On August 29th, 2011, CoreLogic's (CLGX) board announced it had "formed a committee of independent directors to explore a wide range of options aimed at enhancing shareholder value including, but not limited to, cost savings initiatives, an evaluation of the Company's capital structure, possible repurchases of debt and common stock, the potential disposition of business lines, the potential sale or business combination of the Company and other alternatives." The stock reacted favorably, rising 27% on hopes the company would be sold. Amazingly, investors who got crushed in the stock threw their support behind the sale of the company in a press release that was written, vetted, and published just 2.5 hours after CLGX's public announcement. After analyzing the situation, I believe a sale is highly unlikely at current prices and as a result, the shares could face significant pressure. My conclusion, supported below, is based on three assessments:
- CoreLogic's definition of EBITDA wildly overstates how a potential buyer would view EBITDA. Typically, EBITDA is a proxy for cash flow. CLGX's definition of EBITDA is very different than most. The company's cash flow, and a more reasonable definition of EBITDA, support a stock price materially lower than today's promoted price. CoreLogic is a rollup of a number of acquisitions and was recently spun out as an independent company. As a result, its financial transparency is very limited. It does not help that CoreLogic has not had a CFO for most of fiscal 2011 and its prior CFO left after receiving an SEC Wells notice citing "certain disclosure matters" at his prior company. Management's definition of "adjusted" EBITDA makes little sense. It appears that investors and analysts have regurgitated management's definition with little scrutiny (despite large creditability issues highlighted below). Unfortunately for current shareholders, potential acquirers are unlikely to blindly accept management's "adjustments."
- CoreLogic faces an unquantifiable, and potentially significant, legal liability that will make it unattractive to a potential buyer. In a worst case scenario, the open ended risk could cripple the company. This is an area that has not been a focus for investors (not one question on the second quarter 2011 conference call) but I expect to be a huge sticking point that will likely scare any potential suitor away.
- I attempted to analyze EBITDA through the eyes of an acquirer, which was an exercise that I encourage all investors to perform. The implications for defining EBITDA correctly are significant and extend beyond suggesting the company is overvalued. If debt investors agree with my interpretation of EBITDA, then the company could be in violation of its debt covenants.
I believe CLGX is highly overvalued and unlikely to find a buyer at, or near, current prices. Based on cash flow and a more reasonable expectation of EBITDA, I estimate the shares are worth roughly $5.00 per share, which is where the price appeared to be headed prior to the boilerplate announcement. As a result, current investors could face greater than 50% downside.
CoreLogic was spun-out of a title insurance company First American (FAF) in June 2010. According to SNL, FAF completed 15 to 20 "financial technology" acquisitions and investments between September 2004 and June 2009. The cobbled up businesses were lumped together to form CoreLogic. It is my understanding that roughly 80%-85% of the company's revenues are tied to the U.S. housing market (around 55% origination activity and 20%-25% for default services). CoreLogic has two reporting segments: Business & Information Services and Data & Analytics. The Business & Information Services business is a slow growth, highly cyclical, people intensive, lower margin business. One could argue that this business has "over-earned" the past several years driven by the housing market, low rates, government programs and the foreclosure boom (that recently stalled). The Data & Analytics business is still a relatively slow growth business but has a better margin profile (although I believe the margin is overstated--see below). This segment also includes highly cyclical and low multiple business lines including property valuation services, automated valuation, appraisal review, the MLS data product, and the credit reports business.
Below are CoreLogic's products as defined in their 10k. Based on the descriptions provided, it appears to confirm that housing related products (with customers such as mortgage originators, mortgage lenders, mortgage servicers, real estate agents, and property managers) make up the strong majority of the business.
Business and Information Services
Main User Based on Description
Tax services - property tax data
Flood data services
Mortgage lenders / servicers
National JVs (appraisals & services to loan originators)
Loss mitigation services
Real Estate Owned (“REO”) asset management
Mortgage lenders / servicers
Mortgage lenders / servicers
Mortgage lenders / servicers
Broker price opinions (“BPOs”)
Mortgage lenders / servicers
Field services (property preservation)
Data and Analytics
Property valuation analytics and services
Mortgage lenders / servicers
Data and information
Mortgage lenders / servicers
Fraud detection analytics and services
Other predictive analytics and MBS analytics
Tenancy, data and analytics products (Multifamily)
Mortgage lenders / property managers
Under-banked credit services
Payday and credit card lenders
Mortgage & Auto lenders
Realtor solutions (Multiple Listing Services (“MLS”)
Real estate agents
The board's "review of alternatives" is most likely in reaction to the weak second quarter 2011 earnings and a scary reduction in their earnings guidance. Despite holding its 2011 "adjusted" revenue guidance (it went from $1.55 billion-$1.65 billion to $1.575 billion-$1.625 billion), management dramatically lowered its "adjusted" EBITDA guidance from $335 million-$365 million to $260 million-$280 million and "adjusted" EPS from $1.05-$1.10 to $0.60-$0.65. Management was unable to succinctly explain the dramatic decline in profitability. As a result, the share price collapsed.
Management and the board's creditability came into serious question following the second quarter results and outlook. The company had just issued $857 million of new debt in the quarter, including $400 million of senior notes on May 16, 2011, just months before the stunning collapse. Just as surprising is the use of some of the debt proceeds to repurchase a startling $161.4 million of stock in the second quarter (despite the weakness in the business). Year-to-date, CoreLogic repurchased $176.5 million of stock at an average price of $18.55. I wonder why they would have been so irresponsible as stewards of capital. Given the reaction from debt investors on CoreLogic's conference call on August 5th, 2011. I would not be surprised if the board is attempting to avoid security class action lawsuits from shareholders and debt holders. A far more ominous conclusion would be that the board sees the potential litigation risk, the deteriorating business fundamentals and questionable financial disclosures and is hoping to find an unsophisticated (or dumb) "white knight" to bail them out.
EBITDA Significantly Overstated?
CoreLogic's valuation by sellside analysts is based on a sum-of-the parts EBITDA analysis. Any financial analysis is only as good as the inputs, and I believe many investors and analysts are erroneously calculating EBITDA. I believe management's definition of EBITDA will differ dramatically from how any presumably sophisticated acquirer will view EBITDA. In CoreLogic's case, EBITDA differs wildly from cash flow, making it a red herring. Management's numerous "adjustments" to EBITDA are difficult to decipher, deconstruct and explain. The dramatic difference between management's adjusted EPS and adjusted EBITDA should be an initial red flag (as it is slightly harder to adjust things away in EPS). For example, CLGX currently trades at 19x its 2011 consensus estimate (which is still an "adjusted" / overstated number) and 6.5x its 2011 consensus adjusted EBITDA estimate. It is important to highlight that I believe BOTH are overstated, but EBITDA more so. Taking a step back, there are no major one-time items in the second quarter 2011 above the "income from operations" line (so before interest expense and investment gains and losses). However, CLGX's adjustments magically converts $4.6 million of "income from operations" into $61.1 million of Adjusted EBITDA.
As I stated above, CoreLogic is a rollup of a number of acquisitions and was recently spun out as an independent company. As a result, its financial transparency is very limited. The unexpected turnover in the CFO position has added to the limited visibility into the earnings model. In February 2011, CoreLogic's CFO Anthony Piszel received a "Wells notice" from the SEC, indicating the SEC staff intended to recommend that it file civil charges against him. According to CoreLogic, the charges are "in connection with certain disclosure matters during Piszel’s tenure at his previous employer Freddie Mac." Piszel was the CFO of Freddie Mac from to the day it was taken over by federal regulators. This dramatic departure, in combination with the handling of guidance, debt issuance and share buyback (funded by leveraging up the company) has significantly strained management's creditability. In another potential hit to creditability, a Bloomberg article suggests that "very suspicious" options activity took place minutes before the board's announcement on August 29th. The article seems to imply that the suspicious trading could be related to leaked information or insider trading.
I am surprised that investors and analysts simply regurgitate management's definition of "adjusted" EBITDA despite management's creditability issues and the old CFO's previous indiscretions (he was presumably the architect of CLGX's "adjusted" calculation). Management's definition of "adjusted" EBITDA makes little sense to me. I believe any potential acquirer will come to the same conclusion. Below I highlight why some of the adjustments are nonsensical and will later provide in my opinion a much more relevant EBITDA estimation:
- Add back of joint venture and equity in earnings of affiliates. CoreLogic adds back the EBITDA related to joint venture and equity in earnings of affiliates. Between 20%-25% of year-to-date earnings and 15%-20% of "adjusted" EBITDA add backs have come from the "equity in earnings of affiliates" line (a VERY material amount). CoreLogic provides limited disclosure on their joint ventures (there is no disclosure in the 10k for the number of JVs, their size, or the names of the businesses). However, the "appraisal business within our joint ventures" was one of the contributing factors for the weak outlook. In the 10k, the "National Joint Venture" business is defined as: "several joint ventures that provide products used in connection with loan originations, including title insurance, appraisal services and other settlement services. These joint ventures are reflected as investments in affiliates on our consolidated balance sheets and our share of the income is reflected as equity in earnings of affiliates in our consolidated statement of operations." In their "adjusted" EBITDA, management adds back 100% of the EBITDA related to their JVs as a revenue item without any associated costs. Not only is this an unusual way to adjust for this item (I cannot recall another company that adjusts EBITDA for JVs) but it also materially distorts the margin profile of the business. Based on revenue disclosures from one of the JVs, I estimate CLGX's overstated their adjusted EBITDA margin by 250 basis points in the first half of 2011. If these are in fact appraisal businesses, they are extremely low margin businesses, but CLGX is flowing it through at nearly 100% margin. A potential acquirer is going to evaluate each JV on its own merit and value them accordingly. If "appraisal" businesses make up the majority of these joint ventures, I would assign very little value to this segment of CLGX's earnings stream.
- Capitalized database costs. In reviewing sell side analyst research, most analysts appear to view CLGX's database management business as its most attractive based on the high margins and strong "cash flow." However, the high margins and cash flow are very deceiving and I believe ephemeral. CLGX capitalizes the cash investment in their database business. This asset is then amortized through the income statement and added back (so completely ignored) in EBITDA. As a result, even GAAP EBITDA is a highly unreliable measuring stick for the business. For example, in 2010 CLGX spent $24.8 million of cash for the "purchase of capitalized data" and recognized $17.7mm of amortization expense related to the database on the income statement. Since investors are currently evaluating CLGX on EBITDA, the cost of this "investment" never hits the P&L. These databases (for example eviction, court or criminal records) would not be very useful without updated information. As such, these expenses are ongoing, and should not be viewed as one-time, non-cash, or subject to exclusion. However, the amortization expense is added back to EBITDA and completely ignored. As a result, analyst models for CLGX's supposedly "highest multiple business" are overstated. In one model I reviewed (Barclay's), the "Risk and Fraud" EBITDA estimate would be 20% lower after adjusting for this cash item. This adjustment, along with the analyst's suggested high single digit / low double digit suggested multiple, would knock $200 million to $300 million off the analyst's valuation, or up to 25% of the company's market cap! This treatment is one of the factors driving the huge delta between adjusted EBITDA and cash flow (see below for more detail). Not surprisingly, CLGX continues to focus on acquisitions in this area, including their largest recent acquisition, RP Data in May 2011 (which accounts for the increase in the "net capitalized data and database costs" on the balance sheet below). If management can continue to acquire database businesses and have arguably its most important expense ignored by investors, I guess I cannot blame them for trying to continue this strategy. This works as long as investors are complacent and fail to scrutinize the numbers. Unfortunately for current shareholders, potential acquirers are unlikely to blindly accept management's "adjustments."
Less accumulated amortization
Net capitalized data and database costs
Cash for purchase of capitalized data
****this amortization expense relates only to capitalized data and database development costs
- Other adjustments. Even after reviewing the 28-page 2Q financial release (pdf), the 48-page 2Q slide presentation, the 60-page 10q, it is very difficult to reconcile "adjusted" earnings (maybe this is why investors do not scrutinize the figures and give management the benefit of the doubt). For example, in the fourth quarter, management announced that it planned to add back $20 million of "infrastructure / IT" spending in 2011 in the adjusted results. The second quarter "adjustment" add backs included a $3.7 million pretax for "restructuring related severance and retention expenses" (adding back employee retention costs!?), a $7.5 million add back for "non-capitalized efficiency investments" (HUHH!!!!!!) and $4.7 million for "litigation settlements and acquisition related professional fees." I am not sure what the most questionable "one-time expense" is, but I can make strong arguments that acquisition costs for a rollup is a cost of doing business and that litigation expense will be an ongoing cost as well (see below for details).
The adjustments are not the only unusual items in the financials. For example, pretax earnings have benefited by $10.4 million in the first half 2011 as the company has significantly reduced its allowance for doubtful accounts.
Gross accounts receivable
Allowance for doubtful accounts
Accounts receivable, net
What is clear is that there is a large divergence between free cash flow, GAAP EBITDA and "Adjusted EBITDA." As the table below highlights, the cash flow profile of CLGX is atrocious. According to the company's financials, and adjusting cash flow for the purchase of capitalized data, CLGX generated less than $100 million of free cash flow in 2010 and a paltry $2.6 million in the first half 2011. This means CLGX is currently trading at a 20x free cash flow multiple on what may prove to be a peak earnings year (2010) for the company. Given the lack of cash flow so far this year, the analysis is not particularly valuable (other than to suggest the company is overvalued). Even more surprising, roughly 65% of CLGX's free cash flow in 2010 and over 100% of the year-to-date free cash flow was generated from dividends from JV investments. Management has signaled that their "NJV" business is struggling this year, which suggests its largest cash flow source could be under pressure.
CFO for continuing operations
CFO for discontinued operations
Purchase of Capitalized Data
FCF - continuing operations
Free cash flow - total
Income from operations
GAAP EBITDA margin
Adjusted EBITDA - according mgt
At a very minimum, the company has "disclosure" issues. At worst, management is materially misrepresenting the financial condition of the company and potentially living in the grey area of violating securities law.
Lawsuit Large Overhang
Litigation risk has created large overhangs for many financial stocks in the past year. Investors in CLGX's closest competitor, Lender Processing Services (LPS), have been decimated in part due to mortgage foreclosure and appraisal litigation and investigation risk. LPS's stock is down 40% year-to-date. Bank of America (BAC) has been in a tailspin as its mortgage litigation and mortgage putback risk have sparked widespread fear that it has a large potential hole in their capital base. Investors in JP Morgan have weathered $10.4 billion of litigation expense over the past six quarters. On its second quarter conference call in July, JP Morgan CEO Jamie Dimon stated: “there have been so many flaws in mortgages that it’s been an unmitigated disaster…and
everybody is going to sue everybody else." What is clear is that mortgage related litigation has been far more disastrous than almost anyone could have predicted. I believe litigation risk for CLGX's is just emerging. I believe the unquantifiable and potentially significant legal liability will make it unattractive to a potential buyer and in a worst case scenario, could further cripple the company.
One thing is clear-- there are staggeringly high risks related to mortgage litigation and mortgage putbacks today. Branch Hill Capital, one of the first firms to highlight Bank of America's potential liability, estimates that BAC faces a liability of $22 billion-$27.5 billion. The financial guarantor Assured Guaranty (ticker AGO) has been a vocal advocate for the putback issue. AGO paid significant insurance claims on insured mortgages and has vigorously pursued putbacks on grounds of faulty underwriting. It has experienced some success. In April 2011, AGO settled with Bank of America for $1.6 billion related to mortgage backed securities and rep and warranty claims. Bank of America is not an isolated case. Assured has specifically mentioned at least four other financial institutions for which it is pursuing large settlements. On its second quarter conference call, AGO's management highlighted its claims against Credit Suisse:
"Using Credit Suisse as an example of a counter party who has not been living up to its contractual commitment to repurchase defective mortgage loans, we’ve reviewed files for approximately $1.9 billion of mortgage loans on Credit Suisse deals, and found that 93% or $1.8 billion contained breeches of reps and warranties…We count 18 pending RMBS-related lawsuits against Credit Suisse by the Federal Home Loan banks, Monoline insurers, and other RMBS holders…Sadly, the situation with Credit Suisse is not unique, and we note similar behavior in not fulfilling contractual obligations among the other rep and warranty providers like UBS, JPMorgan, and Deutsche Bank. And I expect to release similar statistics regarding these counter parties in my upcoming presentations."
On the same call, Assured Guaranty’s management commented on defective mortgages, stating: "we continue to find significant breaches in a large percentage of loan files, which include misrepresented income, appraised value, employment as well as the occupancy status of the borrower." According to AGO's management, over 50% of their rep and warranty claims relating to high severity losses were do to appraisal deficiencies (I do not have a linked document source for this comment, I suggest readers verify with management themselves as this is a key point).
As monoline insurers, the GSEs, private label mortgage security holders, and the Federal Home Loan banks continue to pursue legal remedies against mortgage underwriters, I believe it is only a matter of time before the underwriters go after appraisals for their portion of the liability. According to Appraiser Law Blog,
representations and warranties were freely made by appraisers to secure lender business during the real estate bubble, which leaves appraisal firms highly exposed today. In fact, I have obtained sworn testimony from the former CEO of CoreLogic's eAppraisalIT (“EA”) business where he states: "I should mention we warrant and rep every appraisal for fraud and gross negligence." According to Appraiser Law Blog
: "We will see a few lenders sue AMCs to enforce appraisal “warranties” which obligate the AMCs to pay losses and costs for mortgage repurchases and fother losses blamed on faulty appraisals. If the AMC did not properly evaluate the wording of any representations and warranties given in recently drafted lender contracts, the AMC may find itself liable for liabilities relating to appraisals delivered long ago. In some ca
ses, the liabilities assumed by AMCs are well beyond their financial resources." As one of the largest appraisal and AMCs (Appraisal Management Company) in the United States, CLGX is highly exposed. In a world where "everybody is going to sue everybody else," CLGX could increasingly find themselves in the cross hairs of lawyers.
On May 9th, 2011, a significant shift took place for appraisal liability when the FDIC sued CoreLogic (pdf) (and LPS in a separate case) as the receiver for Washington Mutual. The FDIC is suing for $129 million and alleges that they found "gross negligence" in 194 appraisals out of 259 they sampled. All of the appraisals were performed between 2006 and 2007 in CoreLogic’s eAppraiseIT unit. The suit alleges that "despite the representations and promised EA made to WaMu, at least 194 of the appraisal services EA provided failed to comply with federal and state law, regulatory guidelines, and USPAP. EA used appraisers who lacked the skill, experience, and qualification necessary to perform appraisals requested. EA's "quality control" of the appraisals it provided to the Bank was severely inadequate. Consequently, EA delivered appraisal services in a
gross negligent manner and provided products which contained substantially inflated appraisal values.” Of the "grossly negligent appraisals," the suit alleges violations included "inadequate or improper licensing of appraisers, inadequate research, failure to perform required site visits, lack of support for site valuations, use of appraisers unfamiliar with the relevant geographical area, failure to note information obtained from interested parties, use of improper comparables, unsupported adjustments to comparable, failure to report prior sales, failure to acknowledge a declining market or in-area price variations, and/or tying compensation or employment to appraisal results."
Under the contract between CoreLogic and WaMu, "EA agreed to insure the competency and qualification of its appraisers, to conduct meaningful quality control review of the appraisals, and to police WaMu's loan staff and act as an intermediary between WaMu's loan originators and EA's appraisers. In the EA Agreement, EA specifically promised to inform WaMu of any inappropriate contacts or requests by WaMu employees concerning an appraisal or the assignment of an appraisal. According o the agreement, EA was to act as the "gatekeeper" between WaMu loan staff and the actual appraisers, and EA had a duty to "report any inappropriate contacts or requests by [WaMu] employees concerning an appraisal or assigning an appraisal." The lawsuit includes two examples where the “gross negligence” appeared apparent, including cases that used dubious comparables, made strange adjustments, and a case where the "appraiser cherry-picked the very highest priced comparables rather than five recent sales in the same building."
I urge investors to review the contract between CoreLogic and Washington Mutual (an exhibit to the lawsuit). The contract states, in my opinion, that CoreLogic is culpable if they did not follow the guidelines of the contract. The FDIC appears to agree with my assessment. According to the lawsuit (pdf)
, CoreLogic "contractually guaranteed any damages caused by EA's failure to perform its obligations under the EA Agreement…EA also promised to ensure the qualifications of its appraisers and to stand behind its appraisers…Ensuring such qualifications should have been equally important to EA because EA stood behind those appraisers, as stood behind any subcontractor it hired to perform Services under the EA Agreement, and remained responsible and liable for a subcontractor's compliance with the [EA Agreement] and performance hereunder…EA agreed to indemnity and hold harmless WaMu for loss, damage, claim, or expense arising out of or relating to any claim by WaMu related to the inadequacy of Service, including without limitation, appraisals provided by Supplier pursuant to this Agreement."
The FDIC lawsuit only included a small sample of mortgages, so the damages (and ultimate potential liability) could grow. The "FDIC and its experts have reviewed in depth only 259 of the many thousands of appraisals provided by EA." In fact, the 259 appraisals represent only 0.1% of appraisals EA performed for WaMu. The FDIC found that "less than 3% of the appraisals reviewed, were found to be fully compliant with the applicable professional standards. And "more than 75% of the appraisals reviewed…were found to contain multiple egregious violations of USPAP and applicable industry standards. Those violations constitute a degree of carelessness that rises to the level of gross negligence.”
After reviewing company emails from separate but related case (Cuomo v First American eAppraiselT) that is heading for a jury trial, it appears to me that the FDIC allegations may have merit (although I would like to make it clear that I am not a lawyer). According to a Bloomberg article
: "the Cuomo suit alleges that eAppraiseIT…allowed WaMu loan officers to "handpick" appraisers who submitted high valuations…In one instance, New York investigators said eAppraiseIT lifted the estimate of a property to $2.3 million from $1.6 million after WaMu told the company the loan would close only at the higher figure. The suit disclosed a Feb. 22, 2007, e-mail from eAppraiseIT's then-president…who wrote that the company would "roll over" and submit to WaMu's demands.”
On September 2, 2011, the FHFA, the conservator for Fannie Mae and Freddie Mac, sued 17 large financial institutions for “misrepresenting the quality of mortgage backed securities sold to Fannie Mae and Freddie Mac.” The language from the lawsuits is problematic for appraisal service providers, like CLGX, who provided rep and warranty for their work. Among the 17 defendants are some of CLGX’s largest customers. A common theme in nearly all the lawsuits is negligent appraisals. For examples, below are some of the comments from the Ally Financial / GMAC lawsuit (pdf) (one of CLGX’s largest customers):
“These misrepresentations with respect to reported LTV ratios also demonstrate that the representations in the Registration Statements relating to appraisal practices were false, and that the appraisers, in many instances, furnished appraisals that they understood were inaccurate and that they knew bore no reasonable relationship to the actual value of the underlying properties. Indeed, independent appraisers following proper practices, and providing genuine estimates as to valuation, would not systematically generate appraisals that deviate so significantly (and so consistently upward) from the true values of the appraised properties…The FCIC found that mortgage loan originators throughout the industry pressured appraisers…to issue inflated appraisals that met or exceeded the amounts needed for the subject loans to be approved, regardless of the accuracy of such appraisals...These inflated appraisals resulted in inaccurate LTV ratios...Moreover, upon information and belief, underwriters, including certain of the Fraud Defendants, influenced the appraisals used to determine LTV ratios. Government investigations have uncovered widespread evidence of appraisers being pressured to overvalue properties so more loans could be originated. For instance, several witnesses, ranging from the President of the Appraisal Institute to appraisers and lenders on the ground, confirmed that appraisers felt compelled to come in “at value” -- i.e., at least the amount needed for the loan to be approved -- or face losing future business or their livelihoods. Given the systemic pressure applied to appraisers, upon information and belief, the appraisers themselves, the originators, and the underwriters did not believe that the appraised values of the properties -- and therefore LTV ratios -- were true and accurate at the time they communicated the information to potential.”
If the FHFA’s findings are true, CLGX could face large liabilities. Providing appraisals that are “inaccurate and that they knew bore no reasonable relationship to the actual value” and even “rolling over” “to pressure from loan originators” is likely a violation of federal and state laws (in addition to regulatory guidelines and USPAP), and likely a violation of CLGX’s contracts for reps and warranty. As a result, CLGX could be found liable for negligent appraisals.
The FDIC and FHFA’s lawsuits may open a Pandora's Box. Since May 1, 2011, the FDIC has sued 40 individual appraisers and appraisal firms in addition to CoreLogic and LPS. Importantly, the FDIC is likely providing discovery for the rest of the mark
et. Monoline insurers, the GSEs, private label mortgage security holders, the FHLBs, additional FDIC and even mortgage underwriter lawsuits could follow. Assured Guaranty has specifically mentioned that there are many now defunct underwriters that it has claims against but no assets to go after. I believe vendors to these underwriters, including appraisers, may face legal recourse to these losses.
My belief seems to be supported by a bombshell disclosure in CLGX's latest 10q, "currently, governmental agencies are auditing or investigating certain of our operations. These audits or investigations include inquiries into, among other matters, certain appraisal matters and marketing services." At June 30, 2011, CLGX had $5.8 million "reserved for litigation and regulatory contingency matters." Shockingly, this is down from $8.0 million at March 31, 2011 (a $0.02 per share benefit in the 2Q11 despite adding back $4.7 million of legal settlement and acquisition expenses in adjusted earnings).
To date, this issue has largely been ignored by investors. There was not one question about the FDIC lawsuit on the second quarter conference call. I believe CoreLogic may have represented to investors that the lawsuit and legal risk are not a material concern to them. Bank of America management shared the same initial reaction to the putback issues when they surfaced in October 2010. DJSP Enterprises (ticker DJSP.PK) shared the same initial reaction to the foreclosure processing issues that eventually bankrupted them. I am not in a position to estimate what CoreLogic's potential liability may be, or how expensive it may be to defend themselves. I do feel very confident that it will be materially higher than their $5.8 million litigation reserve. But given the limited cash flow of the company, even a small liability could put the balance sheet in a precarious position. At minimum, I believe the unquantifiable liability will scare potential suitors away from CoreLogic.
Given the extent of the liability and the billions of losses sustained in the housing meltdown, many constituencies will continue to search for culpable parties. As a result, appraisal may not be CoreLogic's only potential legal risk. I would not be surprised if products such as loss mitigation services, REO asset management, default technology, claims management, broker price opinions, property valuation analytics, fraud detection and credit solutions also come under scrutiny. These services make up over 50% of CoreLogic's product offering.
Debt Levels Extremely High Under A More Reasonable EBITDA Calculation
I attempted to calculate my own "adjusted" EBITDA that does not add back JV EBITDA at 100% margin or infrastructure spending, adjusts for the "cash cost of database" and adds back restructuring, acquisition, legal expenses, debt financing fees and excludes investment gains. Again, this is a conservative approach as acquisition and legal are likely ongoing costs of business as are employee retention costs, but we have excluded these costs below:
Restructuring add back
Litigation and acquisition add back
Purchase of capitalized data
New Adjusted EBITDA
Annualized 1H run-rate
Debt to annualized ebitda
Since the midpoint of management's adjusted EBITDA for 2011 is the same as first half 2011 levels, this suggests that my $172 million annualized EBITDA estimate will be relatively close to full year 2011 levels.
Midpoint of full year Adjusted EBITDA
First half adjusted EBITDA
Implied 2H adjusted EBITDA
The recently signed credit facility agreement includes a maximum total leverage ratio of 4.25x with a step down to 4.0x next year and 3.5x in 2013. Based on my analysis above (which is on the net of cash basis not total leverage), CLGX currently has a 4.5x debt to adjusted EBITDA ratio. I do not believe it is unreasonable for CLGX debt holders to be in a position to question whether the company is currently in (or could be in the near future) violation of its debt covenants.
EV / EBITDA
Implied stock price
Based on my analysis of EBITDA, CLGX is currently trading at 11.5x the current first half EBITDA run rate and a similar valuation on a full year basis. At 6.5x times my 2011 EBITDA estimate, CLGX would be trading at $3.27 per share.
A Desperate Move?
I understand why CoreLogic's board would be embarrassed for their repeated missteps since being spun out of First American. The "review of strategic alternatives" reminds me of the recent desperate move by The St. Joe Company's (JOE). In the face of deteriorating fundamentals and questions about potentially overstating their financial position, the homebuilder's board hired Morgan Stanley and: "unanimously decided to explore financial and strategic alternatives to enhance shareholder value. The Board intends to consider the full range of available options including a revised business plan, operating partnerships, joint ventures, strategic alliances, asset sales, strategic acquisitions and a merger or sale of the Company." The day after the announcement in February 2011, the stock opened up at a six month high at $30.23. Nearly seven months later, the shares are languishing 40% lower. CoreLogic's management may not appreciate the scrutiny on the company's financial disclosure and legal risks. Prior to its spin out, CoreLogic's eAppraiselT unit had some history with attempting to silence critics. In one case, it sued a former appraiser who "accused eAppraiselT of demanding that appraisers engage in “unethical” activities and reported that she had received information showing that eAppraiselT tampers with electronic appraisal documents." The injunction to quiet the appraiser was denied by the courts. My analysis above excludes additional risks to CoreLogic's business and overlooks the secular and cyclical declines in the business model. I estimate CoreLogic's top 10 customers make up 35 to 40% of revenue. Given the legal issues facing large banks like Bank of America (BAC), Wells Fargo (WFC), JP Morgan (JPM) and Citigroup (C), there is a movement to insource functions and further control the quality of mortgage origination. This may be why CLGX is losing customers. Also, Basel III bank regulations significantly increases the capital requirements for mortgage servicing assets. Large banks, CoreLogic's largest customers, have just begun to shed mortgage servicing. If this trend continues CoreLogic could see materially lower volumes in its mortgage servicing business lines. In addition, stabilizing the housing market may take many years. Currently, the MBA is forecasting down originations in 2012 despite a shockingly aggressive 67% assumed growth in purchase volumes. And finally, the new Dodd-Frank appraisal rules have just begun to pressure margins.
If I rule out a possible sale of the company, what other options are left? If I break down the options that the company highlighted in the press release, very few appear to create value for shareholders:
- "review cost savings initiatives" Cost savings initiatives has been an ongoing process as evidenced by the recurring / non-recurring restructuring costs and other "non-capitalized" infrastructure spending.
- "evaluation of the Company's capital structure, possible repurchases of debt and common stock" As discussed above, given the company's cash flow profile and extremely high debt to cash flow and "non-adjusted" EBITDA, I think options to repurchase debt are extremely limited. It does appear to be absurd to suggest the company should repurchase debt or common shares a quarter after issuing $857 million of new debt and repurchasing $161 million of stock at significantly higher prices.
- "potential disposition of business lines" This is the most likely option for the company. Management has previously stated that it would like to dispose of the default business or other non-core businesses. I believe there is a very limited universe of potential acquirers for the default business and the potential multiples of this business are extremely low given the cyclicality and regulatory risk. If that is the case, a sale of the default business would be highly dilutive to already fleeting earnings profile of the company. CLGX already trades at a lofty 19x their "adjusted EPS" number that is overstated (in my opinion).
My adjusted EBITDA valuation suggests the company is worth $3.27 per share plus an additional $1.75 for the joint venture investments (8x aftertax run rate earnings before adjusting the figure for the RP Data acquisition--so likely conservative). This suggests a $5.00 fair value stock price, or greater than 50% downside from current levels.
Disclosure: I am short CLGX.