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Lender Processing Services - Lots of Free Cash Flow, Little Legal Obstacles
Posted by: Frank Voisin (IP Logged)
Date: March 21, 2012 07:09AM
Lender Processing Services, Inc. (LPS) provides technology and services to the mortgage lending industry, with its primary customers being top 50 financial institutions. It is the market leader in mortgage processing and default management services in the United States. Approximately 35% of revenues are derived from its Technology, Data and Analytics segment which provides solutions for automating loan servicing, with the remaining 65% derived from its Loan Transaction Services segment which helps mortgage lenders reduce the expense of managing defaulted loans and closing mortgage transactions.
LPS was spun off from Fidelity National Financial, Inc (FNF) in 2008. As part of the transaction, FNF saddled LPS wish a significant amount of debt ($1.585 billion). It is common for parent companies to saddle their subsidiaries with debt when they are spun off. You can read more about this in Joel Greenblatt’s excellent You Can Be a Stock Market Genius. As Greenblatt points out, there are often opportunities to be had in spun-off companies, provided you conduct the appropriate due diligence and determine that the company can handle the debt. Now, we are several years post-spin in the case of LPS, so we can get an idea of the company’s profitability and cash flow over the period, and take a look at its actual ability to service the debt.
Here’s what we find about the company’s debt load at December 31st for each year since it was spun off:
It is important to recognize that the company has a natural (partial) hedge in the form of exposure to both new mortgages (in the form of its Technology, Data and Analytics segment, which helps the banks process new mortgage applications and service existing clients), as well as mortgages in default (via its Loan Transactions Segment). So when times are good, revenue should be expected to come largely from the TDA segment, and when times are bad (like now), revenue comes from its LTS segment (which currently makes up 65% of revenues). This reduces the cyclicality of the company’s revenues and allows it to generate relatively strong earnings throughout the business cycle.
Just how strong is the company’s performance? Well, first recall that the company started with a significant debt load. When debt is high, equity is low (holding the enterprise value somewhat stable). So any equity-based returns metrics would be useless. Instead, we would want to consider the company’s invested capital (Equity + Debt – Cash) over the period. One of my favourite metrics is CROIC (Cash Return on Invested Capital), which divides free cash flow by average invested capital.
Here’s what we find for CROIC:
Say what? The company has been on its own for just a few years and it is already contracting is shareholder base? Yes! When it was first spun off, the company had 95.3 million shares. Today it has 84.4 million, and a remaining share repurchase authorization of $95.1 million. This seems like a pretty clear signal that the company believes its shares are undervalued, especially when the same cash could have effectively doubled the amount of debt repaid instead.
So what gives? Why isn’t the company trading significantly higher given its prodigious free cash flow? Perhaps this gives us a clue:
Quote:This relates to accusations regarding “robosigning.” The company’s response can be found here. Furthermore, the company has been dealing with federal regulators over similar concerns and has entered a consent order, whereby the company has been going through a three-stage process of reviewing its procedures with the regulators to uncover and problems. In the recent conference call, the company provided an update on this process (emphasis added):
Quote:A major catalyst will be for the company to resolves its remaining issues. It took a $78 million provision in the most recent quarter to reflect the costs it has estimated it will incur related to these issues. Here’s what the company said about the charge (emphasis added):
Quote:So where does all of this leave us? It appears that the company has some legal and regulatory issues which it is aggressively and proactively working on. Furthermore, the company has done its absolute best to set up a reserve for the amount it believes it will cost to fully resolve these issues. Besides these issues, the company is a free cash flow machine (generating about twenty cents for every dollar of capital it has invested, every single year!), and has been using that free cash flow to repay debt and repurchase shares, both of which will help shareholders in the long run.
By my estimates, it is really easy to get to an intrinsic value that provides significant upside from today’s prices. There appears to be a large margin of safety.
What do you think of LPS?