Nationstar (NYSE:NSM) has been a tough investment since I first wrote about the stock earlier this year. Despite having a lot of potential for the future and being a great operator in its space, the stock has bounced up and down between 30 and $35 for much of the year. I'm certainly disappointed that the market remains so pessimistic on the story, but I continue to believe that ultimately the stock will move much higher.
One fundamental tenet underlying the business of major banks today is to outsource all mortgage servicing as fast as possible. Banks want to make loans, but they do not want to service those loans. Doing so just makes them far too much of a target for regulators and politicians either for additional regulation, for new capital raising requirements, or just for political theater. Regulators and politicians understandably do not like this tactic (after all they need someone to attack), but they also can't stop the banks from exiting this line of business. Companies like Nationstar are willing to do this work and they can do it profitably. And as long as these fundamentals continue to hold (and they look iron-clad and permanent right now), then Nationstar will do well.
The bear argument on Nationstar generally comes down to one of two things: there are no barriers to entry in the mortgage servicing business and/or regulators will put new restrictions in place that will hurt these guys too much for the business to be any good. The fact that they two arguments are diametrically opposed (regulations create barriers to entry by making it harder and less attractive for new competitors to enter a market) does not seem to be an issue for pessimists on the stock. That said, I don't think either argument will prove true in the long-run.
Barrier to entry are beginning to develop in the mortgage servicing space as the capital needed for MSRs rises, banks become more picky about their partners (under pressure from regulators), and the need for efficient economies of scale in the business become apparent. Yes, servicing mortgages is a low-margin business, but as long as a firm can keep costs in check, the business can be a natural monopoly (or oligopoly anyway). Put differently, I believe that the marginal cost curve for NSM and a few peers is decreasing or constant for the business through the entirety of the cost curve. Given this, I simply do not put any stock in the bear argument about barriers to entry at all.
Granted, the slowdown in mortgage originations has hurt Nationstar, but that is only a temporary phenomenon. (does anyone really believe that we are permanently stuck at a below peak level of housing purchases? Even with an expanding population? The concept just beggars belief in the long run.) If it were not for the regulatory pressure on banks and the mortgage services, I believe that huge volumes of MSRs would still be flowing to Nationstar and a select few peers.
Speaking of political pressures, the regulatory issues surrounding Nationstar are what is really holding the firm back in my view. The CFPB and the State of NY in particular are causing headaches for NSM and its efforts to force individuals to pay their mortgages. I'm sure that with all of the volume that NSM handles there are a few mistakes that get made, but having looked at the evidence, I believe that regulators are mainly making a mountain out of a molehill here to score political points with the public. Ben Lawsky and the NY DFS are up to the same type of fake pro-consumer witch hunt that they engaged in with the whole force-place insurance issue. (Long-story short for people who don't know about that; people with mortgages are required to have homeowner's insurance for obvious reasons. When people do not pay their insurance bill, the insurance gets cancelled and the bank forces them into a new bank issued homeowners insurance policy which has a higher premium. This makes sense because these are people who by definition do not pay their insurance and this is correlated with riskier behavior and a higher incidence of P&C loss.)
The point here is that the force-place insurance debacle provides something of a roadmap for the mortgage servicers. Banks were forced by Lawsky to make changes to force-place procedures (send out extra warning letters, etc. - nothing overly serious - trust me, I deal with these issues daily). I suspect the same thing will happen with mortgage services. Then over time, the market will stop getting worked up over nothing and will come to embrace the mortgage services again.
Importantly, I think this day may be approaching. The news out of Lawsky's office has been relatively quiet of late regarding mortgage services including NSM, and there are some indications that a new crusade against regional banks may be starting. If it does, mortgage servicers will no longer be the enemy of the week, and the markets can start to breathe a little easier regarding Nationstar's earnings.
Speaking of those earnings, they were pretty good at last report. Earlier in the month, NSM reported operating EPS of $0.87 (vs. $0.89 consensus) and GAAP EPS of $0.74.This was not amazing, but for a stock where earnings were supposed to be cratering by now, and where I think full year earnings will be circa $4, it is pretty good. At this stage NSM is trading at well less than 10X this year's earnings. That's just not going to persist long-term.
In particular, I think the outlook for NSM looks good going into the second half of the year based on a few factors. First, servicing profitability is going up. The company said it expects profitability in that area to improve 2 bps by year end. (Trust me that's a bigger deal than it sounds initially - profits are only 9 bps right now so 2 bps more is a big deal. By the way, remember what I was saying about this not being a business that will attract tons of competitors? Who wants to get involved with a business where if you are really good at it, you get 10 basis points? There are just much better opportunities for new entrants in other areas.) This will add probably $0.15-$0.20 to next year's EPS depending on the size of NSM's year-end servicing portfolio. NSM has $20B in pending MSR deals and they will undoubtedly add to this over time. Second, Solutionstar is getting more and more profitable. NSM seems to be implying about $100M in pre-tax profits in 2H2014. Finally, lower interest expenses will help the firm going forward as they have redeemed a large pile of expensive notes (they were paying ~11%), and the low interest rate environment should help ensure that debt costs stay manageable for the foreseeable future.
Given all these factors, I continue to maintain my view that Nationstar is a good long-term investment. The waters are rough right now, but the company is doing all the right things and in time investors will be rewarded as the market regains its faith.
Disclosure: The author is long NSM.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.