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Altisource Portfolio Solutions (NASDAQ:ASPS)

Q4 2012 Earnings Conference Call

February 13, 2013 11:00 a.m. ET

Executives

Bill Erbey – Chairman

Bill Shepro – CEO

Michelle Esterman – CFO

Analysts

Carter Malloy – Stephens Incorporated

Doug Kass – Seabreeze Partners

Ryan Zacharia – JAM

Operator

Good day, ladies and gentlemen, and welcome to the Altisource Fourth Quarter Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today’s conference, Ms. Michelle Esterman, Chief Financial Officer. Ma’am, you may begin.

Michelle Esterman

Thank you, operator. We first want to remind you that the earnings release, Form 10-K and quarterly slides are available on our website at www.altisource.com. These provide additional information investors may find useful.

Our presentation today contains forward-looking statements made pursuant to the Safe Harbor provisions of the Federal Securities Laws. Statements in this conference call and in our press release issued earlier today, which are other than historical fact, are forward-looking statements. Factors that might cause actual results to differ materially are discussed in our earnings release as well as our public filings. The company disclaims any intent or obligation to publicly update or revise any forward-looking statements, regardless of whether new information becomes available, future developments occur, or otherwise.

Joining me for today’s call are Bill Erbey, our Chairman; and Bill Shepro, our Chief Executive Officer.

I would now like to turn the call over to Bill Erbey.

Bill Erbey

Good morning and thank you for joining today’s call. I plan on spending a few minutes on our key 2012 accomplishments and our vision for 2013. Michelle will provide an overview of our financial performance, and Bill will expand upon our 2013 strategic initiatives.

The fourth quarter caps off a year of impressive growth for Altisource, increasing our service revenue and earnings per share by 39% and 60%, respectively, over 2011. Fourth quarter 2012 earnings per share increased 11% over the third quarter of 2012, and operating profit margins increased from 26% to 27%.

We’re very pleased with the fourth quarter margin expansion, particularly given that one, we incurred $2.7 million of costs in the fourth quarter related to the creation and separation of the residential asset businesses; and two, we were growing the staff required to support the approximate doubling of Ocwen’s private label serving portfolio.

With this doubling, we anticipate the default services margins to increase by seven percentage points over 2012 by the end of this year. This reflects the operating leverage of our platform, even without the implementation of our next generation technology. The increase in margins in the default services business will be partially offset by higher costs in our Technology Services and corporate segments, as we prepare for our expected 2013 and 2014 growth.

Reflecting on our progress since 2009, the year we separated from Ocwen, our earnings per share and market capitalization, including Altisource Residential and Altisource Asset Management, have grown at a cumulative annual rate of 61% and 69%, respectively. Further, as you can see on slide four, we have also increased our service revenue operating margins from 20% in 2009 to 27% in 2012.

We are proud of our 2012 accomplishments, each of which positions us for future growth. First, we completed a capitalization and separation of Altisource Residential, which we refer to as Resi, and Altisource Asset Management, which we refer to as AAMC; and fully developed our property management, lease brokerage and construction management capabilities within Altisource. Second, our focus on the sale of origination related services to the Lenders One members resulted in origination related revenue growth of 72%. Finally, we continue to provide high quality services to Ocwen, while preparing for their anticipated growth.

We believe 2013 will prove to be another exciting year for each of our segments at Altisource. In our Mortgage Services segment, we’re focused on three key initiatives first, managing the ongoing volume from the legacy portfolio, growth from the Homeward and ResCap platforms, and additional potential wins from Ocwen’s pipeline; second, developing new default related services to complement our current suite of offerings; and third, expanding the sales of origination related services to the members of Lenders One.

With respect to default services, as you can see on slide five, for the entire United States the number of residential loans in default today is almost the same as the average for the last four years. This reflects the ongoing dynamic of roughly the same number of loans going into default as are resolved each month. The continued elevated delinquency levels and ongoing portfolio churn afford Altisource a long-term earnings tail for default related services businesses.

With respect to mortgage originations, even with the forecasted decline in 2013 originations, we expect significant revenue gains from our origination related businesses. As you can see from slide six, despite origination services’ impressive revenue growth and Lenders One origination market share expansion, we only generated about 1% of the service revenue available from the loans originated by Lenders One members. As we continue to develop and grow our origination related services, this remains a very large market opportunity for us.

In our Financial Services segment, we believe 2013 will mark a turning point in our earnings. By the second quarter we will have completed a multiyear process of consolidating three operating platforms into one. This simplifies our operating infrastructure, improves our workforce efficiency and flexibility, and lowers our technology costs. We also anticipate benefiting from Financial Services’ 2012 investment in a sales team to develop a pipeline of new business. We intend to pursue growth from existing customers and deeper penetration of the industries we currently serve. We’re particularly excited about our planned expansion of collections services for charged-off mortgages.

In our Technology Services segment, we plan on increasing our investment in personnel to support Ocwen’s and Altisource’s growing businesses and to accelerate the development of our next generation technologies, the effect of which will be a marginal decline in pre-tax income in this segment. We’re continuing to first focus on the technologies that are critical to Ocwen’s operation.

These include REALServicing, our loan servicing system; and REALDoc, our correspondence generation, intelligent document intake and image storage platform. Once these technologies are fully staffed and we are making meaningful progress with the software development, we will refocus our efforts on recruiting the staff to complete the development of our next generation vendor management and spend management software. The investment in these technologies should significantly improve Altisource’s and Ocwen’s margins.

Finally, we plan to look for business acquisitions that align with our vision and accelerate the achievement of our strategic objectives. These include acquiring the fee based businesses associated with Ocwen’s acquisition of the Homeward Residential and ResCap servicing platforms. We have agreed on a combined price of $218.6 million, which we believe will provide an unlevered return to Altisource of approximately 20%. The fee based business acquisitions are strategically valuable to Altisource, helping us maintain our business model with Ocwen, expanding our footprint and providing significant revenue and earnings growth to Altisource.

I will now turn the call over to Michelle for a financial update and the discussion of 2012 margins. Michelle?

Michelle Esterman

Thank you, Bill. This morning we reported fourth quarter 2012 service revenue of $121.7 million, net income attributable to shareholders of $30.3 million and diluted earnings per share of $1.20.

Slides seven and eight provide highlights of our results for the current quarter and year compared to prior periods. Compared to the third quarter of 2012, service revenue increased 3% due to modest increases in referrals from Ocwen’s servicing portfolio, expanded origination related services to the Lenders One members, partially offset by the seasonally expected decline in Financial Services.

I’d like to spend a minute on slide nine, as we believe the inclusion of related party and third party service revenue per delinquent loan will assist you in developing your forecasting models. The majority of service revenue in our Mortgage Services segment is from default related services that we provide for Ocwen’s servicing portfolio. We earn default related service revenue from related parties and third parties, both of which are highly correlated to Ocwen’s servicing portfolio.

As Ocwen’s servicing portfolio continues to evolve and include a greater percentage of GSE performing loans, we believe this information will be more helpful in assisting you with forecasting our service revenues.

As you can see on slide nine, our related party service revenue per delinquent loan for non-GSE loans has declined from $244 in the third quarter to $224 in the fourth quarter. As this is primarily attributable to an increase in the percentage of delinquent loans in foreclosure that are under review for modifications, we believe this is a deferral of revenue and not a permanent loss.

As for the delinquent GSE loans, both related party and third party revenue per delinquent loan increased during the fourth quarter as we expanded our related service offerings on GSE loans.

Net income attributable to shareholders increased 12% over the third quarter of 2012, primarily from revenue growth, operating efficiencies and lower global effective tax rates, partially offset by costs related to our growth initiatives. Some of the costs related to our growth initiatives include technology development, expenses related to our rental asset businesses and interest expense.

In 2012, the Technology Services segment increased its compensation and benefits expense to support the accelerated development of our next generation technologies.

To support the development of the rental asset businesses, the Mortgage Services segment incurred fourth quarter non-recurring expenses of $2.3 million and third quarter non-recurring expenses of $0.3 million related to the separation and distribution of Resi and AAMC. In addition, the Mortgage Services segment incurred fourth quarter expenses of $0.4 million and third quarter expenses of $0.6 million to build out our rental property management capabilities.

To finance the capitalization of Resi and AAMC and other growth initiatives, we borrowed $200 million in November 2012 under a senior secured term loan at a current interest rate of 5.75%. As a result, we incurred fourth quarter interest expense of $1.2 million. We believe that these expenses represent strategic investments in the future of Altisource.

Turning to our gross profit margins, our fourth quarter 2012 gross profit as a percentage of service revenue was 44%, compared to 42% in the third quarter of 2012. The improvement in gross profit margin was primarily attributable to revenue growth and workforce efficiencies in our Mortgage Services segment, lower vendor cost in the Technology Services segment and lower technology costs in the Financial Services segment as we migrate it to fewer platforms.

Partially offsetting these improvements, we incurred employee costs to support the boarding of Ocwen’s Homeward and ResCap servicing acquisitions. and non-recurring costs to develop the rental property management businesses. Excluding the cost to develop the rental property management businesses, our gross profit margins would have been 45% in the fourth quarter of 2012 and 42% in the third quarter of 2012.

From a cash perspective, we generated $19.4 million in operating cash flow in the fourth quarter of 2012. This represents $0.16 for every dollar of service revenue. compared to $0.36 for the third quarter of 2012. The lower fourth quarter operating cash flow per service revenue dollar is primarily the result of timing differences in converting accounts receivables to cash.

We primarily deployed fourth quarter 2012 operating cash, along with cash from the $200 million term loan in three ways, first, by capitalizing Resi and AAMC with $105 million and distributing 100% of our ownership in these companies to our shareholders; second, by lending $75 million to Ocwen; and third, investing $11.4 million in facilities and technology to support our growth.

The capitalization and distribution of Resi and AAMC not only benefits our shareholders through their ownership in these new businesses, but also provides a long-tailed revenue stream for Altisource as a service provider to Resi. The loan to Ocwen provides Altisource with an attractive return on our excess cash until we acquire the fee based businesses in connection with Ocwen’s portfolio acquisitions.

I will now turn the call over to Bill.

Bill Shepro

Thank you, Michelle, and good morning. 2012 was a strong year for Altisource. We focused on providing high quality services to Ocwen’s growing portfolio, while intensifying our efforts on our strategic initiatives to diversify and expand our revenue base. I plan on spending a few minutes on our 2012 accomplishments, and then discussing our strategic focus for 2013.

Our 2012 growth was largely driven by Ocwen’s servicing portfolio expansion, primarily from Ocwen’s acquisition of the Saxon and Chase portfolios. We were instrumental in boarding these volumes and experienced growth in our default and Technology Services revenue as a result.

We also made great strides in 2012 in putting in place the operating platform to provide residential property management, lease brokerage and construction management services. We also created capitalized and separated Resi and AAMC. With $100 million of initial equity, we believe Resi is poised to execute on its strategy of achieving above-market returns by, one, acquiring non-performing loans at a lower cost than directly acquiring REO; and two, operating at a lower cost than its competitors.

We believe that as Resi acquires assets, it will become a serial equity raiser, with Altisource as the exclusive provider of property management, lease management and rehabilitation management service to Resi. That growth will, in turn, provide attractive growth and diversification to Altisource.

For each home acquired by Resi that requires rehabilitation, we estimate that Altisource will generate approximately $1,625 in one-time revenue from the renovation and initial marketing and lease brokerage services. Once homes are part of the rental portfolio, we estimate that Altisource will generate approximately $1,275 per home in recurring revenue per year.

Turning to our 2013 initiatives, they are: supporting Ocwen’s growth; two, expanding origination related services revenue; three, deploying Hubzu to the non-distressed home sales market; four, developing our next generation technologies; and five, improving the earnings in our Financial Services segment.

Our first initiative and primary focus in 2013 will be boarding and providing services to Ocwen’s growing servicing portfolio. We are working diligently to prepare for the on-boarding of the Homeward and ResCap platforms.

In the fourth quarter, we solidified with Ocwen the plans for boarding these loans on our servicing platform. To facilitate a seamless transition, all the non-GSE loans will be boarded on REALServicing in the first half of 2013. While we generally do not begin receiving Ocwen referrals until loans are boarded on our servicing system, we are exploring options to direct referrals to Altisource sooner for certain lines of business.

We also revisited our staffing models in the fourth quarter and determined we will need fewer additional Mortgage Services employees than originally anticipated to meet the heightened referral volumes, which should contribute to the seven percentage point increase in our default services margins that Bill discussed earlier. This is reflective of improvements in the operating leverage of our model, even without the deployment of our next generation technology.

Our client, Ocwen, with its recently announce servicing acquisitions, is now positioned as the fifth largest mortgage servicer in the United States. As the structural shift of servicing to non-banks continues, we expect Ocwen to continue to grow. Ocwen’s highly scalable platform and low cost operating structure positions it to be very competitive, as additional mortgage servicing portfolios become available.

While we provide a suite of default related services today, there continues to be opportunities to develop new services to complement our current offerings. In our Mortgage Services segment, we are developing short sale and deed-in-lieu processing offerings. We believe these services will not only accelerate our growth, but will also help Ocwen extend its performance leadership.

Turning to slide 12, our second initiative is growing our origination related services to the members of Lenders One. The members of Lenders One represent approximately 10.5% of the U.S. residential origination market. We believe we enhance the profitability and competitive position of the Lenders One members through the members’ retention of Altisource as their service provider. While we have taken a very deliberate approach in rolling out our origination related services to the members, we are pleased with the initial progress we have made.

Turning to slide 13, our third 2013 initiative is to deploy Hubzu, our online real estate transaction website to the distressed and non-distressed home sales market. Our 2013 efforts to grow Hubzu will center on, one, offering Hubzu to other servicers to sell their REO; and two, providing Hubzu to individual listing agents and brokers. In this regard, we have started sales conversations with servicers and financial institutions to add them to our marketplace and further extend our leadership position in online home sales. Beginning in mid-February, Hubzu will be available to individual listing agents and brokers to lay the foundation for a broader entry into the non-distressed home sale market.

As Bill mentioned earlier, our fourth 2013 initiative is the development of our next generation technologies, including REALServicing. We believe the next generation of REALServicing will not only provide Ocwen with enhanced servicing effectiveness, efficiency and scalability, but also greater agility in responding to the changing regulatory servicing environment. The redevelopment of our other technologies will, in time, support margin expansion at Altisource through lower employee, technology and vendor costs.

Lastly, slide 14 outlines the Financial Services segment earnings growth initiatives. As Bill mentioned, we believe 2013 will mark a turning point in Financial Services earnings. We are focusing our sales efforts on the growth of more stable and profitable customer relationship management and mortgage charge-off business lines.

We also continue to focus on operating efficiencies. By the second quarter, we will have completed a multiyear process of consolidating three operating platforms into one. This simplifies our operating infrastructure, improves our workforce efficiency and flexibility, and lowers our technology costs.

In closing, we have a lot of exciting opportunities in front of us, both with the growth of our core operating businesses and our 2013 strategic initiatives. As a result, we expect 2013 to be a very strong year for Altisource. Further, with good progress against our 2013 strategic initiatives along with a full year benefit of the referrals from Ocwen’s Homeward and ResCap servicing platform acquisition, we are well positioned for an even stronger 2014.

At this time, we would like to open the call up for questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Carter Malloy with Stephens Incorporated. Your line is open.

Carter Malloy – Stephens Incorporated

Hey, guys. So on the businesses that you’re acquiring from Ocwen, can you give us a little more sense in terms of when you expect to close on those and, more importantly, the revenue and margin profile of those?

Bill Shepro

Carter, we’re just going through the regulatory process, and so we expect to close those transactions by the end of the first quarter. From a revenue and margin perspective, we’re essentially going to move those businesses off to the Altisource platform. So you should expect similar revenue and margins as we experienced on the legacy portfolio. And then as we improve our operating leverage in our default services business, you’ll see those margins improve as we gain operating leverage.

Carter Malloy – Stephens Incorporated

Okay. So you need those platforms to move over to you guys in order to get that business at all or how much revenue is actually attached to those? And is that – is any of that revenue you would have not otherwise gotten?

Bill Shepro

Yeah. Carter, I mean the – we’ll be providing the same suite of services that we provide to Ocwen’s legacy portfolio on the portfolio acquisitions. We’re starting to develop the interfaces now to generate some of the referrals in sort of the business-as-usual method. And then once the acquisition closes, we’ll essentially be moving those businesses we acquired on to our operating platform.

Carter Malloy – Stephens Incorporated

Right, okay. So effectively, for you guys to on-board those loans on to your platform you needed to buy these businesses?

Bill Shepro

That’s right.

Carter Malloy – Stephens Incorporated

Okay, all right. And then also, Bill, you talked about margins within default going up 7%. I just want to be clear; was that by the exit rate of the year or the full year versus 2012? And then also can you talk about overall margins of the business given the investments you guys are making?

Bill Shepro

Yeah. The 7% point improvement is by the end of the year in our default services business. Overall we expect our operating margins to be roughly flat to 2012 even after taking into consideration the investment we’re making in our corporate segment and in our Technology segment.

Carter Malloy – Stephens Incorporated

Okay, great. And then certainly you would have some expansion in 2013 as you get the leverage off of those investments, correct?

Bill Shepro

I think you mean 2014, Carter.

Carter Malloy – Stephens Incorporated

I’m sorry. 2014, you’re right.

Bill Shepro

Absolutely.

Carter Malloy – Stephens Incorporated

Okay. Thanks so much.

Operator

Our next question comes from the line of Doug Kass with Seabreeze Partners. Your line is open.

Doug Kass – Seabreeze Partners

Hey, Bill. How are you? Two unrelated questions. Firstly, can you explain the sharp drop in the effective tax rate? It was virtually zero in the quarter and, I believe, for the first nine months it was a tad under 10%. And what should we be modeling for full year 2013?

Secondly, what was the head count at year-end and how does that compare to, say, three months ago and what can we expect the workforce to be by year-end 2013?

Michelle Esterman

Sure. So on the taxes, what we’ve seen over the course of 2012 is we have had more of our income in lower tax jurisdictions. And so that has driven down our overall effective tax rate for 2012 to about 7% for the year. Looking forward, we expect our tax rate to, as we continue to grow, remain about the same as 2012 or possibly a little bit lower.

Doug Kass – Seabreeze Partners

Great. But why was it zero in the quarter?

Michelle Esterman

It was – just the way accounting works. From a quarter-to- quarter basis, you true up to what you expect your annual to be.

Doug Kass – Seabreeze Partners

Got you.

Michelle Esterman

So in the fourth quarter we had a true-up and adjusted that to 7% for the year.

Doug Kass – Seabreeze Partners

Thank you. And on the workforce?

Michelle Esterman

Yeah. On the workforce, you really saw a stable workforce from the third quarter to the fourth quarter, so no real change in numbers.

Bill Erbey

But we were carrying excess head count. We would – we could have been at lower head count levels had we not done the two potential acquisitions from Ocwen. So we – as opposed to terminating those people and then simply rehiring them, we elected to run with the excess head count.

Doug Kass – Seabreeze Partners

Thanks, guys. A very good quarter.

Bill Erbey

Thank you.

Operator

Thank you. Our next question comes from the line of Ryan Zacharia with JAM. Your line is open.

Ryan Zacharia – JAM

Hey, guys. Thanks for taking the question. I just want to understand a little bit more, to Carter’s question, about the acquisition of the businesses related to Homeward and ResCap. And I mean I was under the impression that the services agreement that Ocwen has with Altisource kind of baked in any bolt-on acquisitions, but it almost sounds like Altisource had to buy these businesses in order to get the service revenues from Ocwen. Am I understanding that correctly?

Bill Shepro

Yeah. Ryan, I think the market’s evolved since we first established Altisource. And Homeward and ResCap, to some degree, have already developed similar Altisource-like businesses that we essentially acquired from Ocwen as – and Ocwen essentially baked that into their bid when they went to go buy the servicing lines. And so we believe...

Ryan Zacharia – JAM

But didn’t the agreement that Altisource has with Ocwen already allow Altisource to capture that business regardless?

Bill Shepro

Yeah. Ryan, we have an agreement with Ocwen where we’re the exclusive provider of the services, Ocwen has the ability to rebuild it. If you look to the press release we issued yesterday with respect to the Homeward and ResCap acquisitions, Ocwen cannot rebuild the services and provide it to itself. Also, frankly, we’re trying to support Ocwen’s ability to grow. And us helping support their bids by buying these fee based businesses allows Ocwen to grow. So had we not contributed, it may be more difficult – it might have been more difficult to acquire the servicing lines.

Bill Erbey

It would have basically. Ryan, if you looked at the – if Ocwen were to maintain those businesses, they would have made, we believe – we believe they would have made less returns because they don’t have the global platform and technology that Altisource has. So by doing the transaction the way it occurred, Ocwen gets basically a payment that helps them in terms of acquiring the business and Altisource is able to move them on to the platform and even with that payment they get very attractive rate of returns as they’re more – far more efficient than other platforms that don’t have international – or global footprint and technology.

Ryan Zacharia – JAM

But if Altisource was still under the Ocwen umbrella and it was Ocwen Solutions, you would have bought those businesses and then you would have just either sold them to a third party or shut them down.

Bill Erbey

It would have – if they were still under the same umbrella, we would have moved them on – same thing we’re doing here, we would have moved them on to our existing platform, which is far more efficient than the existing platform. They’re the ones we...

Ryan Zacharia – JAM

Okay. Thanks.

Operator

Thank you. I’m not showing any further questions at this time. I’d like to turn the call back over to Ms. Michelle Esterman for closing remarks.

Michelle Esterman

Thank you. Thank you for joining our call today, and we look forward to speaking with you next quarter.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program, and you may all disconnect. Everyone have a great day.

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