Magic Formula Stock Review: Lender Processing Services (LPS)
Lender Processing Services (LPS) is the largest mortgage processing provider in the United States. The company offers services that cover the entire span of a mortgage loan, from origination through service of existing loans and even handling defaults. Examples of services provided include title search, closing, lien recording, appraisals, flood zone certification, foreclosure, property inspection, and so forth. LPS was spun off from Fidelity National Information Services (FIS) in 2008.
This company has an attractive business model. LPS is in effect an outsourcing solution for lending institutions, primarily large banks. Revenue is dependent on the volume of mortgages coming through the pipeline. One nice thing about the business is how it is set up to thrive during boom or bust periods for real estate. When the housing market is strong, LPS earns increased business on its loan origination services. When it is extremely weak, mortgage default volumes skyrocket and LPS earns the dough providing foreclosure and other end-of-life functions.
It is this latter factor that has led to booming business conditions over the past year. The U.S. housing market has been in shambles, with the bad loans, over-borrowing, and overpriced housing markets of 2004-07 now resulting in one of the worst busts in history. Mortgage loan delinquency rate (mortgages late on payment or in foreclosure) stands today at an incredible 13.5%. When you consider that the historical norm for this number is around 1.5-2.0%, the extraordinary difficulties in the mortgage market are clear. This flood of delinquent loans is overburdening lenders, too. Almost 23% of loans delinquent for 12 months have not been foreclosed upon yet. A more normal number is about 5%. Usually the foreclosure process begins anywhere from 3-6 months of delinquency.
LPS benefitted greatly from these conditions. Sales were up 29% last year, operating profits 23%. Revenue from default services rose 34% over 2008, and was 140% higher than 2007 (maybe the last "normal" year, although still elevated). In addition, a wave of refinancing due to historically low rates helped increase loan origination service revenue 27% from the trough of 2008 (it was still below '07).
Going forward, LPS should be able to grow modestly this year. As mentioned, delinquent loans continue to be way above historical norms, and that backlog of overdue loans may start to move to foreclosure proceedings. However, it is unlikely that LPS will be able to maintain its current levels of revenue for more than a year or two. The weak part of the cycle for this company is stagnant or slow growth, where neither defaults or new loans are high. At some point, hopefully within the next two years, the mortgage market should begin its slow climb out of the current hole, at which point demand for LPS's services should contract dramatically. Over our one-year holding period we will see growth, but the longer-term outlook may hold the valuation down.
Three other things concern me with LPS as a Magic Formula Investing (MFI) pick. Financial health is one. LPS was spun off with significant debt, nearly $1.3 billion vs. a relatively small cash position of just $70 million. Short-term it is not a major concern, as interest coverage is a reasonable 6.4 times, and the majority of debt does not come due until 2013-14. But a few years down the road, when revenues contract, that coverage ratio will tighten and LPS could be squeezed paying the principal off if they do not build a sufficient cash cushion. Situations like this also conspire to keep valuations low, limiting our returns over a one-year period.
The second concern is that the valuation just is not that low for a MFI stock. The trailing earnings yield is 10.2%. Against reasonable 2010 estimates, it's 11.8% (both on an MFI basis). That is not bad, but MagicDiligence is looking more for low to mid teens, over 20% if we're lucky. What can I say, I'm cheap! Playing around with the numbers, and considering that high default markets benefit the company more than real estate booms (going by historical revenue ranges), I come up with a fair value around $47. That is not enough of a margin of safety from the current $41 to recommend the stock as a Top Buy pick.
The third and final concern is the concentration of customers. Bank of America (BAC), Wells Fargo (WFC), and JP Morgan (JPM) account for almost a quarter of revenues. The top 5 customers account for 44%. Considering the size and scale these large banks generate, it is not inconceivable for them to move their mortgage processing operations in-house. Any one of them doing so, or even publicly considering it, would be a big hit to the stock price.
In a nutshell, Lender Processing is a decent but not great MFI choice. I have a positive rating on it, but it is not a slam dunk. It is a good business that should continue to benefit from advantageous conditions over the next year or two. But the concerns over an earnings peak, high debt levels, and large customer concentrations could conspire to keep the valuation low and limit investment gains.