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  • Shorting Palo Alto Networks, Inc. (PANW) ($52) - Part 1

    Palo Alto Networks, Inc. (Short @ 54 with 1-year target of 20)

    November 9th, 2012

    Palo Alto Networks, Inc. (NYSE:PANW) is a newly-public enterprise network security company which is highly overvalued given its highly competitive market, revenue opacity, and excessive insider selling (the latter being the catalyst for this thesis). The market believes PANW's platform is revolutionary in a growing industry- I believe that the network security business is a highly competitive industry and that PANW has little pricing power. Insiders seem to know this and seem desperate, hence a secondary offering of year's revenue less than four months after ipo.

    • Corporate internet security is a highly competitive market that is not growing as quickly as before and is forced to underprice its largest competitor to gain market share. From PANW's own prospectus, its market (defined as "Network Security market and Web Security[ii]) is expected to grow from $10B in 2012 to $13.4B in 2016 - that's only 7.59% per annum vs. 11.6% from 2009 to 2010[iii]. Earlier forecasts of 2012-2016 were more optimistic as well, as the market has been lowering expectations
      • Despite a next-generation product, PANW's gross margins are lower than CHKP, its main competitor. Check Point Software Technologies Ltd., the leader in the firewall and UTM (Unified Threat Management) market, the main focus of PANW, has gross margins of 87.6% vs. 72.3%. At a high level, this means that PANW is underpricing CHKP to gain customers.
      • Fundamentally, network security is a tail risk market and is therefore underpriced. Like seat belts, internet security is usually a time-waste/drain unless an actual attack/error happens. It is one of those cases where successes are unknown but failures (breaches) can make headlines (e.g. Google servers attacked[iv])
      • Internet firewalls and network security face price competition due to mass availability of free-mium model. Free personal firewalls are a dime-a-dozen (see free Avast, Zonealarm), and so only very complex/large corporations require the added power of PANW and are willing to pay for it.

    [i] Prospectus pursuant to Rule 424(b)(4), October 17, 2012, page 9. www.sec.gov/Archives/edgar/data/1327567/...

    [ii] Prospectus pursuant to Rule 424(b)(4), October 17, 2012, page 2

    [iii] www.websense.com/assets/white-papers/IDC...

    [iv] www.nytimes.com/2010/01/13/world/asia/13...

    Disclosure: I am short PANW.

    Nov 13 3:52 PM | Link | Comment!
  • The Next Opportunity In Mortgage Servicing Rights (HLSS, ASPS, OCN)

    Summary (Recommendation: Buy with 1-year target of $40)

    Home Loan Servicing Solutions, Ltd. (NASDAQ: HLSS) is the next iteration of the unique opportunity in mortgage servicing rights. The second spinoff from Ocwen since 2009, HLSS is an income vehicle that holds non-agency/non-prime mortgage servicing rights bought by Ocwen Financial, the largest subprime servicer in the United States. After a 1000% 3-year return in his previous spinoff (NASDAQ:ASPS), I believe that William Erbey, the Chairman of both companies will replicate this success with HLSS as a dividend growth/income vehicle to directly hold new mortgage servicing rights that Ocwen acquires/holds. To review:

    • Mortgage servicing rights are cheap because regulation and political risk have forced noneconomic selling and less competition. New capital requirements from Basel 3 limit the amount of mortgage servicing rights can make up 10% of Tier 1 capital, compared to 100% previously[1].
      • As a result, HLSS gets business (from Ocwen) because banks and other financial institutions are forced sellers. Ocwen bought servicers from Goldman Sachs and other institutions because of the political/legal liability, as evidenced by the multibillion-dollar mortgage settlement in February of this year.[2]
    • At the same time, market conditions in credit and prepayments make such non-agency (e.g. subprime/alt-a) rights very valuable. Non-agency mortgage servicing rights are more valuable with low credit losses (specialization of OCN) and hurt by prepayments. Both are moving in favorable directions.
      • Foreclosures are down, and through ASPS, the technology services firm and other spin-off from OCN, HLSS has access to the one of the top platforms in the industry (as shown by consistent profitability and 20% operating margins/return on assets of ASPS). This has limited credit losses, which from Ocwen has shown a reduction in delinquency from 28% in 2010 to the lowest level in years at 21% in 2012. Macro data from Case-Shiller supports this view.
      • Prepayments are down. In Q3 investor presentation, HLSS notes that prepayment speeds slowed from 15.2% to 12.6%[5]. Because the company invests in non-agency mortgage servicing rights, it is not as affected by interest rate movements. In any case, rates have been low for so long that we believe any refinancing will not be as vigorous as previous rate decreases.
    • HLSS is in a prime position to exploit such a dynamic and based our calculations, is valued at only ~7.6x 2013 forward earnings. With the Homeward acquisition earlier this month, UPBs (unpaid principal balances that are serviced by the rights) that HLSS may hold ultimately triples, from $47B to $124$B -$167B (47 + 77-120)[6]. We feel this trend may continue, with the optionality of a possible Rescap purchase.
      • Ocwen continues to successfully bid for loan portfolios. It grew serviced unpaid principal balances (UPBs) $41.3B in 2011 and $34.2B in the first 6 months in 2012[7]. Annualized, that is a 50% growth that has been partially reflected in revenue/earnings. Last Q In particular, the last $10B of wins was only in June, meaning increased earnings have yet to be shown much on earnings.
      • Even without operating leverage, we believe a 100%+ increase in UPBs will flow to 100%+ increase in net income, meaning the annualized 0.37$[8] (minus 0.03$ in nonrecurring earnings) = 4*0.33*(1+100%) = 2.64$ eps next year (2013). This means at the current price of ~$20, HLSS trades at 20/2.64 = ~7.6x next year earnings.
      • HLSS current trades at 25x ttm earnings, which is somewhat understated because of earlier losses (company only started in March of this year). Annualizing this quarter's net income, we get ~15x normalized earnings multiple. At this current (market) multiple, a doubling of eps can double the stock, leading to the rough target of 20*2 = 40.
    • Finally, consistently profitable outright insider buying by Chairman Erbey. After directly buying $10mm at the offering price, Erbey bought more shares at the $15 level in August just before the prior run. The chairman of this company is so confident and eager that he is outright buying shares just months after buying $10mm in the ipo, i.e. the most knowledgeable insider is so aggressive that he is averaging up even after owning 5%[9] of the company.

    Catalyst

    Continuing wins from Ocwen (including Rescap optionality)

    Continuing revenue and eps growth

    Risks

    Unexpected slowdown in Ocwen's portfolio growth

    Change in relationship between Ocwen and HLSS (unlikely, as Erbey is the largest shareholder of both).

    Implementation

    Average into a position in the next week or two, as the stock remains volatile/illiquid day to day.

    *Disclosure: we hold a sizable long position in HLSS, ASPS.

    Regards,

    Stanley


    [1] www.jdsupra.com/legalnews/proposed-basel.../

    [2] www.nytimes.com/2012/02/09/business/stat...

    [3] www.realtytrac.com/images/affiliates/For...

    [4] HLSS Q2 investor presentation, ir.hlss.com/events.cfm

    [5] HLSS Q3 investor presentation ir.hlss.com/events.cfm

    [6] ir.hlss.com/releasedetail.cfm?ReleaseID=...

    [7] OCN 2012Q2 10Q, page 29

    [8]ir.hlss.com/releasedetail.cfm?ReleaseID=...

    [9] HLSS S-1 (August 2012) p136

    Disclosure: I am long HLSS, ASPS.

    Tags: HLSS, ASPS, OCN
    Oct 25 7:34 AM | Link | 2 Comments
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