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Market Musings - January 25, 2018 (Drive-By Analysis: Walter Investment Management Edition)

|Includes: Ditech Holding Corporation (DHCP), HCC
Summary

Walter Investment Management is emerging from Chapter 11 Bankruptcy Reorganization.

Existing Shareholders should receive 8.5% Ownership of the Reorganized Entity, Plus Half of the 10-Year Warrant Issuance.

WAC appears undervalued in the mid-70s cent price range.

We continue our blog series: Market Musings, Volume 2, Edition 5, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present Drive-By Analysis: Walter Investment Management Edition.

In this edition of Market Musings, we take a quick look at Walter Investment Management Corp (WAC). WAC was originally established in 1958 by homebuilder-cum-industrialist (and later billionaire) Jim Walter. WAC operated as the captive financing business of Walter Energy, originating and purchasing residential loans and servicing these loans to maturity. In April 2009, WAC was spun off from Walter Energy; merged with Hanover Capital Mortgage Holdings; qualified as a REIT; and began to operate as an independent, publicly-traded company. After the spin-off, in 2010 WAC acquired Marix, a high-touch specialty mortgage servicer, and in 2011 WAC acquired Green Tree, a leading independent mortgage loan servicer providing high-touch servicing of GSE, government agency and third-party mortgage loans. As a result of the Green Tree acquisition, WAC no longer qualified as a REIT. Since then, WAC grew its servicing and originations businesses both organically and through a number of acquisitions, including the acquisition of a national originations platform in 2013 from ResCap and significant bulk servicing right acquisitions in 2013 and 2014.

Sadly for shareholders, in November 2017 WAC filed for Chapter 11 bankruptcy reorganization, per the following (source):

(Interestingly, Walter Energy also filed for Chapter 11 back in 2015 and has since re-emerged as a public company under the name Warrior Met Coal (HCC), regarding which see our Market Musings blogs dated November 3, 2017 and November 13, 2017, respectively).

WAC's demise appears to have been caused by a combination of low interest rates (which can exacerbate portfolio runoff as borrowers refinance their mortgages) and an unfortunate foray into reverse mortgage lending. However, none of WAC's prior issues really matter that much to prospective shareholders, who look to the future rather than the past. Despite filing for Chapter 11, WAC's shares currently trade in the mid-70s cent range:

Why not zero? Well, WAC's existing shareholders will not be wiped out by the bankruptcy filing, as is normally the case. Instead, shareholders will own a combination of stock and warrants in the reorganized entity. The stock portion should comprise approximately 8.5% equity ownership of the new entity. We arrive at this 8.5% figure by deducting from the total reorganized equity value (1) 73% allocable to the convertible preferred holders and (2) 10% allocable to management pursuant to an incentive compensation plan, and multiplying the resulting figure (i.e., 17%) by 50% (for which, see the excerpt from WAC's Form 10-Q below). Shareholders will also be entitled to half of the 10-year warrants to buy common shares which are expected to be issued in connection with the reorganization (details of which are described in the Plan of Reorganization located here). Additional details regarding the foregoing are included in WAC's most recent 10-Q filing, as follows:

A week ago, the reorganization plan was approved by the bankruptcy court (source):

What could the 8.5% equity interest for existing WAC shareholders be worth? According to the most recent Monthly Operating Report (or MOR) filed with the bankruptcy court (source), WAC (at the holdco level) had shareholder equity as of December 31, 2017 of negative $440 million:

As noted in the reorganization press release included above, though, $800 million of WAC's debt will be wiped out. Thus, on a pro forma basis, we should expect shareholder equity to be around $350 million or so ($800 million minus $440 million), with minimal intangible or goodwill assets included. As the existing common shares will receive 8.5% of the reorganized equity, book value for these holders on a pro forma basis will be approximately $30 million ($350 X 8.5%). With 37.4 million common shares outstanding as of November 2017 (per the Q3 2017 10-Q), this means that pro forma book value per share attributable to existing holders will be about $0.80/share, higher than where the shares currently trade. 

Moreover, long-term interest rates are finally rising, boding well for the value of WAC's mortgage servicing assets. Below we see that the 10-year Treasury yield has appreciated approximately 60 bps over the past five months, from slightly over 2% in early September 2017 to 2.64% currently (source):

Finally, we need to ascertain the value of the warrants. Admittedly, we have not yet done the necessary diligence to reach a conclusion regarding this number, so this item is still TBD. 

CONCLUSION: Long WAC.