By Brett Horn
CoreLogic's (CLGX) undervalued shares offer two different routes to investor gain, in our opinion--through a buyout, or through market recognition of the company's value.
CoreLogic provides data, analytical tools, and processing services for the mortgage industry. While we knew 2011 would be a tough year for the firm as the tailwind from the refinancing boom recedes and mortgage origination remains weak, it has been even tougher than we expected--even the company's default business is struggling. The company's origination and default businesses typically work against each other, but government interference has caused the firm's default business to decline before origination volume could pick up.
In August, when CoreLogic substantially lowered its outlook for the year, the stock imploded. While the third quarter was much more positive and the stock has risen materially, we still think the shares are undervalued. Investors looking at the shares today have two ways to win, in our view: either through a sale of the company or a long-term convergence to fair value. While we're skeptical that the company could achieve our fair value estimate of $21 per share in a buyout, this route would result in a quick out for investors. If the buyout discussions come to nothing, then long-term investors can wait for the market to recognize CoreLogic's fair value.
In the Long Term
CoreLogic is a solid business from a long-term perspective, in our opinion. While smaller than peer Lender Processing Services (LPS), CoreLogic is a leader in certain areas and a solid number two overall. We think it has sufficient size to leverage its fixed costs and produce excess returns. As the company sells noncore businesses, it will become more centered on the fundamentally attractive and moaty data business.
While 2011 has been weaker than expected, we think the default business won't necessarily follow a straight path down, and the weakness in 2011 is a deferral of revenue, not a loss. While new foreclosures are likely to remain low until the banks and the state attorneys general work out a deal, and the timing of that deal is difficult to predict, this does nothing to change the condition of seriously delinquent but not-yet-foreclosed-upon borrowers. Therefore, we think it is likely that we will see a spurt of foreclosure activity once the legal issues are worked out.
Still, the long-term trend for the default business is definitely down, as the volume of distressed mortgages remains well above normal. While we believe that the robo-signing controversy has temporarily accelerated what otherwise might have been a smooth glide down for the default business, in the long term, this business must ultimately fall off materially.
Mortgage originations remain weak, and the possibility of a substantial near-term improvement is low, but long-term volume should start to normalize. Home sales have been depressed since the housing bubble burst and have shown no sign of improvement since, absent some temporary spikes due to government programs designed to spur sales. While we don't expect a quick recovery, house sales are below levels reached even before the housing bubble and should ultimately improve.
Even if industry conditions don't improve, the company's restructuring efforts should boost profitability. In addition to selling the bulk of its nonmortgage businesses, the company has undertaken cost restructuring efforts. It initiated a head count reduction this year, which management estimates will save $30 million annually (with only $20 million of those savings appearing in 2011). Additionally, CoreLogic believes it can substantially lower its IT costs by closing redundant data centers and rationalizing end-user testing. Management estimates it can save $50 million annually through these efforts, with those savings developing over a two-year period. With the release of its third-quarter results, the company raised its target for cost savings through these actions to $80 million-$100 million. Therefore, we think it's likely that the company can achieve substantial bottom-line improvement before the mortgage market normalizes.
In the Short Term
Shortly after releasing second-quarter results, CoreLogic announced it was exploring strategic alternatives because of pressure from a large shareholder. Then in late August, the company announced that it had retained investment bank Greenhill (GHL) to look at ways to enhance shareholder value. We think the only new option placed on the table then was a potential sale of the company.
CEO Anand Nallathambi says he and the board agree that the current market price dramatically undervalues the business, and that this view is the driver behind the board's willingness to look at strategic alternatives. So far, management has been excluded from the buyout discussions. We think management is not a willing seller at this point, as it doesn't believe it can achieve a fair value in this environment. We don't see any obvious strategic buyers, but we could see management accepting an offer below our fair value estimate if an opportunistic buyer appeared.
Still, CoreLogic is not a forced seller, and a look at comparable market valuations suggests a reasonable buyout price could be at a premium to the current stock price, even after the recent rise. CoreLogic is still profitable, holds a substantial cash balance, and is not in imminent danger of violating its covenants. As a result, we don't think it is under pressure to sell at a price the board would find less than adequate. There has been speculation that several potential buyers are looking at CoreLogic, with most being private equity firms. If this is true, then it would lend some support to the idea that CoreLogic could realize a price above the current market price.
What Could Go Wrong
The main risks are more negative surprises in the near term, legal risks, or a sale at a distressed price. Given the state of the mortgage market, further bad news cannot be ruled out, and the default business could continue to fall off more quickly than the origination business can improve. Additionally, the company does face some legal uncertainty. The FDIC recently filed a lawsuit against CoreLogic and Lender Processing Services over appraisals done for Washington Mutual. While we think CoreLogic has reasonable defenses and this lawsuit itself is not a major threat (the damages claimed only equal a little more than $1 per share), it could lead to problems if the lawsuit were successful and encouraged others to file similar claims. On the other hand, the fact that no bank has brought charges on its own behalf argues against this being a widespread issue. Finally, we're skeptical that the company can realize a fair value for its business in this environment. A sale for all or parts of the business below fair value cannot be ruled out, although new investors shouldn't be too concerned on this front, as even a sale below fair value would probably result in a quick return.