Home Loan Servicing Solutions' CEO Discusses Q3 2013 Results - Earnings Call Transcript

| About: Home Loan (HLSS)

Home Loan Servicing Solutions Ltd. (NASDAQ:HLSS)

Q3 2013 Earnings Call

October 17, 2013 11:00 AM ET

Executives

James Lauter – SVP and CFO

William Erbey – Chairman

John Van Vlack – President and CEO

Analysts

Mark DeVries – Barclays

Bose George – KBW

Stephen Laws – Deutsche Bank

Mike Grondahl – Piper Jaffray, Inc.

Jim Young – West Family Investments

Nick Agarwal – Wells Fargo Securities, LLC.

Operator

Welcome to the HLSS Third Quarter Earnings Conference Call. At this time all participant lines are in a listen-only mode. (Operator Instructions). Today’s call is being recorded. If you have any objections you may disconnect at this time.

And now I would like to turn the meeting over to Mr. Jim Lauter, Chief Financial Officer. Sir you may begin

James Lauter

Thank you. 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 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 third 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 email, 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.

A reconciliation of each non-GAAP financial measure to the most comparable financial measure or measures calculated and presented in accordance with GAAP can be found on our earnings press release.

As indicated on slide three joining me for today’s presentation are Bill Erbey, Chairman of HLSS and John Van Vlack, President and CEO of HLSS.

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

William Erbey

Thank you, Jim. It’s a pleasure to share with you HLSS’ results for the third quarter of 2013. The quarter further demonstrated the stability of HLSS’ asset values, financing structure and earnings, reinforcing my confidence in the safety and security of HLSS as an investment.

In a quarter where the yield on 10 year treasuries experienced more than a 50 basis point swing and some other yield oriented companies experienced significant inter-quarter asset volatility HLSS’ results were unaffected.

As it has since its inception HLSS purchased assets in the third quarter that have limited credits for mark-to-market risk, assets that generate stable fee-based income and financed these assets primarily with committed fixed rates term notes. While this approach could mean some foregone earnings in periods where short term rates failed to follow the forward yield curve we believe this strategy reduces risk and results in a higher risk adjustment return.

HLSS accomplished much in the third quarter but two achievements stand out. The company’s financial structure was significantly enhanced, and unpaid principal balances serviced almost doubled. The acquisition was financed with the proceeds from the second quarter’s $323 million equity offering and $350 million term loan offering and added mortgage servicing assets with unpaid principal balance of $83.3 billion to HLSS’ portfolio.

On the heels of this growth HLSS continued to reduce its cost of financing with the issuance of $750 million one and three year term notes and a renewal of its variable funding notes at improved terms.

Finally HLSS reduced its operating expense ratio to 18 basis points of assets under management and reported no change in servicing asset valuations during the quarter.

Now we turn the call over to John Van Vlack who will speak to the company’s third quarter results in more details. John.

John Van Vlack

Thank you, Bill. We continue to execute on the business plan in the third quarter and are pleased to have begun to achieve record profitability while maintaining our low risk profile.

Slide five provides an updated view of our assets. After closing a large purchase on July 1 we ended the third quarter with a total of $6.8 billion in total assets collateralized by almost $177 billion of unpaid principal balance of mortgage loans.

As in the prior quarter 90% of assets were cash or non-agency servicing advances which are virtually no credit risk given their overall collateralization and limited mark-to-market risk. The remaining 10% were non-agency rights to MSRs which benefit from the same overall collateralization and continue to experience conservative stable valuation with virtually no correlation between interest rates and prepayment speed.

Slide six provides an update on our advanced financing terms. We were busy in the third quarter securing committed fixed-rate term note financing for the non-agency servicing advances we acquired and renewing or amending existing notes to improve pricing.

We issued term loans out of our master trust facility in August and September, we renewed our variable funding notes or VSNs at lower spreads while reducing our non-use fees, we placed in new money market note and amended the related draw note at a reduced spread and we established a new advanced financing facility, the pricing of which will improve when we complete the rating process.

Our third quarter effective interest rate of 2.4% came down a bit from the second quarter. We project an overall effective interest rate under advance financing of approximately 2.25% in the fourth quarter.

Thanks to the floating rate earnings on our custodial accounts which had an average balance of $1.2 billion in the third quarter we plan to maintain offsetting amounts of floating rate borrowing which will safely enable us to lower our borrowing costs.

Slide seven is our retained fee curve that depicts the economic split with Ocwen for the assets we own. We established or retained fee on each assets purchased 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 third quarter retained fee curve is very similar to one we presented last quarter as it included this one purchase. Given the size of that purchase we did not complete any flow purchases in the third quarter but expect to do so early in the fourth quarter.

Prepayments this quarter were 13.7% annualized, which was an increase from last quarter’s low of 12.5%. One contributor to the increase in the prepayment fee was the loss mitigation activities on portfolios newly boarded on Ocwen’s platform which often results in somewhat higher initial prepayments but which will ultimately reduce default related prepayments.

We are pleased that the earnings accretion from the July purchase and term loan issuance more than offset the higher amortization expense this quarter and allowed HLSS to report record earnings.

Regarding expectations for our fourth quarter results and sticking with our benchmark prepayment rate of 13.5%, our current expectations for fourth quarter earnings is in the range of $0.49 to $0.50 per share.

Now I’d like to turn the call over to Jim Lauter who’ll walk through our third quarter earnings and cash flow drivers and results.

James Lauter

Thank you, John. Slide eight shows our third quarter earnings and our management reporting format. Servicing revenue was $200.8 million or 45 basis points of average UPB serviced. The contractual servicing fee as measured in basis points of average UPB decreased from last quarter due to our most recent servicing acquisition. But I want to remind everyone that our targeted yield did not change.

When we purchase a portfolio with a lower servicing fee we simply earn a greater portion of that fee than we would otherwise. Subservicing fees were $102 million or 23 basis points, leaving us with retained fees of $98.8 million or 22 basis points from which to pay our operating expenses and to provide a return to our shareholders. The incentive portion of the subservicing fee was 76% of the total and was reduced by $3.5 million this quarter because of the ratio of advances to UPB exceeded the target set forth in our subservicing agreements with Ocwen primarily because of large seasonal property tax payments.

Interest expense was $36.1 million or eight basis points of UPB. The purchase price for the right to MSRs that we acquired on July 1st was 28.8 basis points reflecting the portfolio’s average contractual servicing fee of 38 basis points. Although the total portfolio almost doubled amortization dropped to five basis points of UPB or $24.6 million versus six basis points last quarter as a result of the lower purchase price. The increase in operating and other expenses to $3.2 million in the current quarter compared to $1.9 million in last quarter was primarily driven by year-to-date through-up in our tax provision and other non-recurring charges.

We expect our full year effective tax rate to be approximately 1%. Net income was $34.9 million or eight basis points.

Slide nine is a graphical depiction of our cash flow which starts with our net income and then adds back non-cash amortization and changes in other assets. A $188 million decline in servicing advances resulted in a $16 million decrease in the advance haircut. The maximum rate at which we can borrow on our servicing advances was just under 91% after adjusting for the impact of undrawn credit and was little changed from last quarter.

Cash generated available for distribution exceeded dividends declared of $32 million by 2.5 times. After paying dividends we had $51 million of cash available for reinvestment which we expect to deploy in a fourth quarter flow purchase. We expect to continue to generate significant cash in excess of our dividends after closing its planned servicing acquisitions we anticipate that Ocwen will own non-agency servicing assets with UPB of approximately $58 billion.

I’d now like to hand it back to Bill for one final slide before we take questions. Bill.

William Erbey

Thank you Jim. Some of you may remember slide 10 from previous presentations. It compares the yield on our equity against the yield of our triple B rated advanced financing and now also the yield of our corporate term loan that was not outstanding the last time we shared this chart.

As you can see since the rate volatility increased this summer there has been some softening of our share price even as our earnings have grown and the combined effect has been an increase in our earnings yield.

Our firm investors they recognize HLSS as low business risk and strong track record of growth but they also point out the company’s 32% premium to book value and dependence so far on its seasoned asset class from a single asset seller. I believe this perspective leads some investors to value HLSS by amortizing the current premium to book over the remaining life of the assets. The resulting adjusted yield appears close to the yield on our corporate debt and appears to discount earnings beyond those anticipated on our current portfolio.

While this approach to valuation would make sense to me if HLSS’ growth prospects were limited I am very comfortable then we’ll be able to acquire additional assets with similar risk and earning characteristics. I believe that delivering on this could materially change the outlook on our shares, increase substantial value for our shareholders.

I’d now like to open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Mark DeVries with Barclays.

Mark DeVries – Barclays

Yes, thanks and could you talk a little more just the incremental financing cost from the financings you did this past quarter and kind of where you think the all-in cost would go below the two in a quarter you expect for the fourth quarter?

John Van Vlack

So the all-in financing cost for the assets that we acquired recently is on an overall basis very similar to the existing portfolio. So we’ve been terming out that borrowing and so in the mean time we’ve used variable funding note capacity, the variable funding notes are shorter terms that are little bit cheaper generally, especially the current Libor rates. But then we have the unrated facility that’s in the rating process which is little bit more expensive so it really all averages out to be very similar to the existing portfolio.

Looking forward we’ve got a couple of moving pieces, I think that when we achieve the ratings on the second facility we’ll see some incremental reduction in the financing cost. Part of that is baked into the 2.25% guidance that we provided for Q4. And then going forward it’s going to depends on how the markets move and the tender that we pursue in the ABS markets.

So there is not really any guidance I can give beyond that, that 2.25%.

Mark DeVries – Barclays

Got it. And just one of the embedded cost of financing your advances, is the hedge cost you incurred a more mature interest rate risk. I think volatility at least from the shorter end of the curve, well I guess you would hedge that it’s been relatively low.

If you actually see volatility if it looks like the feds going to start tightening so it picks up and your hedge cost go up. Is this your pricing of these transactions with Ocwen contemplate that and is there an adjustment in price that still gets your targeted yield with a higher implied hedge cost?

John Van Vlack

Well when we price this purchases Mark, and rather one when we determine the split of the servicing fees we take a high enough portion of that servicing fee to cover the long term cost of the advanced financing. And so our primary strategy rather than hedging is fixed rate committed long term notes.

And so the slide six on the chart at the bottom right hand corner that shows just the fixed rate notes. We don’t include the variable funding notes on here which provide us with spare capacity. And so we bake that cost and long term fixed rate financing and fees portfolio. We also have the custodial account floating rate earnings which is an offset to some of the borrowings. So we intend to block in that cost very, as soon as practical after purchasing each portfolio.

So we don’t really have to take action in anticipation of any fed moves for the assets we are already own. We just need to make sure that when we get ready to buy in more assets that we price appropriately based on the interest expectations at that time and that we go ahead and we have the discipline to lock in the term financing.

So we haven’t really executed any hedges since we’ve gotten the longer tenure ABS term notes. So our strategy is really one of fixed rate borrowing and then maintaining the custodial account balances at a floating rate that offset the remainder of the borrowings.

Mark DeVries – Barclays

Okay great. And I just wanted to make sure I understood your comments around the prepayments fees in the quarter a little better. It sounds like the increase you saw on a sequential basis was due to boarding newer loans, with less fees and where you are more in the earlier stages of loss mitigation. Would you expect, ultimately what you are going to get through that, the loans you just floated will have prepayments fees that are more in line with kind of where the portfolio was before. I guess what I am trying to get at is kind of what the longer term outlook for your prepayments is?

John Van Vlack

Yeah that we do expect the loans we boarded to have very similar characteristics, is a little higher proportion of Alt A loans and so the voluntary prepayments the refi’s and muni’s and Alt A are slightly higher but the involuntary will be slightly slower.

So I just would point out that over to the course of last year we’ve seen a range that has been as high as 14 and then a low at 12.5 and so I certainly expect that we are going to continue to operate within that range and that we would absent any other changes that we would expect to see no gradual drift down in the prepayment fees as the portfolios that, that were recently boarded go through that seasoning process.

And but longer term we still see the potential for lower prepayments as the loans that are in the foreclosure process go through that pipeline.

Mark DeVries – Barclays

Okay. And do you have the sense for what the prepayment fees would have been had you not added those new ones or are you still kind in that 12.5% range on the older loans?

John Van Vlack

There still would have been an uptick in the prepayment fees we would have been in the low 13s.

Mark DeVries – Barclays

Got it. All right, thanks.

Operator

Our next question comes from Bose George at KBW.

Bose George – KBW

Actually just a follow up on that prepayment question. Was principal reduction modifications on the new stuff that you got part of that as well or just the factors you mentioned earlier?

John Van Vlack

Yes. The principal reduction modification is really the main loss mitigation initiative that drives the prepayments in near term.

Bose George – KBW

Okay. And what was, in terms of in terms of the total prepayments fees like how much of that was driven by the reduced principal?

John Van Vlack

Principal reduction modifications contributed roughly 3% on the overall portfolio but higher on the newly boarded portfolio.

Bose George – KBW

Okay great thanks. And then actually in terms of the guidance for next quarter that using that 13.5% is a benchmark for prepayments?

John Van Vlack

Yes, that’s correct.

Bose George – KBW

And then just actually a question on the comment on CapEx you made earlier. Just wanted to be clear what the good run rate number for CapEx would be quarterly sorry, OpEx number sorry?

John Van Vlack

Yeah, I think if you back out approximately a $1 million which was related to the income tax through-up that would give you a good number for the run rate. The run rate didn’t go up too much with the increase in the size of the portfolio in Q3. There was certain things like audit fees, bank fees things of that nature are variable. But it would be in the low two range.

Bose George – KBW

Okay thanks. And then one last thing just going back to Bill’s final comment on longer term growth. I mean you guys have mentioned the task, other asset classes, agency servicing advances I think Ginnie Mae buy out loans. I mean just wanted to get an update how you guys are thinking about that and when we might potentially see some growth in other areas?

John Van Vlack

So we are very busy working on different ideas and so we have a tendency to want have all the details worked out before we make definitive comments and before we provide guidance on timing and we feel very good about the portfolio of non-agency. We do secure type servicing assets, that’s available at Ocwen. And so we want to make sure on the other asset classes that we take our time to work out all the details and to be able to, either to make those investments consistent with the business model we have today in terms of the safety and security credit risk mark to market et cetera.

Bose George – KBW

Okay, great. Thanks a lot.

Operator

Our next question comes from Stephen Laws, Deutsche Bank.

Stephen Laws – Deutsche Bank

Hi good morning. Most of my results specific questions have been answered. So may be if you guys could just help me think about kind of the larger picture around voluntary prepayments, especially as maybe it relates the home price depreciation. It seems like a lot of the issues with purchasing a home tend to be meeting the 20% down payment requirement.

How does the HPA as home prices increase, will that translate to a higher voluntary prepayments as borrowers maybe there is pent-up demand to move assuming they can never get out from their current position? Or may just help me think about sort of the macro issue on voluntary prepayments?

William Erbey

Yeah, so I’ll try that to answer that question. I think there is a large secular shift that I think is going to be occurring in the mortgage and in the housing space. With the evident QM if you look back in 2012 about 35% of Americans could qualify for more jump, differentiation between qualification and affordability and that’s according to Core Logic. They also studied the impact of QM. And QM basically will reduce that number by about an half. So I feel a small portion of the population to actually qualify for a new mortgage as of January 1. I think that will, I think your question is an excellent one in terms of what happens if there’s home price appreciation and which you have more of households moving and greater household formation and more prosperous time.

And I think the question is yes I think there is a countervailing force and that’s really just will be the ability of people to qualify for new mortgage in those circumstances. Most of our borrowers are exceedingly credit impaired. And so that’s what I think is more of a limiting factor in the not prime world then it would be in the prime world.

Stephen Laws – Deutsche Bank

Great, that’s helpful. I appreciate the color there. Anything going on here with the events in DC and have workers that haven’t been receiving their pay checks do you expect to see a tick up in delinquencies advances around that?

John Van Vlack

Well, the answer is yes. I am not sure I have any number off the top of my head with precisely how many of in our portfolio are in fact government employees with regard to that and we are attending to try to work with them to bridge this period. But hopefully it appears that this is going to get resolved that they will start receiving pay checks again.

Stephen Laws – Deutsche Bank

Yeah, it looks like they are making some headway there. Well I thought it was a great quarter. I appreciate the questions and I look forward to seeing you guys in early December for your investor day.

John Van Vlack

Thank you.

Operator

Our next question is from Mike Grondahl, Piper Jaffray.

Mike Grondahl – Piper Jaffray, Inc.

Yeah, congratulations guys. The first question, as we think about the new opportunities you guys are looking at, can you give us a sense of your earnings in maybe 2014, ‘15 or ‘16, what would your goal be to have those new opportunities sort of contribute in terms of an earnings percentage out a year or two or three.

John Van Vlack

One thing I like to just sort of interject. There is a reason why we really would prefer not to comment about the new activities. I think those need to be developed to the manner that would be consistent with our PFIC treatment and we would like to defer them, I think that’s in the best interest of all the shareholders for us to do so.

Mike Grondahl – Piper Jaffray, Inc.

Okay, I understand.

John Van Vlack

Vague response, Mike I apologize for that.

Mike Grondahl – Piper Jaffray, Inc.

Okay, but mix of earnings I mean could it be 10%-20% over the next couple of years? I mean is there an opportunity that you see that could be real meaningful?

John Van Vlack

All the asset classes that we are looking at are large in their own way and many of them are much larger than the asset class in which we are participating today. And that’s really the genesis of what we are referring to is that to the extent that we have an unlimited runway or a very large pool of assets from different classes, to an extent you are able to do that as you have a yield that’s higher than your dividend clearing yield as you are well aware, you in fact generate – one theoretically would be able to generate increasing amount premiums to book and that’s really why we think that those efforts will be very important to increase shareholder value.

Mike Grondahl – Piper Jaffray, Inc.

Okay, that’s little more helpful. And then just quick on the $1.2 billion of custodial balances that you earned some interest income on, what is that interest rate that you earned tied to just so we can kind of think about how it would help you hedge in a higher rate environment. Is there a way to think about that, John?

John Van Vlack

Yes, so the current LIBOR rate, spot rate for one-month LIBOR is very low now. I think it’s about 20 basis points so we earn a fixed rate on those accounts that is actually little bit higher than the current LIBOR. Part of that earnings goes to offset bank fees where you would see the earnings increase appreciatively in a linear manner as the short term LIBOR rates go up, if in fact they do go up, would be, they will be up about 40 or 50 basis points.

So if you are modeling this and you have an expectation for the one-month LIBOR spot rate if that were to go above 40 or 50 basis points then you will begin to see a linear increase in the earnings on that $1.2 billion custodial balance.

Mike Grondahl – Piper Jaffray, Inc.

Okay, great. That was helpful. Thank you, guys.

Operator

Our next question is from Jim Young, West Family Investments.

Jim Young – West Family Investments

Hi, this is a macro question for Bill Erbey. Bill you are involved in the broader mortgage finance market and I am just wondering what niches do you currently see that you find attractive in addition to HLSS? Are there any new emerging niches that are developing currently in this mortgage finance industry? Thank you.

William Erbey

We are spending a very large amount of time thinking about where we see the mortgage market going. I certainly as was addressing previously some of the changes that are occurring with the advent of qualified mortgage. There is a large untapped market there. However I think we have to be very judicious in how we go into that market because if you in fact originate a non-QM loan and you don’t have Safe Harbor and your [rebuttal] presumption and you lose the penalties are really quite breathe taking. So we are treading very, spend a long time thinking about it but treading very-very lightly with regard to what we might do there.

We want to make sure we really get it right because getting it wrong would be very punitive shall we say, and that’s really where I see those, one major area that we are looking at. I think other areas that we are investigating and I am trying to be little bit sensitive about things, I am not talking about things that we are going to try to develop within HLSS because of my prior answer.

In the other areas I think you are going to see if non-QM products do not develop in the marketplace I think you are going to see a significant increase in the proportion of families that are actually renters as opposed to owners and those are the two primary large trends that I see right now.

Jim Young – West Family Investments

Thank you.

Operator

Our next question from is Nick Agarwal, Wells Fargo.

Nick Agarwal – Wells Fargo Securities, LLC.

Hi, good morning guys. Thanks for taking my questions. Most of mine have been answered but I have one, can you talk a little bit about the current sort of competitive landscape and pricing dynamics in the marketplace for new purchases?

William Erbey

It’s somewhat of an Ocwen question is in as opposed to HLSS question or...

Nick Agarwal – Wells Fargo Securities, LLC.

Well I mean in terms of potential opportunities outside of Ocwen buying MSRs from Ocwen.

William Erbey

You are speaking from an HLSS perspective.

Nick Agarwal – Wells Fargo Securities, LLC.

Correct.

William Erbey

John, would you like to take that question?

John Van Vlack

Sure. I think probably the best way to answer is to defer Bill to your earlier response that I think anything we would purchase beyond Ocwen would really be considered a new asset class and so I think will be subject to the same limitation in terms of our communication.

Now there are some holders of servicing assets that fit with our current business model, securitized non-agency servicing that we talked to you about providing financing from time to time and I think there are going to be some differences in the third-party valuations on the MSRs. The advances are pretty easy to value the MSR assumptions.

They can vary somewhat but I think we certainly can be competitive in purchasing assets from other parties. We simply would seek to work with parties that we think would make good counterparties and we think that our cost of capital is extremely competitive relative to other funding vehicles for MSRs.

Nick Agarwal – Wells Fargo Securities, LLC.

Okay, thanks John. I appreciate it.

Operator

Our next question is from Steven Eisman, MS Partners.

Unidentified Analyst

Hi, my question has been answered. Thank you.

Operator

(Operator Instructions). At this time we have no further questions. I would like to turn the meeting back to the speakers for final comments.

John Van Vlack

Thank you very much for joining today. That concludes our call.

Operator

Thank you all for participating in today’s conference. You may disconnect your lines at this time.

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