Compass Point: Refi burnout hurting Walter Investment

Reiterates “sell” rating and lowers target price by 20

When Walter Investment Management (WAC) released its second quarter earnings last week, the news wasn’t good.

The company posted a loss of $12.9 million in 2Q14, and its net income was down more than $43 million from 2Q13.

The company said that the decrease in net income, from $88.6 million in 2013 to $45 million in 2014, was due to decling in operating results in the originations segment from 2Q13. This decline is notably linked to HARP-related retention volumes and margins decreasing.

Unsurprisingly, the company’s chairman and CEO, Mark O’Brien, said that the company was not concerned with the weak quarter.

"We believe the combination of strong execution against our strategic plan coupled with ensuring each of our businesses embraces and drives a culture of compliance and positive consumer experience will provide benefits to each of our core constituencies: consumers; clients; our stakeholders; and regulators," O'Brien said last week.

But Wall Street analysts don’t share in O’Brien’s positive view of the future in the wake of the weak 2nd quarter results. Compass Point Trading & Research, which had already downgraded Walter to “sell” in May, reiterated its position and lowered its price target for Walter from $23 to $18.

"The second quarter earnings release was in-line with our expectations as a bounce back in amortization expense pushed servicing margins lower, origination earnings benefited from a larger HARP-eligible servicing portfolio, and the company guided to lower earnings in the back half of 2014,” Compass Point’s Kevin Barker said in a note to clients.

“However, the vast majority of the 2Q14 earnings report was driven by HARP originations and there are a series of regulators investigating WAC's servicing practices,” Barker continued. “We expect the expense associated with addressing regulators concerns (as we have seen from other servicers) and the impact of refi burnout on origination revenue to make it difficult for WAC to sustain GAAP earnings above $0.50 per share over the next several quarters.”

Compass Point decreased its 2014 year-end earnings-per-share projection from $3.50 to $2.83 and also slashed its 2015 EPS projection from $3.26 to $2.55.

Walter has been on Compass Point’s radar for quite some time and this isn’t the first time that it has warned investors about Walter’s future prospects.

In May, Compass Point downgraded Walter to sell after its subsidiary Green Tree Servicing failed eight of 29 compliance tests administered by the Office of Mortgage Settlement Oversight.

After that news came out, Compass Point lowered its target from $28 to $23. After the release of the Walter’s weak second quarter results, Compass Point has now dropped its target price $10 in just three months.

Compass Point also warned investors that Walter would be at the most risk if the Federal Housing Finance Agency sues its servicers and lender-placed insurance providers because the companies cost the government-sponsored enterprises hundreds of millions of dollars by charging excessively high rates for LPI, as the FHFA’s watchdog suggested it should do in a report filed in June.

“If the FHFA were to attempt to recover ‘damages’ related to excessive fees on lender-placed insurance, we do not expect any potential litigation to be a significant hit to the large banks involved in servicing large delinquent portfolios,” Compass Point said at the time. “But it could have a material impact on special servicers that have a less diversified revenue base and service highly delinquent GSE mortgage portfolios.”

Compass Point cautioned that nonbank servicers could be prime targets for the FHFA’s potential wrath with Walter at the forefront.

Compass Point suggested that Walter would be the most “exposed” to the potential litigation. “WAC recorded $85 million of revenue and $46 million of pretax income from their insurance segment during 2013, of which 65% of the policies written were for lender-placed insurance,” Compass Point’s analysts noted at the time.

“Lender-placed insurance is significantly more expensive than voluntary homeowners' insurance and we estimate the total insurance commissions from lender-placed policies could be 70%+ of total insurance revenue for WAC.”

In its latest report, Compass Point said that it is concerned about the potential litigation costs and the costs associated with bringing Green Tree’s servicing practices up to the standard set by the OMSO.

Compass Point is predicting that Walter’s profitability from its servicing segment will continue to drop.

Although we expected a decline in 2Q14, it was more than estimated and likely indicates margins will remain subdued for the foreseeable future as the company deals with regulatory expense,” Compass Point said in its note. “We estimate margins only bounce back to the 3-5 bps range from an average of 6 bps in 1Q12-1Q14.

“Where operating expenses settle in the face of increased regulatory issues is a major driver of earnings going forward.”

As of 11:35 a.m. Eastern on Monday, Walter was trading at $25.59, but the stock is down more than 27% year-to-date and nearly 34% over the last 12 months, according to analysis on the HW30, HousingWire's proprietary index of the stocks that highly impact housing finance.

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