A discussion of spinoffs and a shallow first pass at valuing Altisource.
How I feel about spinoffs
In some ways I am not a huge fan of spinoffs. Some spinoffs are really messy and involve a lot of legal costs as there are conflicts of interest and other complexities that have to be carefully thought through. Spinoffs cost money and management’s attention. I feel that spinoffs destroy a small amount of value. In the end, there is less money for shareholders.
Sometimes CEOs do spinoffs in short-sighted attempts to boost the parent company’s share price. They may throw assets with lumpy earnings, ugly assets, complex assets (e.g. asbestos liabilities), and toxic assets into the smaller spinoff company. They may give the spinoff dangerous levels of leverage (e.g. DEXO and SPMD are spinoffs that went bankrupt due to leverage and may go bankrupt for a second time). The over-leveraging/under-capitalization of spinoffs can destroy value as any bankruptcy will destroy all shareholder capital. In my opinion (and maybe this goes against what Joel Greenblatt wrote in his special situations book) most spinoffs are dubious.
That being said, spinoffs can create interesting investment opportunities. Altisource spun off from the parent Ocwen in 2009. Altisource contains the “good” high-margin business while Ocwen is the “bad” business with lower returns on capital. Ocwen has been consistently raising capital in secondary offerings while Altisource has used the majority of its profits for share buybacks. (Clearly, you’d rather own Altisource than Ocwen.) A dynamic at work here is that Altisource’s profits are related to Ocwen’s asset base as Ocwen is obligated to use Altisource to service its assets. It is good for Altisource if Ocwen continually issues equity and grows its asset base.
The second round of Altisource spinoffs
Altisource split up again into three stocks, of which there are four important entities:
- ASPS – The parent company.
- RESI – Altisource Residential. RESI’s business model is to (A) buy and manage portfolios of non-performing and sub-performing mortgages and (B) rent out the homes they get stuck with whenever foreclosure cannot be avoided. This is a new venture that has no operating history. ASPS will benefit from growth in RESI as ASPS will provide services to manage RESI’s real estate.
- AAMC – Altisource Asset Management. AAMC is RESI’ asset manager and is entitled to payments from RESI based on the level of RESI’s dividend payments.
- NewSource Title Reinsurance (the other new business). NewSource will provide title insurance services to Altisource/ASPS and RESI. AAMC will invest $2M in NewSource equity while RESI will invest $18M into NewSource non-voting preferred shares (12% dividend). ASPS will provide services to NewSource under a Title Insurance Services Agreement. ASPS will receive 90% of NewSource’s net income after “NewSource pays Residential a preferred dividend of 12% (which is an annual cumulative rate)”.
The relationship between NewSource, RESI, and AAMC is tricky. RESI will receive a 12% dividend yield… this is a very good return. AAMC will receive $840K (adjusted by CPI) in management fees from NewSource plus 10% of net income. Not bad for a $2M investment. Net income will likely consist of returns from the insurance float and profit from title insurance/reinsurance, which has extremely high margins. I think ASPS is the loser in this deal. NewSource will insure/reinsurance title insurance on “mortgage loans and real estate sourced by Altisource through its relationships with Ocwen and Lenders One, a national alliance of leading community mortgage bankers, correspondent lenders and suppliers of mortgage products and services”. It will be directing its hugely profitable title insurance/reinsurance policies into NewSource where RESI and AAMC will take their cut.
I believe the idea behind RESI is to use it as a vehicle for leveraging returns at ASPS. RESI and Ocwen are listed on the prestigious (and expensive) NYSE exchange… the listing should help them raise capital. ASPS is listed on NASDAQ while AAMC is on Pink Sheets. Both ASPS and AAMC will spend less money on listing fees than RESI and Ocwen.
I’m impressed by what Altisource has stated in their 10-K:
We seek to deploy excess cash generated in a disciplined manner. Principally, we will continue to reinvest excess cash in developing compelling services that we believe will generate high margins. In addition, we may seek to acquire a limited number of complementary companies that fit our strategic objectives. Finally, given the tax inefficiency of dividends, the low returns earned on cash held and our current belief to pursue a limited number of acquisitions, we believe one of the best ways to return value to shareholders is through a share repurchase program.
It strikes me that Altisource’s management team is trying hard to allocate capital intelligently. They are clearly trying to maximize after-tax shareholder returns.
Overall, I think that William C. Erbey really gets it. By raising capital in the public markets through Ocwen (and potentially RESI), he is creatively finding ways to leverage Altisource’s returns.
What to buy
It seems to me that ASPS and AAMC are designed to deliver the greatest shareholder return.
As far as AAMC goes, I don’t quite understand how to value it. It has a negligible amount of cash, asset management agreements with RESI and NewSource, and 10% of NewSource’s net income. The last item is very difficult for me to value. At a share price of $84 and a market cap of $187M, AAMC seems potentially overpriced. If you were to combine RESI and AAMC, their mutual agreements would cancel out. The combined entity would have cash of about $105M plus NewSource’s deals with ASPS. RESI and AAMC combined have a market cap of $311M, implying NewSource’s deal with ASPS is worth $205M. Ignoring the value of the NewSource preferred shares, 10% of title insurance net income implies a value of roughly $2050M for the title insurance business from ASPS. $2050M is almost ASPS’ entire $2.13B market cap. To me, this does NOT add up. Perhaps I am missing something.
As far as ASPS goes, it is an incredible growth stock with no immediate signs of slowing down. Ocwen is taking on more loans so Altisource is almost guaranteed to grow its revenues in the near future. From 2008 to 2011, Altisource has grown revenue per share by 37.6%/yr, earnings per share 97.3%/yr, and free cash flow by 58.5%/yr. There are very few stocks out there with that level of revenue growth. Altisource currently has a reasonable P/E ratio of ~21.5.
*Disclosure: No position in ASPS, though I may initiate one in the future. No position in Ocwen, RESI, or AAMC.