After Thursday’s close, Capital One (COF) announced the acquisition of ING Direct and the terms are favorable for Capital One shareholders. Capital One will be paying tangible book value after the mark-to-market of ING Direct’s balance sheet. The deal will be accretive to tangible book value and earnings immediately. Capital One claims the IRR is greater than 20%. In addition to the financial benefits, the operational and strategic benefits for Capital One are:
- substantially reduces risk on liability side of Capital One’s balance sheet,
- reduces future acquisition risk,
- puts capital to work in a low risk manner,
- fixes a mistake Capital One made 8 years ago by allowing ING Direct to become the leader in direct banking, and 5) makes sense because Capital One is the logical acquirer for the national direct banking footprint of ING Direct.
Read the rest of this article on SeekingAlpha.com: Capital One’s ING Direct Acquisition Terms Are a Pleasant Surprise.
This post is an excerpt from the 1st Quarter Investor for my hedge fund. If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.
I started a short position in Walter Investment during the last week of the quarter when they announced a huge unexpected acquisition. Walter Investment was successfully spun-off from Walter Energy in early 2009. The company operates a sub-prime mortgage servicing business that had been an affiliate of its former parent’s home building division. Walter closed the home building division prior to the spin-off. Walter Investment’s servicing platform has a good system for collections, and the company had always retained its own loans, so underwriting stayed strong compared to the rest of the industry.
Since the spin-off, the company had been looking for a way to grow. Because Walter had closed down its home building business and lending platform, the company did not have a natural way to originate or add loans to its servicing platform. The existing portfolio of loans throws off attractive but declining cash flows, so Walter pays an attractive dividend but cannot increase it. The company’s strategic plan had been to purchase small portfolios of mortgage loans from distressed banks in the Southeast to grow its portfolio of loans. Management thought they could find some bargain portfolios to purchase and use their strong mortgage servicing platform to rehabilitate the purchased mortgages.
Although it had completed a small deal or two in this area, late in the 1st Quarter, the company announced the very large acquisition of Green Tree Credit Solutions, which owns a mortgage servicing portfolio and platform focused on special servicing of problem mortgages. Special servicing is a high-touch servicing of delinquent loans. In its investment presentation, Walter points to the growth of special servicing business and the large earnings per share accretion in the deal as compelling reasons for the acquisition. I believe Walter is making a poor strategic and financial decision by acquiring Green Tree. Here’s my short thesis:
1. Buying Green Tree at the Peak of the Cycle – The special servicing business has grown as the balance of outstanding delinquent mortgage loans has grown. However, we are seeing delinquencies decline industry-wide as the flow of newly delinquent loans slows. Walter’s own investment presentation shows slowing growth of the addressable market as the flow of new mortgage delinquencies declined from $1.9 trillion in 2009 to $1.7 trillion in 2010 and is projected to further slow to $1.4 trillion in 2011, $1.0 trillion in 2012 and $0.8 trillion in 2013.
2. The Acquisition creates Massive Tangible Book Value Destruction – Walter’s management team points to the earnings accretion from the deal, but the book value destruction of the deal is devastating. Walter’s current tangible book value is $21.54 per share. I estimate that the book value will drop close to zero per share. The payback of book value from the earnings accretion will be 15-20 years.
3. Sellers are Taking 97% of Deal in Cash – The current owners of Green Tree do not see the value of holding a stake in the combined entity. Instead, they are willing to pay taxes to get cash now. I suspect they see their growth slowing and are happy to walk away with a decent multiple on peak earnings for a very cyclical business.
4. Green Tree’s platform duplicates Walter’s existing platform – Walter gains close to nothing with this acquisition because Green Tree’s servicing platform is so similar to Walter’s existing platform. Plus, the expense synergies are almost completely wiped out by higher taxes as Walter moves from a REIT to a C-corp.
Walter is trading at only 7x pro forma earnings, so the stock is inexpensive if I am wrong that these are peak earnings for Green Tree. However, Walter’s management is buying upwards of $1 billion worth of intangible assets on a $500 million equity base. The margin for error here is low with little downside protection.
The Peridot Capitalist wrote an interesting article defending Buy-and-Hold investing. He argues that Buy-and-Hold doesn’t work if one ignores valuation. I agree with him and would extend his argument to include that we can’t ignore whether a company’s franchise is getting strong and weaker while executing a buy-and-hold strategy. Buy-and-hold, as practiced by Buffett and Munger, involves investing in companies with strong franchises. As time goes by, the franchises either get stronger as profits are reinvested in the business to create a stronger brand or expand distribution or introduce new products, or sometimes, franchises get weaker because of shifts in consumer tastes, increased competition or regulatory changes. Monitoring changes in a company’s franchise strength is an important part of a buy-and-hold strategy.
Using Peridot’s Coke example, not only was valuation stretched in the late 1990s, but Coke’s franchise has weakened. Coke’s major market of carbonated soda drinks (CSDs) has stagnated. Consumers are shifting to healthier non-carbonated drinks such as water, iced tea and sports drinks. Coke missed a major opportunity to buy Gatorade’s parent, Quaker Oats, due to a board revolt against the CEO. Even though the price for Quaker was high at the time, the continued growth of Gatorade may have justified the acquisition. As a franchise like Coke’s gets weaker, investors are less willing to pay high valuations for the stock.
The advantages of Buy-and-Hold are the power of compounding and tax-deferral. Potential Buy-and-Hold investments are companies that can compound their earnings growth at high rates of return for many years. These companies are often in stable businesses or industries. They may have pricing power over their customers or may have recurring revenues under long-term contracts. These companies reinvest their excess profits back into their franchise to make it even stronger. By holding the same stocks for years, investors are getting a interest free loan from the government by not having to pay taxes on gains until the investment is sold.
“Buy-and-hold” is not a “Buy-and-Forget” strategy. As Peridot suggests, the valuation of a stock is extremely important when buying a position. As time passes, investors also need to continually monitor the strength of the company’s franchise. As a company’s franchise weakens or threats to the business franchise emerge, investors should exit these long-term holdings.
At Gator Capital, we follow a buy-and-hold strategy but are rigorous about valuation and franchise strength. We do heavy valuation work prior to entering a position. We also monitor valuation through the life of the investment. We also assess the business franchise of the company and continually monitor the company for any changes in a franchise’s strength.
