The Basic Fallacy Regarding Altisource

Jan.16.14 | About: Altisource Residential (RESI)

When looking at Altisource Residential Corporation (NYSE:RESI), one can be tempted to analyze the stock by looking at its multiples to book value or to earnings. This is basically wrong, there is a tremendous fallacy in doing so.

The fallacy

If we compute RESI's price/book value, we come to a value of 3.46 times, using $1.47 billion as the market cap (this will change with today's share issuance) and $425 million as the equity (this too will change with today's equity issuance).

So is this right? No. It is wrong. You see, RESI's economic returns from its business of buying non-performing loans and resolving them (through foreclosure, short sales, refinancing, etc) has to support not only its own market capitalization, but also Altisource Asset Management Corporation's (NYSEMKT:AAMC). Whatever money RESI makes will be divided by those two entities, with no other business supporting them.

This means that the true market capitalization which ought to be considered is RESI's+AAMC's, and the book value which ought to be considered is also RESI's+AAMC's. The result from this is that the true price/book value at which this entity trades is much higher than it looks. It is (1470+2810)/(425+4+350)=5.49. This means that RESI's business is actually trading at 5.5 times book value.

And it gets worse. Not only is the business trading for 5.5 times book value, but it operates in a field where foreclosures and delinquency are falling fast. Thus, for the same players trying to buy those NPL loans, there will be less product supplied. This means that whatever margin there is in the business, that margin is likely to contract.

Profits?

And is there margin? It's hard to say from RESI's profit & loss statement, for as I've written before, the entirety of RESI's earnings, as well as 80% of its revenues, come from a model. That is, they are made up and not real. Those earnings are the same as a home builder recording profits as he builds the home and not when he sells it. They're the same as General Motors recording earnings on cars as they move down the production line and not when it sells them.

Plus it gets even worse. RESI books these "profits" as it moves the loans it bought towards a "Broker Price Opinion" that's based on an exterior appraisal. This means the broker values the property just by considering its outside appearance (and location, etc). Now remember, these are deeply non-performing loans on rather cheap and old homes. There will be cases where the copper has been stripped out, there will be lack of maintenance, there will be mold, there will even be meth some times. Put simply, an exterior opinion seems highly insufficient.

The effects of these failings, however, are mitigated by the fact that we only know the values of the properties sold, which could easily mean an average of the properties which were "sellable". This is an effect similar to Sears (NASDAQ:SHLD), where people generalize the values of the properties Sears sells to its entire store base. Such is wrong because Sears is selling those properties for which there is demand - sometimes, it's very best properties, unrepresentative of the rest. The same effect might well be taking place with RESI.

So there you have it

One of the best performers in the entire market, AAMC, and another solid performer, RESI, have their entire extreme value predicated on a model which produces profits before there are any profits. And the entire thing is further supported on a fallacy where each stock is considered on its own, instead of adding the market capitalizations of both and comparing it to the value produced by RESI's business.

The end result is a pool of money in a competitive industry being valued at 5.5 times book value and also trading on a multiple of imaginary model-derived earnings.

Conclusion

RESI and AAMC are trading at a much higher valuation than it looks, due to the fallacy of not adding the market capitalizations of the two stocks when considering the valuation of RESI.

Furthermore, the business RESI and AAMC act in is much more doubtful than it looks. RESI's earnings come entirely from a model and some of the inputs on that model are very doubtful (BPO's based on exterior appraisals).

Finally, counteracting all these negatives we have the story where this company buys NPLs "on the cheap" and then can sell the resulting real estate into a rising real estate market. For now, this story might well win against reality, even though foreclosures are falling quickly and this means more competition to buy a smaller pool of NPLs.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in RESI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.