An overlooked financial niche soars

The sector as a whole may not be doing well recently, but check out what's happening with mortgage servicers.

By Stock Traders Daily Aug 23, 2012 3:48PM

From Stock Traders Daily


As a whole, the financial sector is rife with risks and potential pitfalls. This was on display when the European sovereign debt crisis came to the forefront once again this past spring. One of the sectors that took it hardest on the chin was the financial sector.


The headwinds and risks facing the group are all too familiar at this point -- balance sheet concerns, increasing regulation and liquidity risks from a credit event. But as fears ease, financial stocks have rebounded sharply. The Financial Select SPDR ETF (XLF) has rallied for a 13% gain since early June and may not be done yet as the stock market continues to show amazing resiliency (complacency?).


With that said, the financial sector, from a broader perspective, is one that I continue to avoid. Simply put, the risk/reward scenario just doesn’t cut it for me. Net interest margins are razor thin and will continue to be so for the foreseeable future given the Federal Reserve’s mandate to keep rates extremely low into 2014. This fact, combined with the premise that Europe may very well get much worse before it gets better, keeps me away from most financials.


However, there is one niche within the sector that I find very intriguing that hasn’t received the attention it deserves. The niche that I am referring to is the mortgage servicing space, in which firms buy mortgage servicing rights from the original lender and then perform a variety of duties on those mortgages. These tasks typically include recording mortgage payments, calculating interest rates, determining taxes and insurance from escrow accounts, and negotiating modifications on loans that are heading towards default. It is that last task in particular that has been a boon for these companies.


There aren’t too many publicly traded stocks that focus exclusively on this service, but the ones that do have been scorching hot. Here is a closer look at a few of them:


A rising star

 Overall, it hasn’t been a pretty year for the IPO market, but Nationstar Mortgage Holdings (NSM) has been a notable exception. The stock has more than doubled from its March 8 IPO price of $14 and is trading near all-time highs.


Before discussing what has been driving the stock, here is a little background on the company. NSM is a non-bank residential mortgage servicing company -- although it does originate and then sell some mortgages -- that is majority owned by Fortress Investment Group. It services loans as the owner of mortgage servicing rights (MSRs), which it refers to as "primary servicing," and it also services loans on behalf of other mortgage owners, referred to as "subservicing."


Now with the nuts and bolts taken care of, let’s take a look at the catalysts. First, the underlying trends occurring in the industry are very favorable for NSM and other mortgage servicers. For instance, in the aftermath of the financial crisis, major banks have been looking to reduce or eliminate their exposure to mortgage servicing due to greater regulatory, legal, earnings volatility, and headline risks. Companies like NSM have been able to scoop up these assets on favorable terms, and this is expected to continue for a long time.


In fact, during its second-quarter conference call on Aug. 14 (it beat on both top and bottom lines) management commented that it sees $300 billion in bulk-servicing opportunities, and that this figure continues to increase monthly. It said that as large banks continue to transfer these assets to outside sources that the runway for growth is very considerable with as much as $2 trillion in transfers projected over the next several years.


From a technical standpoint, there is no resistance to speak of since shares are trading near post-IPO highs. But, with the stock looking parabolic on a weekly chart, it may behoove traders to wait for it to consolidate and cool-off before entering a trade.

Consider the source

All Altisource Portfolio Solutions (ASPS) has done since spinning off from Ocwen Financial in August of 2009 is gain about 1,000%. It continues to make all-time highs and it almost seems like a foregone conclusion that a $100 share price is in its near-term future.


ASPS is essentially a play on the ongoing foreclosure situation hitting the residential mortgage market. Its mortgage servicing unit is by far its largest segment, at around 76% of total revenue, and generates nearly all of its revenue by providing mortgage services to Ocwen’s residential loan portfolio. This mainly includes default management, REO (foreclosure) asset management, REO sales, and settlement services.


ASPS’ financial results have been stellar. Looking at its most recent quarter, per-share profit surged by 117% from a year earlier to $1.13, good for a 4-cent beat, with revenue rising by 55% to $144.2 million. Not surprisingly, the driver for its impressive growth was its exposure to foreclosures. Management stated during its conference call that it captures roughly 50% of the title work on REO closings, and 72% of the title work on insured pre-foreclosure reports. It believes it can expand these capture rates to 75% and 80%.


Foreclosures and defaults figure to be a meaningful catalyst for ASPS for some time. In fact, it believes the market opportunity for default-related services will remain strong for the next three to five years, if not longer. But, it does realize that this will peak, so it is focusing on a few other initiatives to help it achieve its long-term goal of 20% or more earnings growth. These include developing and growing its loan origination services and developing its residential asset business for home rentals.


Two for the road

Lender Processing Services (LPS) is more technology-oriented, offering clients its Loan Servicing Platform (MSP), which provides support for loan setup and maintenance, escrow admin, investor accounting, and default management. The company says that MSP processes more mortgages by dollar volume than any other servicing system.


On the heels of a blow-out quarterly report on Aug. 2, the stock has spiked to 52-week highs, although it may encounter some resistance in the $28 area. Also, from a growth perspective, the Street isn’t quite as bullish on it, projecting EPS growth of just 4% next year.


Lastly, Fiserv (FISV) is a more diverse financial services company that does have exposure to loan servicing. It also provides Internet banking, transaction processing, electronic bill payment, financial consulting, and many other services, so FISV is clearly not a pure-play here. Its growth has not been nearly as robust -- revenue was up 3% in Q2 -- and it guided for modest 2012 revenue growth of 4% to 6%. But, the stock is currently going through a constructive consolidative period here after a prolonged run higher, and its valuation looks quite reasonable with a one-year forward price-to-earnings ratio of about 12.


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