Mortgage originators are having a banner year, and the market for mortgage banking initial public offerings (IPOs) has been hot. We saw Rocket Companies (NYSE: RKT) go public in August through a normal offering and United Wholesale Mortgage prepare to go public this quarter via a special purpose acquisition company (SPAC). The Mortgage Bankers Association (MBA) forecasts that mortgage origination volume will hit $3.2 trillion this year, the highest since 2003.
Another mortgage company striking while the iron is hot is New Residential Investment (NYSE: NRZ). The company recently filed a confidential prospectus with the SEC to potentially spin off its mortgage and servicing arm. What does this mean for New Residential stockholders?
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New Residential changes its business model
New Residential has historically been an originator of mortgages that do not fall within the government’s qualified mortgage (QM) safe harbor. These loans would have been called Alt-A back in the day, and they are typically used for investors who plan to rent out the properties or for self-employed borrowers who have high deductions and therefore earn more than their tax returns suggest. During the early days of COVID-19, the mortgage market seized up, and many of the mortgage real estate investment trusts (REITs) were put in difficult positions with their counterparty lenders. Some, like New Residential, went as far as to completely change their business models. The company exited the non-QM lending business and decided to focus on plain-vanilla conforming lending (loans that are guaranteed by the government).
The market is ignoring the value of the origination arm
On its third-quarter earnings conference call, New Residential laid out its case that the stock is undervalued. Here is the argument. New Residential is being valued as a typical mortgage REIT, which trades largely based on book value and its dividend. In the aftermath of the early 2020 mortgage meltdown, most mortgage REITs are trading at discounts to book value. The big agency REITs, like Annaly Capital Management (NYSE: NLY) and AGNC Investment (NASDAQ: AGNC), trade at 8% to 10% discounts to book value. New Residential trades at a 10% discount to book. While that may seem normal for a mortgage REIT, it is not normal for a mortgage originator. Mortgage originators do not trade based on book value, they trade on an earnings multiple. To use an extreme case, Rocket’s book value per share is around $3.22, and the stock trades at something like 6.3 times book. New Residential is making the case that the mortgage arm should be valued much higher than book.
New Residential argues the mortgage company should earn anywhere from $638 million to $674 million this year after taxes. Assigning the operating company a price-to-earnings (P/E) multiple of five times to six times gives the mortgage and servicing arm a valuation of $5.58 to $7.66 per share. The non-banking operations have a book value of $10 per share, so if you add the two together, the entire company could be worth in the high teens.
New Residential takes a page from the 1990s corporate playbook
If New Residential is indeed spinning off part of the mortgage arm (we don’t know for sure, since the SEC filing is confidential), then the company is forcing the market to set a value for the operating company. These sorts of corporate maneuvers were common during the late 1990s dot-com boom. Mature companies with nascent internet arms would see the insane valuations being placed on internet companies and would sell something like 15% of their internet arm and see a boost in the stock price. New Residential’s stock price reacted favorably to the news, rising 10% on the day of the announcement.
Is New Residential’s estimate of five to six times earnings reasonable? Probably not. Rocket, whose app gives it a decided advantage over other originators, trades at 5.3 times 2020 analyst estimates. PennyMac Financial Services (NYSE: PFSI) and Mr. Cooper Group (NASDAQ: COOP) trade at around three times 2020 estimates, and are probably more comparable. Why are these multiples so low in general? The S&P 500 has a P/E of something like 36 and the mortgage origination sector is experiencing phenomenal growth. Here’s why:
Wall Street’s view of the mortgage origination sector is too pessimistic
The Mortgage Bankers Association sees origination volumes falling in 2021, so Wall Street analysts think 2020 earnings will be the best for a while. The analysts are treating these stocks like cyclicals. I made the argument that the MBA forecast is probably too conservative, based on research from Black Knight. So while New Residential’s internal valuation multiple may appear over-optimistic at the moment, the earnings estimates might be too conservative, which means there is still hidden value in the stock. Not only that, but New Residential just hiked its quarterly dividend to $0.15 per share, which gives the company a 6.2% dividend yield. No other originator out there pays that sort of yield.
Wall Street has yet to give New Residential the full valuation of the origination arm, which is probably due to the fact that the filing is confidential. We will have to wait for the company to give more color on what it is doing. That said, income investors and value investors who like the mortgage origination story should take a look at New Residential.
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