Analysis of Recent Financial Services IPO Clayton Holdings (CLAY)

Apr.17.06 | About: Clayton Holdings, (CLAY)

Clayton Holdings, Inc. (CLAY) was structured by TA Associates in 2004 as a roll-up of 3 separate companies: Clayton Services, First Madison, and CFIS. TA Associates laid debt onto the company to not only complete the acquisitions but also give themselves a payout. Post-offering CLAY will be carrying around a bit of debt, $114 million. Post-offering TA Associates will own 46% of CLAY.

From the S-1:

We provide a full suite of outsourced services, mortgage-related analytics and specialized consulting services for buyers and sellers of, and investors in, mortgage-related loans and securities and other debt instruments. Our services include transaction management, which consists of due diligence, mortgage processing services for buyers of mortgage loans (conduit support services), professional staffing, and compliance products and services, as well as monitoring of mortgage-backed securities (credit risk management and surveillance), and specialized loan servicing services (special servicing).

CLAY believes its entities founded the non-conforming loan expertise market 15 years ago.

Essentially CLAY provides mortgage loan and mortgage backed securities expertise with focus being analytics/ consulting/ outsourcing. Most of CLAY's services are provided to participants in the non-agency segment of the mortgage backed securities (MBS) market and the non-conforming mortgage loan market.

Non-agency MBS are comprised primarily of mortgage loans that do not conform to the underwriting guidelines of Ginnie Mae, Fannie Mae or Freddie Mac. This catagory of loans/ securitizations has exploded this decade. Securitization rates for non-conforming mortgage loans have increased from 34.6% in 2000 to 60.1% in 2005. Growth in this class of securities has exploded, so has the demand for specialization in this arena.

Due diligence (analysis) on closed non-conforming loans is the leading revenue driver here. CLAY's business can appear a bit complicated, however CLAY is essentially an offering whose primary business is due diligence with the rest of their services stemming from there. With the heavy growth in these type of loans, expertise in this area has been in strong demand.

Customers of CLAY's services include capital markets firms, banks and lending institutions, MBS issuers/ dealers, mortgage and bond insurance companies and fixed income investors. CLAY's parts have been providing these services for 15 years now and CLAY believes they are the leading player in all of their service areas. During 2005, CLAY performed detailed analysis on over 930,000 loans totaling over $175.0 billion in principal value, which represented 9.0% of the total principal balance of U.S. non-conforming mortgage loan originations over such period. As of December 31, 2005, CLAY was monitoring over $308.0 billion in loans underlying MBS, which represented 19.4% of the total outstanding U.S. non-agency MBS at such date.

CLAY makes the point numerous times that their products and services cover the entire lifecycle of non-conforming mortgage loans.

The 3 largest clients Bear Stearns, Lehman Brothers and Morgan Stanley accounted for approximately 33% of 2005 revenue. With due diligence being the revenue driver here, the fact that the largest players in the sector rely on CLAY for analysis of non-conforming mortgage backed securities products is a testament to CLAY's expertise in this arena. A very good sign.


After paying down $36 million in debt on offering, CLAY post-offering will be carrying approximately $114 million in debt. This is not at a level that will impede operations but debt servicing did eat up roughly 30% of operating earnings in 2005. I would expect CLAY to continue to look for acquisitions and don't see debt levels dropping significantly in the mid-term.

Since the formation in 2004, CLAY has experienced 5 straight sequential quarterly revenue increases booking strongest revenue quarter in 12/05.

Due to CLAY's recent formation combining 3 existing entities revenue data is not comparable going backward. It appears CLAY has enjoyed strong organic growth the past few years though as their niche has seen tremendous growth. In 2005 CLAY booked $207.5 in top-line revenue. Gross profit came in at 65%. Operating expenses appear well contained even with relatively high amortization expenses resulting from the 3 company roll-up. Operating expenses came in at 25% in 2005.

Factoring in debt-servicing on the $114 million post-offering debt and folding out one-time charges, net margins for 2005 came in at 4%. Earnings per share came in at 45 cents putting CLAY's trailing PE of 36 at a mid-range pricing.

Going forward into 2006, CLAY's results will depend on the continued strength of the non-conforming mortgage loan market. I think this is an area in which we need to forecast quite a bit more muted growth in 2006 than we've seen past 2- 3 years. This type of mortgage loans (and subsequent MBS securitizations) have seen their strongest period in at least the past 20+ years. I feel a little uneasy simply assuming this sector will continue to boom in the face of rising shorter term rates, of which many ARM mortgages are based. Plus one can run into quite a bit of trouble assuming a strong cyclical market will continue at record high levels.

Amortization/ debt servicing are really impacting CLAY's net margins and that isn't going to change anytime in the near future. I think these factors coupled with the probable unsustainability of recent strong growth will keep CLAY from really being able to grow the bottom line substantially in 2006. CLAY is a fairly difficult offering to project for 2006 because they are also really the only public pure-play in their sector. I think we can be safe in assuming a 10-15% top-line growth rate here for '06.

Along with that growth I think CLAY may be able to bump net margins to the 5-6% levels as well. If both come to pass I would expect CLAY to earn approximately 70-75 cents in 2006. If the housing market remains strong in '06 this number could prove to be low, conversely if the housing market sees a precipitous drop-off this 70-75 cent number could prove to be aggressive.

At 70-75 cents earnings in '06 CLAY would be coming public mid-range at 22 X's 2006 earnings. Due to the factors mentioned above I've a little less confidence in this projection than usual. I wouldn't be shocked to see any '06 number from 40 cents to $1, although to see that high end revenue would really need to ramp in 2006. CLAY simply has too large an amortization/ debt service number to easily grow the bottom line without a substantial increase in revenue.

A slowdown in the housing market, particularly the higher risk mortgage loan market. This is a very real risk and one reason to be cautious paying up too much for CLAY. There is a chance here that CLAY is coming public right at a sector peak for its market. Sector peaks are always easy to see in hindsight, very difficult at the time though. CLAY's focus is on the segment of mortgage loans that have benefited the most from the low interest rates and home price appreciation. It would be a reasonable assumption that CLAY's targeted niche would also be the area of the home mortgage market to be most affected from a slowdown.

Also the recent resignation of founder and President, Stephen M. Lamando, effective December 31, 2005, may impact the business going forward. Mr. Lamando will continue to serve on the Board of Directors so this looks more like a normal retirement than anything else. Still worth mentioning.

Expertise type IPOs tend to do rather well overall through good and bad markets alike. The one thing to be wary of here is the possibility CLAY is IPOing right at the peak of its niche. Also keep in mind that CLAY's top customers are the leading houses on 'the street'. Often when this is the case with an IPO, price will tend to move well ahead of numbers. CLAY's customers will know if business is continuing strong well ahead of CLAY's reports. Stock price here could very well be a leading indicator of CLAY's underlying future business strength. This has often been the case when investment banking houses are leading clients: MKTX was sold off for months ahead of the company taking down numbers and conversely CME priced/ opened strong a few years back and was able to sustain a bid in a tough market environment forecasting correctly very strong underlying trends for CME.

I do think CLAY offers pretty solid risk/ reward in range. I tend to like niche/ sector leaders in growth arenas and CLAY fits that bill to a 'T'. I wouldn't pay up here substantially though due to 1) the amortization/ debt service drag on margins and 2) the possibility of this IPO coming right at a sector peak. However CLAY is a leader in what has been a strong growing niche which makes it worth the risk in range and $1-$2 above. I've no real good feel for how this will do initially in the aftermarket, but I will be looking to enter on a reasonable open with of course a stop-out on pricing break. This is definitely one in which to follow the lead of CLAY's client base -- if the likes of Bear Stearns/ Morgan Stanley/ Lehman Brothers accumulate this stock it could be a good mid-longer term play, if there is continued supply here on any blip up than be very very careful.