Home Loan Servicing Solutions Ltd (HLSS) Management Discusses Q2 2013 Results - Earnings Call Transcript

Jul.18.13 | About: Home Loan (HLSS)

Home Loan Servicing Solutions Ltd (NASDAQ:HLSS)

Q2 2013 Earnings Call

July 18, 2013 11:00 AM ET

Executives

Jim Lauter - CFO

Bill Erbey - Chairman of the Board

John van Vlack - President

Analysts

Mike Guandell

Bose George

Mark DeVries

Stephen Laws

Vik Agarwal

Jason Stewart

Operator

Welcome to the HLSS Second Quarter 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode until the question and answer session. (Operator Instructions) Today’s conference is being recorded. If you have any objections, you may disconnect at this time.

I'll turn the meeting over to Mr. Jim Lauter. Sir you may begin.

Jim Lauter

Thank you very much. Good morning everyone and thank you for joining us today. My name is Jim Lauter, and I’m the Chief Financial Officer of Home Loan Servicing Solutions or HLSS.

Before we begin, I want to remind you that a slide presentation is available to accompany our remarks. To access the slides, go to our website at www.hlss.com, select Shareholders, then select Events and Presentations, click on Listen to the Webcast and register. When done, click on Access Event, click on how you wish to listen to the event. Each viewer will be able to control the progression of the slides during the presentation. To move the slides ahead, please click on the gray button at the bottom of the page pointing to the right.

As indicated on slide two, our presentation may contain certain forward-looking statements pursuant to the Safe Harbor provisions of the federal securities laws. These forward-looking statements may be identified by reference to a future period or by the use of forward-looking terminology. They may involve risks and uncertainties that could cause the company’s actual results to differ materially from the results discussed in the forward-looking statements.

For an elaboration of the factors that may cause such a difference, please refer to the risks disclosure statement in today’s earnings release, as well as the company’s filings with the Securities and Exchange Commission, including our 2012 Form 10-K and our first quarter 2013 Form 10-Q, which will be filed later today. If you would like to receive our news releases, SEC filings and other materials via e-mail, please register on the Shareholders page of our website using the e-mail alerts button.

Our presentation also contains references to non-GAAP performance measures. We believe these non-GAAP performance measures may provide additional meaningful comparisons between our reported results and how we internally manage our business. Non-GAAP performance measures should be viewed in addition to, and not as an alternative for, the company’s reported results under accounting principles generally accepted in the United States.

As indicted on slide three, joining me for today’s discussions are Bill Erbey, Chairman of HLSS; and John van Vlack, President.

Now, I’ll turn the call over to Bill Erbey, Bill?

Bill Erbey

Thank you, Jim. It’s a pleasure to share with you HLSS’ results from the second quarter of 2013. Now, in its second year of operation, HLSS continues to grow its business and exceed expectations. With the recent turbulence in the bond market reducing the book value many income oriented stocks and increasing financing cost, it’s good but not surprising to that HLSS enjoyed another quarter of stable asset valuation, and lower effective advance financing costs.

HLSS set the stage in the second quarter for substantial growth by raising $662 million of debt and equity to purchase additional assets from Ocwen. HLSS is the third follow in equity offering resulted in book value accretion and the new HLSS term loan will result in earnings accretion.

Slide four lists a few of the highlights for the second quarter, the company earned net income of $27.9 million or $0.48 per share headed by continued low prepayments fees in the mid 12% range, increase dividend from $0.13 to $0.14 per month executed another benchmark ABS financing of $850 million of fixed rate term notes and grew its portfolio to almost $100 billion of unpaid principal balance with a $10.6 billion UPB flow acquisition in May.

Subsequent to the end of the second quarter on July 1st, HLSS deployed the cash rates in the debt and equity offerings by acquiring servicing assets pertaining to $83.6 billion of UPB of non-agency mortgages from Ocwen. In recognition of the expected earning accretion from the debt and equity offering and the related asset purchase and HLSS objective to pay at least 90% of earnings overtime, the HLSS Board of Director has increased the monthly dividend to $0.15 per share per month for the third quarter which is the 15% increase from the $0.10 per share at the time of IPO 15 months ago.

Now, I will turn the call over to John van Vlack, who will speak to the company’s first quarter results in more detail. John?

John van Vlack

Thank you, Bill. We continue to execute on our business plan in the second quarter and are pleased to have achieved record profitability against the turbulent market backdrop. Slide five provides an updated view of assets, we’ll lose growth and assets and MSRs from May flow purchase and it was little change in the asset composition in the second quarter. After backing out the 661.5 million of proceeds from the June debt and equity issuances that was deployed on July 1, our adjusted total asset of $4.2 billion on June 30 were collateralized by almost 100 billion of unpaid principal balance of mortgage loan service.

As in the prior quarter, 90% of assets were cash or servicing advances which have no credit risk given their overcollateralization and no mark to market risk. The remaining 10% were non-agency MSRs which benefits from the same overcollateralization and continue to experience stable evaluations with no correlation between interest rates and prepayments fee. With the July 1 bulk purchase, total assets increased by $2.7 billion but our asset mix was unchanged.

Slide six provides update on our financing terms. Our second quarter effective interest rate of 2.48% was close to our prior guidance and not affected by the recent increase in rates, thanks to our largely fixed rate financing structure and LIBOR swap carried under hedge accounting.

In May we issued $375 million two-year, and $475 million a four-year term notes rated AAA through BBB with an average fixed rate of 1.61%. Through this issuance we were able to lock in the financing cost and availability for most of our projected borrowing for four years. We will be in the ABS market soon to term out the projected borrowing on the assets purchased on July 1.

By September we will know the terms in our ABS execution and pricing under variable funding of renewals. So we will have good visibility in to our future advance financing cost. Whether we achieve our set goal of an all in effective interest rate of 2% on our total advance financing will depend on the market. Even though current ABS rates are higher than for our May offerings, they are still below our average rate. So we expect our overall cost of advance financing to continue trending lower. Further advancing concerns about rates, we can negotiate with Ocwen to adjust the retained fee if the ABS execution in progress is outside the expected range

Slide seven is our retained fee curve that depicts our economic split with Ocwen for the assets we own, updated to reflect the assets acquired in the March flow purchase, and July 1 bulk purchase. We established our retained fee on each asset purchase by calculating how much of the servicing fee HLSS needs to retain in order to cover interest expense, amortization, operating expense and return on invested capital.

The assets added with the May flow purchase had limited impact on the curve as the contractual servicing fee on these assets of 48.5 basis points was close to the 50 basis point average, as were the third party MSR value of 45 basis points and the starting advance UPB ratio of 3.79%.

The final advanced UPB ratio was set at 1.5% versus 1.75 on previous purchases which will allow Ocwen to earn a bit more incentive fee but only if warranted by the performance of the assets.

The terms of the July 1 bulk purchase are also reflected. These assets, a lower third party MSR value, 28 basis points; because the weighted average contractual servicing fee is 35 basis points rather than the previous average of 50 basis points. The advance UPB ratio of 2.87 is also lower than the previous average of 3.81%. So although the routine fee is lower than on previous purchases, the targeted yield on equity for this purchase remains above 8%. Since this is a first asset purchase financed from proceeds of the term loan, I would like to summarize some of the key features and discuss how that affects the retained fee and earnings.

We don’t expect the term loans limit our ability to pay dividends and believe there is significant headroom in the borrowing based task. The term loan gives credit for any asset class that has an observable BBB attachment point subject to a sublimit and does not restrict the acquisition financing or disposition of such assets. This gives us flexibility to continue to run the business in the best interest of our shareholders.

As I mentioned earlier the retained fee at HLSS is set to cover all expenses and is to provide a targeted return on invested capital. The main components of invested capital are the MSR purchase price and capital required to finance the advances. Prior to the issuance of the term loan, the invested capital was 100% equity, but now the new term loan covers approximately one quarter of the total. The addition of this loan to our capital structure which has all in cost of [7/4.9%], reduced our total cost of capital to approximately [4 by 7 and 1] quarter percent.

Earnings decrease in $0.02 to $0.03 per share per quarter resulted when HLSS funded the most recent asset purchase with more than 50% debt, but agreed to a servicing fee split with Ocwen that was based on a targeted capital structure with 25% debt. Taking into account the May flow purchase, the July 1 bulk purchase, and the new term loan; we expect to earn in the range of $0.48 to $0.49 per share in the third quarter resulting in a payout ratio in the low 90% against our increased dividend.

Now, I’d like to turn the call over to Jim Lauter, who’ll walk through our income statement and cash flow.

Jim Lauter

Thank you, John. Slide eight shows second quarter earnings in our management reporting format. Servicing revenue was $128.7 million or 54 basis points of average UPB serviced. The higher average fees on the assets purchased in March accounts for most of the increase from the 50 basis point level in the first quarter. The July 1 bulk purchase will bring this average somewhat below 50 basis points going forward. Subservicing fees were $65.5 million or 27 basis points. Leaving us with 27 basis points of retained fee from which to pay our operating expenses and provide a return to our shareholders.

The incentive portion of this subservicing fee paid to Ocwen was 76% of the total, which is important because this could be reduced if advances exceed our targets. Second quarter results on the advanced ratio which is advances divided by UPB missed the target a bit, with the actual ratio of 3.71% exceeding the target of 3.55%. HLSS paid 1.1 million less incentive fees.

Interest expense was $20 million or 8 basis points of UPB, down from 9 basis points in the first quarter, with interest savings coming from our May ABF term note issuance. An increase in the MSR balance resulting from the floor purchase resulted in higher amortization expense of $13.4 million or 6 basis points.

Net income was $27.9 million or 12 basis points.

Slide nine is a graphical depiction of our cash available for reinvestment, which starts with our net income and then adds back non-cash amortization and changes in other assets. Advances declined by $202 million for the quarter, which combined further improvement in our advanced borrowing rate in the latest ABFI offering resulted in a recovery of our equity investment and advances of $57.3 million.

Cash generated available for distribution exceeded dividend declared of $25.9 million by four times. After paying dividends we had $77.5 million of cash available for reinvestment, which contributed to the cash used in the May floor purchase.

We expect to continue to generate significant cash in excess of our dividend. After closing its plant servicing acquisitions, Ocwen will own non-agency servicing assets with UPB of approximately $58 billion.

Slide 10 shows that our book value per share increased by $1.37 to $17.23 in the second quarter. Accretion from issuing $14.2 million -- 14.2 million new shares in June plus $23 was the main contributor, but there was also a $0.07 lift from our LIBOR swaps turning positive, which you will see on the balance sheet and other comprehensive income.

I'll now turn it back to Bill for one final slide, before we take questions. Bill?

William Erbey

Thank you, Jim. We introduced slide 11 during the equity offering to highlight the differences between HLSS and the number of yield oriented mortgage REITS. We believe that the second quarter results for HLSS further emphasize the differences. On the left hand side of the chart, we have shown the equity leverage ratio, which is assets divided by equity for HLSS relative to the REITs. After adding the new term loan, HLSS is at 5.8 times which compares favorably to the REITs.

In the middle of the chart we've shown mark-to-market assets as a percentage of total assets. As you can see HLSS compares very favorably. The comparison is even more favorable if you consider the stable valuation history for the non-agency MSR assets which are our only mark-to-market assets. The final ratio which is floating rate to total debt shows why we believe our financing strategy protects our earnings from rising rates. Most of our debt 86% as of June 30th is committed six term notes with tenures up to five years. The incremental 14% of our debt that is not fixed, we hedge almost all of the rate risk.

It's important to understand that the advance rates on our borrowings are fixed for the life of each note. So none of our debt is subject to repo risk and our earnings are not dependent on the forward yield curve.

I would now like to open the call up to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Mike Guandell. Sir your line is open.

Mike Guandell

Could you talk a little bit about the lower CPRs and sort of what's driving that?

John Van Vlack

Sure, so the CPR for Q2 was annualized rate of 12.5, so it was down just a bit from the Q1 rates, which was 12.7. And both were below the latest 13.5% rate that we call our benchmark. And I think that the prepayments continue to be very low, the involuntary liquidations are a little bit slow that's probably the biggest contributor. The prepayment speed has been extremely stable on this 3% range for the last five years. So any change is combination of (inaudible) and the pace of liquidations.

Unidentified Analyst

Okay. And then with the increasing mortgage rates late in the quarter, did that really have any effect on your business?

John van Vlack

I really don’t believe that it did. We didn’t see any change in the prepayment rate and there is not, I think the housing recovery is affecting the number of new delinquencies and helping to reduce that number, but that certainly wouldn’t have any immediate effect on our business either. So, I don’t think there was any effect really on our business in any way that we can measure.

Operator

Thank you. Our next question is from Bose George. Your line is open.

Bose George

Going back to the prepay question. Is it fair to say that none of that was really impacted by broader sort of macro-trends. So, when we look at forecasting that number going forward it’s probably going to stay at this level for a little while.

Bill Erbey

Let me try that, John if I can. I would agree as these portfolios mature, as John was trying to say the involuntary rate continues to come down as they get more and more current. So, by corollary you would expect the prepayment speed to be go down and as John said the 3%, the involuntary rate has been extremely stable and very, very low.

Bose George

We definitely agree with the expectation that the involuntary side should come down over time but just it looks like what’s happening now is really just a slowdown of the resolution some of these launches as opposed to any sort of macro improvement that’s driving the involuntaries down, is that fair?

Bill Erbey

Well, no. you’re seeing the delinquency rates coming down in these portfolios.

John van Vlack

The only thing I would add that we don’t think that there is a circumstance that would drive voluntary rate below 3% because a certain number of people move every year and so there is not a lot of refinancing and I think the 3% we view that as a floor on the voluntary prepayment rate.

Bose George

Okay. Can we just extrapolate in terms of prepayment the impact on earnings sort of the same trends of prepayments are done another 100 basis points that would be kind of $0.02 with quarter of earnings.

Unidentified Company Representative

Yeah, I think it’s $0.015 to $0.02.

Operator

Thank you. Our next question is from Mark DeVries. You may proceed.

Mark DeVries

Yes I am going to pile on the prepayment theme question, are you still assuming 13.5% in your guidance?

John van Vlack

We are, yes still. If you think about the earnings guidance of $0.48 to $0.49 per share that was based on a 13.5% annual prepayment rate.

Mark DeVries

So, if we assume it’s 12.5% again you’ve got another $0.02 in the share roughly running further.

John van Vlack

Yes, that’s roughly accurate.

Mark DeVries

Then the involuntary component is roughly three quarters of prepayments.

John van Vlack

Yes. I mean the involuntary is - it’s the biggest component by far and in addition to the 3% prepayment rate, that’s voluntary, there also is roughly 3.5% that represents normal principle reduction and then the rest of it is all involuntary.

Mark DeVries

Well, any sense for the involuntary could drop at some prices just keep going up at a healthy clip?

Jim Lauter

Involuntary is very much a function of the delinquency of the portfolio. It’s correlated between the more delinquent the portfolio, the higher the prepay speed as you begin to bring it down, you’re doing modifications, there in fact the loans are defaulting with regard to it. To go to the extreme, if you had a portfolio that was a 100% current, you would have zero involuntary.

Unidentified Company Representative

There are a certain segment of loans that are in this servicing portfolio that have progressed really beyond the point where they are going to be modified and so they are going to liquidation and so there is going to be some level of involuntary prepayment over the next several years as those loans that it crossed that threshold are liquidated. Beyond that it’s possible that we could see another let down in the prepayment rate.

Mark DeVries

And then going forward what kind of capital mix would you expect as you fund any future acquisitions between equity and debt?

Unidentified Company Representative

I think that with our current capital structure, when we continue to do flow purchases each quarter and each quarter that we are not doing a bulk purchase, we would state approximately the same capital mix that we were at and that we would have at post to July acquisition though it’s approximately 25% term loan and 75% equity and then we would expect that if we were to do additional bulk purchases that we would probably have a similar proportion. Sometimes it can on an individual transaction you may not be at your exact targeted capital ratio just because of size and conventions and so the term loan market doesn’t like really small issuances, so there could be a brief periods of time where you were not at the targeted capital ratio.

Mark DeVries

Okay got it. And then finally I guess your OpEx picked up a little bit Q-over-Q the 2.6 million is that a good run rate for us going forward?

John Van Vlack

That’s probably a little bit high ends a run rate going forward.

Operator

Next question from Stephen Laws you may proceed.

Stephen Laws

Congratulations on a very nice quarter and the dividend increase. I think the prepays and guidances have been covered pretty well but I wanted to talk really more about the total market opportunity. What is the additional supply of available purchases remaining at Ocwen? kind of how big is your portfolio represented to the total kind of subprime servicing assets that are available in the market?

John Van Vlack

So Ocwen I am sure when they have their earnings call they will talk about their pipeline. So we tend to really take our guidance from Ocwen. but Jim did mention that there is $58 billion of UPB of the varieties that we like to purchase from Ocwen the non-agency and so I think we say in our MD&A in the Q that that would give us visibility to being able to stay fully invested for the next two years based on our current size and the rate of run down in our portfolio and I will mention again that we are still looking at other asset classes but I would be very surprised if Ocwen didn’t continue to add non-agency assets that are appropriate for HLSS.

Stephen Laws

Right so it’s best you guys can tell from your pipeline just at Ocwen really no limits or no constrains as far as deploying that monthly cash flow back into new assets and that pipeline is likely to grow overtime.

John Van Vlack

Yeah and so we believe that we have that visibility to being able to stay fully invested based on the pipeline that already exists in Ocwen which is independent of any pipeline for future acquisitions that Ocwen may be planning. And then to that mix you would add in the potential for other asset classes and the potential for arrangements with other servicers and so we just tend to be very conservative in our guidance on those two points.

Stephen Laws

I know it’s early so to work within the others have any discussions progressed to the point where you have an idea of kind of where pricing comes out is it going to be something that’s structured similarly to the Ocwen transactions or do you see them being different arrangements?

John Van Vlack

Well I think we would be open to different arrangements I think that when you look at the financial terms I think our cost of capital is pretty well known we certainly would plan on investing at above our required cost of capital and we would plan on working with strong counterparties in a manner where rates for us is protected owning assets that have very limited credit and mark-to-market risk so I think all of the core tenants of our investment philosophy would still apply but as an example of something that might differ in working with another third party owner of servicing asset we may just focus on financing advances rather MSRs and so that asset mix could look a little bit different.

Stephen Laws

Right I appreciate that color and then I guess kind of one brief comment I know you guys have done a great job inception to-date producing financing cost as I mentioned we have a kind of longer term timeframe of a 2% target although I guess that’s ideally could be achieved will be difficult. What is kind of your timeframe as you look at what we should see from a decrease kind of a pace of decline from here? what are the major steps that can be taken to reduce that financing expense?

John Van Vlack

Well I think each offering represents another opportunity to reduce the overall cost of financings will be in the ABS markets soon seeking to term out the borrowing associated with the July 1 asset purchase and it’s really there has been a little bit of movement in the market based on just the movement of the 10 year in general interest rate movement so it’s not possible to predict I think by September I think we will have very good visibility but the upcoming events of the current ABS offering and then the renewal of the variable funding notes which would take affect at the end of August so I think we will have a much better picture to answer that question in September.

Operator

Next question from Vik Agarwal your line is open.

Vik Agarwal

Hey I just wanted to piggy back on that last question. You mentioned that you could potentially go into products that (inaudible), are there others that you guys are looking at or potentially looking into?

Bill Erbey

Yes, there are a number of different asset categories, they would all have to have the same basic characteristics of our existing assets, as John said we would look at advances on prime (inaudible) but we would not put prime MSRs into this vehicle, because there's different risk reward profile. there is two or three others that we're currently investigating and I think making very good progress on that but that's not something we'd like to go into at this time, what those assets might be. We'll tell you ahead of time before we do it, but we would like to keep that information confidential.

Vik Agarwal

And then also you said in the quarter the servicing asset valuation looks flat, right, I know it's sensitive to movements but for it to move how much do you have to see movements or steepening in the curve for it to really start to move?

John Van Vlack

Well because of the fact that there has been, there's such a small component of the prepayments that they're voluntary and because that voluntary component is not sensitive to interest rates though we don't think that the rates independent of other economic factors and other assumption changes would really ever have a dramatic effect on the evaluation of the MSRs, it's going to be interesting to see when others report what the valuations look like, we would expect that the agency MSRs that those valuations would be higher but for non-agency we've had discussions with our third party valuation provider and they're not expecting really any of the non-agency portfolios to show an interest rate response.

Operator

Thank you, our next question from Jason Stewart, you may proceed please.

Jason Stewart

Just a follow on CPRs and voluntary versus involuntary, is the mix pretty consistent between the different categories such as subprime and all day.

John Van Vlack

It is.

Jason Stewart

And then to think about that in relation to the previous question, if we did see a significant drop in the involuntary default rates or CPRs, would that be the primary driver of the chain in the value of the MSR, and if it is, can you give us a gauge for how big of a drop it would have to be before you would consider making a change.

John Van Vlack

Like, well as I mentioned before it's really driven by the third party evaluation and there's the very interesting dichotomy between the assumptions that are embedded in the third party valuations for prepayments versus the actual experience with Ocwen as the servicer, so there's 18-20% total long term prepayment rate assumption embedded in the current MSR valuation and you heard us say that for Q2, the actual annual prepayment rate was 12.5, I think that the third party valuation providers are really starting to think about whether they would want to make an adjustment. We know part of that delta is Ocwen servicing practices but I think even average servicers are reporting for their non-agency portfolios significantly lower prepayment assumptions than what's reflected in the current valuation, so it causes us to think that there may be an element of conservatism, you know when that current valuation even factoring out the results that we get from Ocwen.

Jason Stewart

So if it's not necessarily the delta between the actual and expected is it more to do with the period of time that it persists. I mean we saw two to three quarters of an increasing delta. At what point would the third party come back to and say we need to take another look at this?

John Van Vlack

That's a very good question. It's not really possible for us to predict when the light bulb may go on, but there's been a persistent difference and I think that that difference though probably will not persist in the same amount forever.

Operator

Thank you sir, next question from (inaudible).

Unidentified analyst

So also on the MSR valuation being flat, I understand you've said a couple of times it's not rates but can you just walk me through which economic metrics or valuation assumptions from the third party could lead us to change the MSR valuation, housing prices or discount rates and which you think are most likely in the future, I assume you're not assuming that they're going to be flat forever.

John Van Vlack

So we, we certainly think there is potential for the third party evaluation to change some of the big drivers for prepayment rates those I think we're pretty consistent with our third party provider in terms of the voluntary prepayment rates though we see that’s staying low they see that’s staying low with regard to the delinquency related prepayments, I think that there is some potential with the recovering housing that - but that could cause the third party valuation assumption to change to a lower expected CPR and that obviously would be favorable to the valuation, I’ll also mention that the cost of advance financing let’s assumed by within the third party valuation that’s LIBOR plus 400 sets quite a bit higher than what we’ve seen in the market and so we’re now really on – we’re coming up in October on the one-year anniversary of HLSS doing its first ABS issuance, which really started moving the cost of financing advances lower and more aligned with other somewhere early AAA rated assets classes and so at some point we could see those assumptions, but those are really the two biggest assumptions that throughout the third party valuation the overall total prepayment rates and the cost of advance financing.

Jim Lauter

And John, they’re not being approached prospective; they’re not forecasting where they think it will go; they’re going to be much reactive to what we actually have experienced and then with the lag decide to make a change, they’re not doing this prospectively, they’re doing it retrospectively.

John van Vlack

I would agree with that and it’s a lengthy lag as we’ve seen.

Jim Lauter

Right, right

Operator

Thanks you (Operator Instructions). The line is still open for question and answer session. There is one question just came in from Bose George again. Your line is open.

Bose George

Yes, I just had a question on HLSS prime, any updates on HLSS prime, is there a question we should save for the Ocwen call?

Unidentified Company Representative

The next update you’ll have is we either are successful with regard to it or we’re not, so I think good progress is being made in all these cases until it’s done, it’s not done but we’re optimistic we’ll get something done there.

Operator

(Operator Instructions).

Jim Lauter

Operator, there are no more questions; I think we can conclude the call and thank everybody for attending.

Operator

Okay.

Jim Lauter

Thank you very much. Have a nice day. Bye.

Operator

And that concludes today’s conference. Thank you for participating. You may now disconnect.

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