Altisource (ASPS) – Part 4 – Reading the 10-K, etc.

This post gets into the financials and is my attempt at really analyzing this company.

Altisource is the kind of company that you can buy and hold for a very long time (e.g. forever).  I think that the most important questions to ask about this company are:

  1. Is management ethical?
  2. Are the economics of the business good?
  3. Does the business enjoy a durable competitive advantage?

#2 and #3 are answered in part 3 of this series.  So let’s take a look at #1.

Operationally, I think that the company is very ethical.  They have not done anything illegal such as robo-signing.  They face very few lawsuits compared to competitors such as Wells Fargo.  And they work hard to keep mortgagers in their homes.

As far as management goes, you can make some arguments against Mr. Erbey’s ethics.  Articles in the media have noted that Ocwen overpaid for Mr. Erbey’s home.  I don’t think that the payment was clearly unreasonable.  The home cost around 4 million and there were about 2 million in additions to it.  I don’t doubt that Ocwen paid above market value for the home.  However, people deserve to be fairly compensated when they have to relocate for employment.  Mr. Erbey can’t exactly enjoy his Atlanta home while working abroad.

As far as the ASPS/AAMC/RESI spinoff goes, the spinoff slightly enriches Mr. Erbey due to his restricted stock grants at AAMC.  It’s kind of sneaky that Altisource is funneling profits into NewSource (of which AAMC will likely be the greatest beneficiary).  Overall however, Mr. Erbey compares favorably to John Malone.  Malone’s spinoffs are far more complicated and craftier.  Malone’s deal with Liberty that protected Liberty against takeovers looks far more unfair to shareholders than anything Erbey has done.

As far as insider compensation goes, it is reasonable.  According to the SEC filings, the directors range in compensation from $52,900 to $162,990 (Mr. Erbey is the highest-paid director).  William Shepro, the CEO, has had his compensation range from $1.4M to $4.4M.  His Altisource shares are worth about $29M ($93.33 X 311.327 shares) so he has plenty of skin in the game.  The level of compensation paid to insiders doesn’t seem that out of line compared to other public companies.

Accounting tidbits

The depreciation method used by Altisource is fairly reasonable if not on the overly conservative side.  Most of Altisource’s fixed assets consist of computer hardware and software.  These are depreciated over 2-3 years.  It is highly likely that Altisource continues to use computer hardware and software that is over 2-3 years old.  These assets would be carried at a value of 0 yet have a market value slightly above that.

Altisource’s accounting looks very reasonable to me and I do not see any signs of overly aggressive accounting.  Altisource does not capitalize any internal software development costs.  There are many companies that do capitalize software development costs.  That practice will increase reported profits and leave intangible assets on the balance sheet.

Hidden assets

The relationship with Ocwen is arguably very beneficial to Altisource.  In the short term, Altisource is guaranteed to grow as Ocwen has significantly increased its loan base.

Altisource owns Hubzu.com (formerly GoHoming), which is an online real estate portal.  The site is being opened up to third-party listings.  In theory, this property can provide serious competition to the traditional real estate model and MLS.  This could potentially turn into a business with very high returns of equity (e.g. somewhat like eBay) if it becomes more popular.  Hubzu has many competitors in this space including RedFin.

Hidden liabilities

As discussed before in part 2 of this series, the deal with NewSource funnels some value out of Altisource.

Future plans

Altisource has stated in its latest conference call and 10-Q that it intends on raising $200M of debt (maybe around 2 years worth of earnings) to buy servicing businesses from Ocwen.  Ocwen acquired those businesses when it made its large loan portfolio acquisitions.

Considering that Mr. Erbey owns a greater percentage of Altisource than Ocwen, I doubt that this deal will be unfair to Altisource shareholders.

Capital allocation

I see some decisions at Altisource that may not be optimal for shareholders.  In general, I get the sense that Mr. Erbey prefers to grow the underlying business (and to start new ones) over maximizing shareholder return.  At the end of the day, I’m willing to put up with this.  I don’t see these moves as destroying value and I think (hope?) that Altisource’s new investments will generate a decent rate of return.  Both Ocwen and Altisource have compounded their share price very well since they were listed.  At the end of the day, the operational performance of the company is much more important than optimal capital allocation.  While Altisource’s past share repurchases were a good move, Altisource would have still performed really well without the share repurchases.  Altisource could simply hoard cash and hold risk-free treasuries and shareholders would likely still do well.

The big picture

The main reason to invest in Altisource is sustainable growth.  I believe that it is the best mortgage servicing-related company around and that its competitive advantages are extremely difficult to duplicate.  While it has a P/E of 21.95 (at a share price of $93.26), I believe that it is a little undervalued due to its extreme growth.

I think that Altisource is the most likely candidate to become the #1 mortgage servicer in the US.  If that scenario plays out and it does become #1, its earnings will likely be several times what they are today.  Of course, I’m not a big fan of projections since they can get wildly and overly optimistic.

Here’s another way of looking at it: even if Altisource had zero growth and Ocwen was not increasing its asset base, Altisource would still be an ok investment.  Since Ocwen is a captive customer, one would expect Altisource to have fairly stable cash flows.  A P/E of 21.95 implies a yield of 4.5%, which is not great but compares favorably to treasuries and bank deposits.  I cannot imagine many scenarios where you would lose a lot of money on Altisource.  The easiest way to lose money would be if Altisource/Ocwen becomes terribly managed and the managers run both companies into the ground in dramatic fashion.

I can’t imagine a lot of downside for this stock (but maybe I simply lack imagination…).  I can easily imagine a lot of upside.  Altisource has an impressive track record of growth and high margins to back it up.

*Disclosure:  Long ASPS at $93.52.  Not long AAMC, RESI, HLSS, OCN, big banks, other mortgage servicers, etc.

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