The basic thought for a case study is that once an idea that was posted exclusively to our premium site has largely played out, I'll post the idea publicly as a case study. Partly I'm posting the idea as a plug for the premium site and partly I'm posting it for a historical case study for those who are interested. Note that I'll try to hold my feet to the fire with these case studies when posting in the future; while I hope there are (many) more winners than losers on the premium site and today I'm posting a "winner" (so far! fingers crossed), I'll try to post losing ideas as well both to be honest and to learn from them! (Last note: as announced Monday, prices on the premium site go from $399/year to $499/year; if you've been on the fence about signing up, I'd encourage you to sign up today to lock in the old rate)
(Note: Below is the COOP idea exactly as posted to the premium site mid-May; there was also an extremely prescient update in late May that noted some disclosures that suggested Q2 earnings were going to be (to use the scientific term) bonkers good).
The 90s sitcom "Hanging with Mr. Cooper" had a delightful theme song that included the line "the man you found may be a catastrophe... he may be cute and all but that don't pay this month's rent."
25 years later, Mr. Cooper (COOP) faces a problem similar to anyone trying to date that cute / catastrophic man: homeowners are, en masse, not paying this month's mortgage, and all signs point to homeowners refusing to pay next month's mortgage as well. In fact, the CARES act provides homeowners with the right to up to a year of mortgage forbearance, so it's likely the trend towards homeowners refusing to pay their mortgage is only getting started. Skipped mortgage payments have mammoth negative implications for Mr. Cooper and that mortgage servicing industry in general: as servicer, COOP must cover any mortgage forbearance; while they will get paid by the consumer when the forbearance is over, the delay between COOP covering the payment and the homeowner making the payment creates a mammoth liquidity squeeze that threatens the whole industry.
Make no mistake, these issues are serious and will impact all servicers. However, in general, the forbearance issue is a liquidity issue. COOP has enough liquidity to survive a forbearance environment dramatically worse than current trends. The same cannot be said for many of their competitors.
So the crux of today's post is this: at today's price of ~$8.50, the market is currently anticipating significant liquidity and earnings challenges for COOP. I think that view is dramatically mistaken; COOP has the liquidity to easily weather the current storm, and as we emerge on the other side, COOP will be positioned to pick up distressed competitors for a song. In addition, the current forbearance cycle is likely to lead to a hugely profitable mortgage modification cycle on the other end, which COOP will benefit from (and may even benefit from in an outsized way if they can take advantage of distressed competitors in the meantime!).
But we'll get to all of that. Let's start with an overview of the company.
Mr. Cooper has three different businesses: servicing, origination, and Xome. The first two (servicing and originations) are far larger and more valuable than Xome; however, Xome does offer substantial upside in some bull scenarios.
Originations is the simplest of the businesses. Here, COOP writes new residential mortgages. The origination side mainly refinances mortgages from the servicing side (i.e. the servicing side has a mortgage with a 6% interest rate that could be refi'd down to 4%; origination would take that client and refi the mortgage for them), but they also acquire mortgages from smaller banks ("correspondent channel") or originate new mortgages through mortgage brokers ("wholesale lending").
Xome is a tech / data platform focused on mortgages and real estate. They have three divisions: exchange (auction of houses, generally foreclosed houses from the servicing side), services (mainly services focused on closing loans: title, escrow, collateral valuation, etc.), and data/tech (mainly Xome analytics, a MLS data and analytics provider). COOP has been building Xome through acquisitions and investment, and, until recently, Xome was mainly an internal use product. However, thanks to that investment, that's started to change: external revenue for Xome increased from 43% in 2018 to 53% in 2019. In more bullish cases, Xome continues to expand and becomes an extremely profitable fintech company; however, given we're buying COOP well below book value, by no means is Xome's upside core to the investment thesis.
Servicing is COOP's main focus. COOP is the largest non-bank mortgage servicer in the U.S. (and third largest overall). A mortgage servicer is the person who handles your mortgage payments every month (collecting the monthly payment, administering tax and insurance escrow, managing foreclosure if necessary, etc.); the right to service a mortgage is known as Mortgage Servicing Rights (MSRs). In return for servicing the mortgage, the mortgage servicer gets a portion of the monthly interest payments. For example, if the interest rate on a mortgage is 4%, ~3.75% of the interest might go to the investor who actually owns the mortgage, while the other 0.25% will go to the loan servicer to cover the costs of servicing a loan (plus, of course, to hopefully turn a profit). MSRs can either be retained by whoever originated the loan or can be sold off to a third party (i.e. JPMorgan might write your loan and then remain the servicer, or a small bank might write you loan and then sell the MSRs to a larger platform like COOP).
The current environment is an absolute disaster for a servicer for three main reasons:
So the near term for mortgage servicing is likely to be poor. And, again, that's largely been reflected in the results to date, as COOP took a mammoth charge on their MSR assets in their Q1'20 earnings.
But what excites me most about COOP is what happens on the other side of the current environment. COOP has plenty of liquidity to get through this environment. They refi'd the majority of their debt in January, and they are running their business to a base case that has forbearance increasing to a substantially higher level than it's currently tracking to, and even in that environment COOP has enough liquidity to get through without raising capital.
The same cannot be said for many of COOP's competitors. Just to name one example, Ocwen (OCN) has been in trouble for years, but, judging from their Q1'20 preannounce, the current environment may be enough to push them from "troubled" to "full blown distress" (though they still seem bullish!). Peers like NRZ and PMSI have also run into some issues with margin and financing. And these are the larger players: there are a significant number of smaller players in the market, and I would guess all of them are having substantial liquidity issues.
That could set up a bonanza on the other side for COOP. At a minimum, in the near to medium future their competitors will have less capital available to bid for new MSRs, so COOP should be able to take market share at attractive rates as we emerge. Even better, competitors in distress or facing liquidity issues may need to sell assets; given COOP will be in a better position than any of their competitors (and already enjoys more scale benefits and a better platform than comps), COOP should be the natural buyer of any distressed assets that come for sale, and any deals should be extremely accrettive (COOP confirmed on their Q1'20 call that, with their liquidity "locked down", they were looking to "play offense in this environment."),
There could also be a big benefit on the back end of this cycle from modifying all of the mortgages in distress / forbearance. Remember, dealing with distressed mortgages is costly. However, investors and the government know that it's costly, and they also know that all parties benefit if they can find a way to bring a distressed mortgage back into performing territory (homeowners benefit because they don't get kicked out of their homes, investors and servicers benefit because they don't have to go through costly foreclosure proceedings). Because everyone is better off if distressed loans can be brought back performing instead of foreclosing, servicers are often given bonuses and fees if they modify a distressed loan to make it performing again.
At the end of the forbearance period, I would guess there's going to be a ton of mortgages that are quickly going to flip to distressed or need some type of modification to avoid distress. As servicer, COOP will need to make those modifications, and they'll be in line for healthy fees as they do so. We saw something similar with the servicers in the wake of the GFC; the government created the Home Affordable Modification Program(HAMP) to encourage servicers to work with homeowners. The HAMP fees proved a bonanza for the servicers, and it sent their stocks near parabolic. For example, here's OCN, which saw its share price ~3x as the HAMP program really kicked in in 2012/2013. You can find more in their 2013 10-k, (particularly p. 39) but the basics of the program is the government had HAMP incentives that could earn several thousand dollars per mortgage, and OCN collected >$200m in HAMP fees from 2011-2013. Those fees drove OCN's profitability through the roof. The big profits, plus a big roll up strategy, sent OCN’s shares through the roof, While it's early, I think there's a serious chance that we see a similar program coming on the heels of Corona, and COOP would be a major beneficiary of that program, as well as to benefit from rolling up the industry.
So, in an upside scenario (and I actually think it's rather likely / possible), a bunch of COOP's competitors are in distress coming out of the crisis. At minimum, that allows COOP to pick up market share in new deals at attractive returns/pricing going forward, but it likely allows for some accrettive M&A as well. Longer term, a bunch of loans will likely need modification coming out of the crisis, and COOP could make a significant amount of money in modification fees on the back end. A similar modification cycle happened after the GFC, and it sent the shares of servicers flying.
But here's the great thing about COOP: at current pricing, you don't need any of that upside to play out to make money. COOP's tangible book value per share is $20.50. The company targets a >$12% return on tangible equity (excluding mark to market earnings or losses on their MSRs), though they've pretty consistently been higher than that number. If you assume they can hit their 12% target, they should be able to earn ~$2.50/share in earnings. Today's share price of $8.50 is good for a P/B of ~0.4x and a P/E of <4x those hypothetical earnings.
Now, there are some issues you can easily take with that valuation:
And all of those concerns are certainly valid.... but I think today's valuation more than overcomes those concerns.
These concerns are also not lost on the management team. Pre-crisis, they consistently discussed how their plans for COOP were to get it to trade up to tangible book value (or higher!) by delevering and improving asset returns.
I'll go through a bunch more points in the odds and ends section, but I'm going to call it for the main write up here. The three major points I hope you take away from this piece are
Odds and end