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.
This year Carol Loomis asked the question whether Berkshire should start paying dividends since the stock price hasn’t risen in 5 years. This was in reference to Buffett longstanding quote that he will pay a dividend when he thinks he can’t create at least $1 of market value for each $1 of retained earnings. Jeff Matthews refers to this as a question that Buffett avoided answering in this thought provoking blog post.
My opinion is who cares whether Buffett answered the dividend question. If you are even asking the question, you should sell your Berkshire stock. The reason to own Berkshire is to get access to Buffett’s capital allocation decisions. Based on his well-documented track record and his well-know thought process, most Berkshire investors think Buffett can make better investment decisions and/or has access to better investment opportunities than they do. The last thing Berkshire investors should want is to have Buffett return the cash back to them in a taxable transaction. Then, the investors will have to decide how to allocate the returned cash.
Historically, investors have wanted management teams to pay dividends because they don’t trust management to spend the free cash flow from the business wisely. The business may be not need capital reinvestment, like Coca-Cola, or it may be a business in secular decline where the best thing to do is harvest the cash rather than reinvest. Shareholders of these businesses probably want managements to pay dividends to make sure they don’t destroy value.
Since the main reason to own Berkshire is to get access to Buffett’s capital allocation skills, if an investor wants Berkshire to pay dividends, then they should sell the stock instead because they obviously don’t believe in Buffett’s ability to create value by allocating capital.
There is a scenario where it makes sense for an investor to want Berkshire to pay a dividend. Maybe an investor thinks Buffett destroys value but think Berkshire is so undervalued that they can make a return by owning the stock and getting him to change his dividend policy. I don’t think Berkshire is anywhere close to a valuation level where this would make sense. At $91,500 per share, Berkshire trades at 1.4x tangible book. It would have to trade below tangible book value for this strategy to make sense.
The reason to invest in Berkshire is get access to Buffett’s skills as a capital allocator. If you want him to pay a dividend, you shouldn’t own the stock. You should ignore the 5-year rolling test about whether he adds more $1 of value for each $1 of retained earnings. He is never going to pay a dividend because he’ll never admit that he can’t add value. If he ever does decide to pay a dividend, you won’t want to own Berkshire.
