Altisource Q3 2013 update: they are shooting for the stars

Altisource continues to take on more debt to fuel its growth.  $70M was used to buy Equator, a company that makes software for mortgage servicing companies.  (Equator competes with Altisource’s REALServicing platform and Altisource’s Hubzu.)  Equator’s sellers are eligible for up to another $80M in earn-outs in the future.  Altisource also previously purchased mortgage servicing businesses from Ocwen.  On top of that, Altisource has been using debt proceeds to repurchase shares. I believe that the interest rate on the debt (5.75%+) is higher than the earnings yield (~3.5%) on Altisource stock.  The repurchases will only work if Altisource continues to grow its earnings.

I’m not a huge fan of companies leveraging themselves.  It will likely end really well or really badly.  If you’re smart, you will make lots of money anyways and you don’t need high levels of debt.  If you’re smart but not that smart, high levels of debt can wipe you out (e.g. look at the history of the homebuilder NVR, a company that emerged from bankruptcy).  Altisource has been getting more ambitious.  The senior secured term loan increased from $200M to $400 million on May 7, 2013 according to the latest 10Q.

Loan boarding and short-term margin growth

As of Q3 2013, Altisource has only boarded 1.2 of the 1.6 million loans that Ocwen acquired.  Revenues and earnings should grow as the remaining loans are boarded onto REALServicing.

On the conference call (transcript), management is projecting a 7% increase in margins:

With regard to margins, we remain largely on plan to increase margins in our default-related services businesses by seven percentage points over 2012 even after amortizing the intangible assets associated with the Homeward and ResCap transactions. Given the modest delay in some of the loan boardings to REALServicing, we now believe that we’ll achieve this margin improvement in the first quarter of 2014. As part of our margin improvement plan, we are focused on revenue growth, employee efficiency, reducing the cost of outside goods and services and bringing certain services provided by vendors in-house at a lower total cost.

Declining defaults

In the long run, management expects less mortgages to default.  This will result in lower revenue for Altisource’s high-margin default services.  Management provides some projections in its investor presentation for the quarter.  If Altisource gains more customers then the default services revenue may stay flat or grow slightly.

Equator acquisition

The transaction hasn’t closed yet so the earnings from Equator haven’t flowed onto Altisource’s balance sheet.  However, loan interest needed for the acquisition is depressing current earnings a little bit.

Management provides a pro forma estimate for how much Equator will make after merger synergies.  I dislike pro forma estimates as they can be overly optimistic.  However, I will be patient and see if management delivers.

The acquisition will push Altisource into new areas of business.  Erbey discusses this on the conference call:

For the last four years, many have defined Altisource by the default-related services we provide our customers, principally Ocwen. Our affinity relationship with Ocwen provided a foundation on which we built our business and remains an important priority for us. Altisource’s vision, however, has evolved to become the premier provider of real estate and mortgage marketplaces, offering both distribution and content.

The Equator acquisition with its marketplace, and real estate and servicing transaction solutions, is in line with this vision and accelerates our evolution and growth. […]

Let me spend a few minutes expanding on Altisource’s vision as depicted on Slide 6. As I mentioned, we are focused on providing marketplaces to the real estate and mortgage industries. Within these industries, we are facilitating transactions related to home sales, home rentals, home maintenance, mortgage origination and mortgage servicing. We like these markets because they are all large. […]

To bring our vision to life, let me provide you with a few examples. Turning to Slide 8, through the Equator and Hubzu marketplaces, we are connecting home buyers and home sellers. Equator’s marquis customer list includes four of the top six U.S. banks and GSEs.

Equator offers business process management solutions to manage real estate throughout the resolution process, and a marketplace to order all other related services, including hiring real estate agents to sell the homes. Hubzu is an online transaction portal that sells homes listed by real estate agents.

There are two opportunities to leverage the combination of Equator and Hubzu. First, we want to make it easy for Equator’s customers and agents to sell their real estate on Hubzu. The Equator platform also has more than 450,000 registered real estate agents, representing 43% of all residential real estate agents in the United States. Second, we want to make it easy for Hubzu’s customers to use the Equator marketplace to order services already offered on Equator associated with a home purchase transaction.

For the mortgage originations marketplace, we connect borrowers with lenders, and lenders with investors. We are leveraging our affinity relationship with Lenders One to grow this marketplace. In addition to the loan closing and sale, we believe 15 to 20 services are ordered in connection with loan origination. We want to make it very easy for originators to order and pay for services associated with a loan closing. To fully develop this marketplace, we need to complete the development of our next-generation technology to allow the Lenders One members to order and pay for services in a seamless fashion.

Intangible assets

Altisource will have amortization charges related to its acquisition of Homeward and Rescap.  I believe that these amortization charges distort its earnings.  Altisource could legitimately report non-GAAP earnings and add these amortization charges back in, but it does not do so.  The 10-Q details the amortization charges to date:

We recognized SG&A of $80.0 million for the nine months ended September 30, 2013, a 47% increase compared to the nine months ended September 30, 2012 ($31.5 million for the third quarter of 2013, a 71% increase over the third quarter of 2012). This increase is primarily driven by higher amortization of intangible assets recorded in connection with the Homeward and ResCap transactions totaling $15.3 million for the nine months ended September 30, 2013 ($7.4 million for the third quarter of 2013; there were no comparative amounts in 2012).

Insider selling

On October 29, William Erbey (Altisource’s biggest shareholder) exercised 21,227 options and sold the shares. These shares somewhere around 0.36% of all the stock he owns.

On Oct 28, 2013, William Sherpo (the CEO) exercised options and sold 9962 shares at $143.52 ($1.4M in proceeds).  Following this transaction, Mr. Shepro holds 549,741 options to purchase ASPS Common Stock and 24,883 shares of Common Stock.

I’m not going to read too much into this small amount of insider selling.

My position in this stock

I will continue to hold onto my shares and don’t see any reason to sell or to add more to my position. I don’t know if the increased leverage is a good idea, though it does not seem like an awful idea. Operationally, it seems like the company continues to do well though I expect its rapid growth to slow down a little.  The stock has performed very well since I wrote about it on Jan 10 at $93.57.  The stock is currently trading at $153.29, up 64%.

If implied volatility on ASPS options remains low, I will likely own calls and/or stock+puts.  I currently have Jan 2014 call options and I may not roll over my entire position as I will likely need cash in 2014 (e.g. taxes, funding my TFSA and RRSP, etc.).

*Disclosure:  Long ASPS.

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4 thoughts on “Altisource Q3 2013 update: they are shooting for the stars

  1. Thanks Glenn for the write-up. Do you still believe the story is unchanged? I imagine the growth assumptions will need to be altered. Your thoughts?

    • I think that Ocwen/Altisource will have to slow down but they will continue to grow in the future, which would be a good thing.

      Interesting things are happening on the RESI/ASPS/AAMC side of things. I’m surprised that RESI was able to raise around $400M. If RESI continues to raise money, it will be good for ASPS (and obviously AAMC).

      • Agreed. If ASPS grows EPS at 20%, it is probably at fair value around 100. What do you think? What is not factored in is the upside from share repurchases, Equator takeover and any other acquisitions they may make. Any thoughts on valuation?

        Thanks for the RESI detail. I agree the rental portion grows with RESI so thats good.

        What is your estimate of AAMC value?

      • Right now they’re paying interest on the money borrowed to buy Equator, which depresses earnings. Equator itself might depress earnings because it is reported GAAP losses at the moment (from what I understand). I’m actually not a fan of software companies that lose money. In theory, Equator will make money in the future. Altisource should be valued based on what it will make in the future: mortgage servicing + Equator + Hubzu + RESI -+ title insurance deal with AAMC + other (financial services, IT services, etc.).

        I think AAMC is clearly overvalued as explained in my original Altisource post. But who knows- it might be fairly valued. If RESI is able to continually raise more equity, then AAMC will be worth more. AAMC is sort of like a royalty on RESI’s assets under management. Plus AAMC has a piece of Altisource’s title insurance flow.

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