Altisource Stock Doesn't Look Particularly Cheap

The following is an abbreviated version of my in depth analysis of recently spun-off Altisource (ASPS). For the full version, visit my site.

Company Background

Altisource is a company that was recently spun off tax free from Ocwen Financial (OCN) and now trades on the NASDAQ under the ticker ASPS. Every three shares of OCN entitled investors to a single share of ASPS and the separation was completed on August 10^th, 2009. The company operates under three different segments/divisions: Mortgage Services, Financial Services and Technology Products. ASPS does business in all 50 states and 4 other countries. While its client list contains more than 75 companies, ASPS relies primarily on OCN and American Express (AXP) for the majority of its revenues. Specifically, relationships with OCN and AXP generate about 2/3rds of total revenue. Accordingly, one of the reasons for the spinoff is to pursue diversification of this customer base. Management believes that as a separate entity ASPS is more likely to cultivate relationships with third parties. However, in the near future there is no reason to believe that ASPS will not still be very dependent on OCN and AXP for business.

As of December 31^st, 2008, the company had 2534 employees, including 651 in Mortgage Services, 1,254 in Financial Services, 479 in Technology Products and 150 in Corporate. The number of employees has likely decreased a good deal since then as ASPS has been very proactive in terms of eliminating positions within the struggling Financial Services division.

Valuation

After trading down to around $10 after the spinoff, the stock has risen sharply to the current price over $13.50. As a result, based on even some optimistic assumptions about future EPS, the stock does not look particularly cheap.

Results from first 6 months
EPS	$0.47
Annualized P/E	14.40x
Owner's Earnings	$0.52
Annualized P/OE	13.02x
Unlevered Free Cash Flow ($M)	11.7
Annualized P/UFCF	14.03x
EBITDA ($M)	20.7
Annualized EV/EBITDA	7.64x

Sources: Capital IQ, company filings, and additional calculations

The above table shows the applicable valuation if the results from the 1^st half of 2009 are annualized (doubled). Aside from the reasonable EV/EBITDA figure, none of the other valuations are that compelling. This is especially true considering that annualized 1H 2009 data is much better than pro forma full year 2008 data. Specifically, with the same share count the company only would have only earned $.45 per share (pro forma) in 2008 and generated $25M in EBITDA. If the trends established in the first half continue into the second half then the 2009 figures will be substantially higher than the 2008 numbers. Having said that, for a value investor it is tough to get excited about a company based on what look like elevated earnings.

In addition, even when earnings valuations are not attractive, it is important to look at the balance sheet to see if there is a sufficient margin of safety based on the company’s assets. In this case the results don’t make the stock look any more compelling at the current price:

Diluted Shares Outstanding (Filing)	24.0
Book Value/Share	$2.73
Period End Price to Book Value	4.98x
Tangible Book Value	$20.8
Tangible BV/Share	$0.87
Period End Price to TBV	15.71x

Sources: Capital IQ, company filings, and additional calculations

At almost 5x book value and 15.7x tangible book, ASPS will never be confused with a Benjamin Graham net-net. In fact, when the earnings valuations are combined with the book value multiplies, it becomes clear that the market is pricing in substantial growth. Now, with the state of the housing and commercial real estate markets, it is very possible that both the Mortgage Services and Technology Products divisions are going see increased demand. Thus, revenue and earnings may continue to grow and eventually justify the multiples. However, the growth multiples leave no room for a margin of safety and thus preclude most value investors from being more constructive on the stock.

Profitability

Having established that shares of ASPS look too expensive for a value investor at the current price level, it is important to analyze the data regarding historical profitability in order to ascertain whether or not this is a company that investors should continue to monitor. Below is a chart on margins and returns:

Return Metrics	FY 2007	FY 2008	2008 Pro Forma^	1H 2009 30-Jun-09
Gross Margin	28.17%	28.24%	28.24%	36.80%
Operating Margin	7.49%	10.72%	10.72%	19.32%
Net Income Margin	5.12%	5.72%	6.73%	12.29%
ROE*	9.12%	15.14%	15.85%	35.98%

*2007 ROE is based on 2007 equity levels

*2008 and 2008 pro forma ROE is based on the average of 2007 and 2008 equity levels

* June 30^th annualized ROE is based on 6 months of income and average equity between Q4 2008 and Q2 2009

^2008 pro forma data includes the add back of a non-recurring interest charge

Sources: Capital IQ, company filings, and additional calculations

From a profitability perspective, it is very positive to see the trend of increasing margins. This could be a sign of increased efficiency and economies of scale that will only improve as ASPS is able to cultivate additional third party relationships. The problem is that it is very tough to know what ASPS’s cost structure will look like as a standalone company. Also, the very impressive margin increases from fiscal year 2008 to the 6 month period ending June 30^th are difficult to gauge in terms of sustainability.

Looking at the data, most of the improvement appears to be coming from revenue increasing faster than COGS and the resultant higher gross margin is helping boost operating income and net income. Also, there could be some pressure on gross margins going forward based on additional SG&A spending in the form of marketing, but the truth is that the margin trends are generally very positive. If ASPS were able to turn the Financial Services business into a profitable segment through additional rationalization of costs, the company wide margins could even improve further. There is no doubt that the emerging opportunities to add revenue and measures to continue to increase efficiency could lead to sustainable gross margins in the 20-25% range. While even that margin structure would not result in the current price looking particularly compelling, if ASPS could establish those margins as a baseline then this absolutely looks like a company and stock to follow on a regular basis.

Competitor Comparison: Valuation and Profitability

ASPS is unique in that it is made up of as assortment of businesses that makes it tough to find perfect comps. However, after some digging, the competitors that emerged as relatively good comparisons were Lender Processing Services (LPS), Fiserv (FISV) and Portfolio Recovery Associates (PRAA). While none of these is perfect, they all have divisions and segments that compete in some way with ASPS. Specifically PRAA’s business model is similar to that of the Financial Services business at ASPS.

Next, FIS has a financial institutional services segment that is not too different from ASPS’s Mortgage Services division and FIS offers technology services to its customers. Finally, LPS has a technology segment that caters to the same clientele as ASPS’s Technology Products group and has a loan transaction division that is similar to ASPS’s Mortgage Services group. Thus, out of the three, LPS looks like best comp but FIS is not too bad and PRAA provides an interesting reference point on the margin potential for a well run asset recovery business.

The following chart highlights the average margins and ROE of these companies over the last few years. What immediately stands out is the extent to which the competitors have traditionally much more robust margins (aside from ASPS’s 1H 2009 margins). This could indicate that ASPS has the opportunity to expand its margins as a standalone company to match those of the competitors. Also included are the margins from the 1^st half of 2009 so that investors can begin to ascertain whether or not they are sustainable. (Click on the chart to expand it)

*Sources: Capital IQ and company filings

It is striking how much lower ASPS’s margins have been (on average) over the last few years than those of the three competitors. There is no way to verify this supposition, but it is possible that OCN was not paying ASPS prevailing market rates for its services. Therefore, as those rates reflect current market conditions more and more, it is only logical that both gross and operating margins will increase.

Average Multiple
TEV/LTM Sales	ASPS	LPS	FISV	PRAA
Current	1.86x	2.21x	2.60x	3.41x
2004-2008 Average	N/A	N/A	2.24x	4.11x
P/E Ratio (LTM EPS)
Current	22.24x	13.95x	21.00x	15.02x
2004-2008 Average	N/A	N/A	19.63x	17.89x
TEV/LTM EBITDA
Current	8.99x	8.50x	8.78x	10.35x
2004-2008 Average	N/A	N/A	10.14x	9.99x
Price Book
Current	4.98x	10.47x	2.61x	2.14x
2004-2008 Average	N/A	N/A	3.23x	3.23x

Sources: Capital IQ, company filings, and additional calculations

From a valuation standpoint, especially when it comes to earnings, it is tough to compare ASPS to the others due the lack of trading history and the fact that ASPS was operating under the OCN umbrella. Accordingly, what it is valuable to look at is the type of multiples the market has traditionally placed on the competitors. Unfortunately, LPS has a limited trading history as well so very little can be gleaned from its valuation. Since this is an earnings and not an asset value story, it makes sense to ignore price to book value for the moment. But, based on earnings and sales metrics it appears that the following ranges are applicable: 2x-4x TEV/Sales multiples, 14x-21x EPS multiples, and 8.5x-10.5x EV/EBITDA multiples. Therefore, once reasonable run rate sales, EPS and EBITDA levels can be established it will be much easier to place a proper valuation range for ASPS.

Investment Conclusion

The original thesis was that the spinoff of ASPS into a relatively uncertain market could lead to a dislocation between intrinsic value and price. Either because of the financial focus of the company (there was a time when all companies that were involved in mortgages were unloved) or due to institutional selling post spinoff, in theory there was definitely some bargain potential. However, after the recent run up and based on a couple of different valuation analyses, the stock looks to be a bit overvalued. In fact, at the current price the market is allocating some higher-end multiples to the stock. Even given the very positive data through the first 6 months of the year, at the current valuation the risk-reward equation is not particularly compelling. Value investors are understandably wary of situations in which they are paying up for earnings growth.

Therefore, this is the kind of company in which John Templeton would have employed the following strategy: determine a conservative estimation of intrinsic value and an associated price that contains a margin of safety and then just monitor the stock. Mr. Market has been extraordinarily fickle and in a flash of irrationality the price could fall into an acceptable range, especially since this company is associated with the dreaded housing and commercial real estate markets. Based on conservative estimates and the OCN dependence, a fair measure of intrinsic value is around $12-$12.50 per share.

If standalone, run rate EPS is going to be about $1 by 2010, then applying a reasonable 12x forward multiple produces a value of $12. Similarly, if run rate EBITDA is going to be about $40M or $1.67 per share, placing a 7.5x multiple generates a value of about $12.50. Therefore, if the stock were to drop to about $10, that would provide a reasonable enough margin of safety to begin accumulating shares. However, if ASPS can continue to show margin improvement and diversify its revenue sources away from OCN, then investors can legitimately become more constructive on the stock as EPS and EBITDA would likely increase further.

Disclosure: No positions