Analyzing Two Mortgage Service Plays

 | Jul 05, 2013 | 10:00 AM EDT
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I hope everyone had a wonderful Fourth of July holiday. This week, this column has highlighted stocks and sectors that should do well in the second half of the year, even in an environment of rising interest rates. We will profile today a pair of mortgage servicers that have had a very strong 2013, but have pulled back recently as interest rates have risen.

The mortgage servicing industry is being buoyed greatly by some of the financial regulations that are being implemented on the "too big to fail" banks. One of the consequences of Dodd-Frank is that is has given banks the incentive to unload their mortgage servicer rights as new rules force banks to hold more capital against MSRs. Lenders from Wells Fargo (WFC), Bank of America (BAC) and others  have been sellers of these rights over the last year.

This trend should continue providing mortgage servicers a tailwind for growth. In addition, the business benefits from significant economies of scale should improve margins as MSR portfolios expand. Ironically, the recent rise in interest rates has punished mortgage servicers even though a modest rise in interest rates would seemingly eliminate prepayment risk for their portfolios. Unless there is a significant additional rise in rates, the housing market should continue to recover.

Here are two mortgage servicers that look undervalued.

Ocwen Financial Corporation (OCN) is a leading, and one of the lowest cost, providers of residential and commercial mortgage loan servicing. It also does residential mortgage lending. The company has grown revenues at better than a 30% compound annual growth rate over the last decade. This sales growth is accelerating mainly on the back of these large acquisitions of mortgage servicing rights. The company's revenues will more than double this year and analysts expect double-digit sales growth in FY2014.

The stock has been more than a "ten-bagger" since the depths of the financial meltdown and is currently priced at $42 a share. Despite this, OCN is selling at just 10x this year's projected earnings and under 8x 2014's consensus earnings estimates. Jefferies initiated the stock as a "Buy" this week and has a price target of $50 on OCN. LadenBurg Thalman also upgraded the shares to "Buy" from "Neutral" in mid-June.

Walter Investment Management (WAC) services over 2 million mortgages with an aggregate balance of $250 billion. Earnings are expected to roughly double to $5.40 a share this fiscal year and the stock sells for around 7x the expected earnings per share.

Consensus earnings estimates for FY2014 currently stand at over $6 a share and the consensus has been moving up over the last month, even with rising interest rates. The stock, however, has fallen from over $40 a share to a little over $33 a share over the past six weeks -- which presents a buying opportunity. The median price target of the eight analysts who cover WAC is $44 a share.

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