A few weeks back, I wrote about “long-shorts.” These are companies that see their businesses improve when the overall economy deteriorates. I’m increasingly convinced that we’re about to see a real doozy of a recession here in America. It will likely be exaggerated by whatever happens in Asia. While shorting gets all the attention, I would much rather own businesses that do well when things fall apart. Simple math says that multi-baggers are much better investments than shorts as the most you can make on a short is 100%.
Altisource Portfolio Solutions (ASPS – USA) is a default mortgage servicer. It owns a suite of products that handle every part of the default cycle from on-boarding a delinquent mortgage to the final sale of the property that is now REO (key services are; distressed real estate solutions, short-sale management, documentation, property preservation, inspection, valuation, escrow, brokerage, closing services, etc). This process often takes a few years per property, hence there is substantial recurring revenue as a property advances down this conveyer belt until the final sale. Since 2014 their revenue has declined in each year as fewer homeowners defaulted. When you have a fixed cost structure, this means that your earnings also decline. To offset these declines, they tried to diversify and acquired a bunch of businesses, which only wasted capital and made a mess of things. Over the past year, they’ve been undoing this acquisition binge and using the proceeds to pay down debt and repurchase shares. By the time that Altisource reports Q3 earnings, much of this disposal process will be completed and what will remain is an asset light service provider with somewhat cleaned up financials and a dramatically de-risked balance sheet. I think that earnings release is the moment when investors finally notice how cheap Altisource really is. What has existed for the past few quarters is a muddled mess of one-time charges and confusion. If you don’t believe me, look at how many pages of adjusted non-GAAP reconciliations they have in their most recent quarterly presentation.
If an economy goes bad, people lose their jobs, home prices decline and homes become worth less than the mortgage principal. In summary, mortgages go bad. I don’t think we’ll see the levels of defaults like during the last cycle, but I expect quite an uptick all the same. Particularly as housing prices as a multiple of income are at some of the highest levels in history—particularly in some of the coastal cities.
That all makes sense Kuppy, but with interest rates dropping, won’t people be able to refinance and stay in their homes? To start with, if that was the case, no one would have defaulted last cycle—especially as mortgage rates dropped a few hundred basis points with Fed rate cuts. This time there’s less room to drop rates—especially as a substantial percentage of mortgages outstanding were underwritten at current low rates. Does a 100-basis point drop in mortgage interest rate really matter when you still have amortization expense? Besides, with rates as low as they are, a much larger percentage of the overall cost of home ownership is related to other things like property taxes, maintenance, utilities, insurance, etc. Those things are all increasing faster than inflation—negating any benefit from lower mortgage rates.
If there’s an increase in mortgage defaults, how good could it get for Altisource? Here I sort of draw a blank. In the last cycle, in the four years between 2011 and 2014 (remember it takes some time for these defaulted properties to make it down the conveyer belt until they’re disposed of), Altisource made $635 million in adjusted operating income. That’s not bad considering the current market cap is only about $300 million today. Though I should note that the mix of businesses has changed since then and their primary customer, Ocwen has a much- reduced book of business—offset by a rapidly diversifying book of non-Ocwen business. In summary, I just don’t know how to build a model for Altisource. Honestly, I haven’t even tried.
Here’s what I do know; if you go by management’s guidance, they should have between $60 and $70 million of operating cash flow this year, in what should be something of a trough year for the business. They have a number of cost savings initiatives that when fully implemented next year will add another $10 to $30 million to this number. They have two remaining venture capital businesses that are costing them about $30 million this year. I assume that these have zero value, but there may be someone in the Ponzi Sector who disagrees and wants to acquire them—which is pure upside to me. Fortunately, Altisource has already ring-fenced one of these divisions and I think the cash bleed decreases as they find partners who want to invest in these things—or they kill them off. Adding it all together and I don’t see how this business isn’t doing at last $100 million of pro-forma adjusted cash flow next year before some decline in the business due to the continued run-off in Ocwen’s business. Finally, as they pay down high cost debt, their interest expense should continue to decline.
Sometimes, when you enter an investment, the future earnings model is murky at best, but if you can determine that you’re paying three times cash flow near an inflection in the business, you don’t need a good model for what happens going forward. An asset light servicing business shouldn’t be this cheap. Why isn’t 15 times cash flow a more appropriate multiple? That gets you to a share price around $100. If I’m right about an increase in mortgage defaults, look out!! The chart above shows what happened last time and there were 50% more shares outstanding then too.
Now that I’ve unloaded on the bull case, I’d be remiss to gloss over the fact that Ocwen is a disproportionately large percentage of the business, Ocwen is a bit shaky, Ocwen is shrinking, the agreement with Ocwen ends in 2025. There are plenty of other potential issues here. Altisource is rapidly diversifying the business, but when you’re handcuffed to a potential corpse, bad things can happen. Still, this is an unusually large position for me. Where else can you buy something at three times adjusted earnings, right before what looks to be an obvious inflection in the business. In the interim, they’re using cash flow to pay down debt and retire shares.
Over the years, I’ve built this site as a way to crowd-source new ideas and gather feedback on my own ideas. I want to find more businesses like Altisource that are “long-shorts.” Think back to the last cycle. Which businesses were multi-baggers as the global economy detonated? If you have any, please send them my way at firstname.lastname@example.org
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Disclosure: Funds that I manage are long shares of ASPS