into multiple names, and look for cheap valuation (low P/Es or P/B multiples) 

Blending of Risk across Sub-sectors

Some of these sub-sectors offset each other with respect to specific risk factors. 

For example, my positions in title insurers could be hurt if mortgage transactions get lower. A partial hedge to that is a position in AGNC. This agency mortgage REIT benefits in that scenario because lower MBS issuance would drive its asset valuation higher. On the other hand, the mREITs have duration risks and could be hurt when rates go higher. The mortgage servicers provide some offset here with their MSR holdings. And so on. 

This is not an exact science because it’s hard to quantify the effect of various risk factors. Nevertheless, it’s good to think through what you’re trying to bet on and the risk you’re exposed to. For now, this portfolio is a bet on household formation, higher mortgage volumes, regulatory environment stabilizing, and various company specific factors such as operating efficiency, low valuation…etc.

Finally, I just started positions in PFSI and WAC this week. Those are for a separate post.

Tenet Healthcare Equity Thesis in Three Words

“Screw the bondholders”, Larry Robbins says.

Ok maybe not in those words.  But at a recent conference, Larry Robbins of Glenview Capital suggested that as Tenet Healthcare (THC), the hospital operator, digest its recent Vanguard acquisition, THC should take advantage of the credit markets to maintain 5x leverage. THC’s debt currently stands at 6x EBITDA (> 70% debt/enterprise value!), but instead of deleveraging, Robbins suggested the company can buy back stock.

Robbins is a power player in healthcare space and supposedly has so much influence on THC management that he actually drove Vanguard deal.

To be fair, THC has other things going for it. Synergies from Vanguard acquisition is one. ObamaCare is another. The company has a sensible strategy of teaming up with reputable non-profit players like the Yale New Haven system. Hospitals industry is ripe for consolidation and THC could be buyers (with more debt?). The conference notes link above noted more. There are concerns about the hospital industry as a whole, and I mentioned some in my HCA write up here, but nothing that can’t be overcome.

Valuation is ok -  ~8.5x EBITDA and 18x 2015 P/E (consensus is expecting some explosive EPS growth). P/E is less relevant here because THC is so highly leveraged (both financial and operating) that any little revenue growth juices earnings disproportionately. By 2016 P/E could easily be under < 15x.

So still, the equity story goes back to leverage. When a company has 6x debt/EBITDA and still want to buy back shares, there ought to be a creditor revolt. But the bond vigilantes are silent. Tenet Healthcare’s 8% senior notes due 8/20 (rated B3/CCC+ by Moody’s/S&P respectively), are yielding a mere 4.4%. What can they do? The Fed started a QE orgy, the ECB is holding the bondholders down, and the BOJ is manning the door. It’s clear that “high yield” bond managers have nowhere else to go.  

Larry Robbins is enjoying this party and he’s inviting all equity investors to join in.

I’m in.­


4/22/2016.  Minor edit as I look back to this very old post. I sold this stock long time ago but this post could be clearer. Added "When a company has 6x debt/EBITDA and still want to buy back shares, there ought to be a creditor revolt. But the bond vigilantes are silent.