MGIC Investment Corporation (MTG) - Normalized ROE does not look attractive

This could turn out to be a multi-part project. I just started looking at this company last week so my insights would be limited. However, I’m writing anyways as it helps me gather my thoughts and move forward.

An Inherently Unattractive Industry

MGIC Investment Corp (MTG) is a Private Mortgage Insurer (PMI). This is one crappy industry. Results are incredibility cyclical and sensitive to some assumptions. On the competitive front, we have already seeing new players trying to compete on not just price, but underwriting terms (NMIH Holdings is an example). Now it looks like the 7 players will not be putting a united front with respect to proposed capital requirements.

Why would anyone buy a PMI then? The standard long thesis says 1) FHA will be giving away market share to the private sector, this coupled with an improving mortgage market will lead to high volumes. 2) Lower losses from legacy vintages running off, as well as fixed cost/operating leverage would lead to a spike in earnings.

Some parts of this hypothesis are valid but I think the sell side tends to bake in both 1) mortgage industry recovery, AND 2) losses stay low at post crisis levels, when in fact the two may not be compatible. While losses are sure to come down from present levels in the next couple years, some analysts seem to assume the pristine underwriting quality of 2009-11 vintage will continue forever. Given that 1) first time homebuyers will be needed to drive housing recover and 2) they tend to be of lower credit quality, the assumption of “2009 forever” is clearly unrealistic.

So you have multiple offsetting factors at play and investing in the sector requires one to say “ok, new businesses will have higher losses at some point, but I don’t think it will be that bad, and meanwhile this thing is dirt cheap and I like the risk and reward”.  This reminds me of my write up on Santander Consumer USA. While there’s a place in your portfolio for a speculative play like this, these could be good ideas but not the best ideas.

Normalized Losses and ROE

Unattractive industries demand great valuations. I want to get some sense of economics and value before filing this away. To do that, some conception of a “normalized return” is needed. Anyone who has followed the industry would know that current loss levels are far from “normal”, since MTG is still working off legacy businesses. So blindly applying some P/E or P/B ratio to next year’s forecast would be meaningless. 

Below are my estimates of new businesses economics when losses normalize, under the current capital regime, and then under the proposed PMIERs.  I’m thinking about this at the opco level so that’s why there’s no interest expense.

 

Two part discussion here, first on impact of capital requirement, then on normalized losses.

First, capital requirements. Management said that if PMIERs goes through, capital requirements for recent businesses probably correspond to 11.5-12x in the old risk to capital framework and that gets them to low teens ROE before reinsurance.  

From 2Q14 transcript: “…Under the proposed eligibility requirements, the mix in the first half of the year seems to require a risk to capital of about 14-to-1 at time of origination, i.e. they are all current. But as we know, even with the high-quality profile, some will go delinquent. So, if you factored that in and probably goes to 13-to-1. And then if you want to add some room away from the capital requirement just to give yourself some margin you probably talking 11.5-to-12-to-1.

And by our calculations, on a direct basis before any reinsurance and whatnot, we think that delivers a return in the lower double-digits. On the current or prior to eligibility requirements that we are issued here, we were think and closer to 18-to-1. And if you give yourself a little room and whatnot operate around 16-to-1. We think those returns are kind of back as Curt said where they probably should be for the overall risk of the business in the mid-teens.”

So let’s say losses will revert higher in new vintages going forward, I think a 10:1 risk to capital, single digit ROE after reinsurance is probably reasonable.

How about normalized losses? In the 2Q14 call, management said the 2009-2011 books are running about 15-20% loss ratio. This is how I got the 35bps loss as % of RIF assumption (50bps premium * 17.5% loss ratio / 25% RIF = 35bps). Keep in mind 2009-2011 vintages are loans with pristine underwriting standards. Going forward as the mortgage industry reach down the credit spectrum, it’s reasonable to think that losses will be higher. How much higher? To give an idea of how volatile these items are, below are historical loss ratios from 1996 to 2006 before the whole industry blew up. I used 50bps credit loss in the above table as a placeholder, but the ROE sensitivity table is all over the place.

So you got a cyclical, competitive industry getting hit with higher capital requirements. What should investors demand? The CEO gave some jumbled answers on the 2Q14 call but I think he meant to say mid-teens return overall and high teens for low FICO/High LTV businesses:

GS analyst: “Now, but if you were just, say, isolated – let's say you were the only player in the industry in a very hypothetical scenario, I mean, what required return would you want to get on those lower FICO, higher LTV buckets? I mean, would you be looking at low-teens? High-teens to account for some of the greater volatility in those buckets?

Curt S. Culver: “Yes, but I, on your question, I think for the lower FICO you need a mid-teens minimum return, given the variability on that business and how quickly things can change. So, certainly it demands a higher return. The returns on the other business will be, I think low-to-mid teens so that certainly would require in my opinion, a high-teens return.

So management want double digit returns but the analysis above shows that ROE with 1) normalized credit loss, and 2) new capital regime will likely be in the high single digits. And MGIC trades at 3x book value when the only thing we can really count on is volume growth. Surely there are better ways to play a housing market improvements? 

Up to now, I have referred to new business economics at the opco level, assuming equity capital = investment assets. In reality there's a mix of vintages books, the investment portfolio is much higher and there's interest expense from the holdco debt. To value MTG you have to take those into account. I won't bore anyone with the model here but my calculation shows that MTG is about fairly valued right now ($8.4 per share).

A Cash Flow Model

REIT Analyst did an SA article on MGIC last week. Specifically, he actually tried to project out the cash flows of mortgage insurance premiums and losses, then calculate a present value. Financials analysts as a group tend to stay away from cash flow statements, so what he’s doing is very different. That and the result of over 100% upside got my attention.

I can understand why his valuation is so much higher than market and what I have above. My guesses are 1) discount rate used - the market is rightly demanding more than 10%, 2) Not all investments are excess. Put another way, they are operating assets required to back the day to day MI business, so the investment income stream needs to be discounted together with other operating cash flow streams.  3) subtle assumption difference in premium, loss curves, reinsurance...can all make a big difference. 

Nevertheless, some sort of cash flow analysis would be useful to quantify the positive effect of legacy vintage running off - a big part of the long thesis. A real deep dive here would mean building a full cash flow model myself. At this point it is not a high priority given all the negatives I discussed earlier.

For now, I say we give this guy the sensitivity table and a set of darts, and call it a day.

Fannie and Freddie: Is the Debate on Net Worth Sweep Enough to Save the Commons?

In this piece I will raise questions and provide some analyses, rather than attempt to make any conclusive statements. My questions are:  “If the Third Amendment (Net Worth Sweep) is repealed, can the Senior Preferred stocks be paid down?  Or is some more fundamental challenge to the conservatorship needed?  And how would the GSE’s build capital if the senior preferred stocks cannot be redeemed?”  I will focus more on Fannie Mae here.

A couple of articles from John Carney of WSJ caught my eyes.

8/11/2014 – Time for Fannie and Freddie Investors to Surrender

8/17/2014 – Snatching Defeat from Victory at Frannie

An interesting point in both articles is that even if the Net Worth Sweep is repealed, Fannie and Freddie would still have trouble paying the 10% preferred dividends, making the commons nearly worthless.

Not surprisingly this angered GSE supporters 

A reader commented on Carney's article: 

“You also fail to mention that if the sweep is invalidated then dividends that they "owed" were calculated incorrectly.  There are strong arguments that can be made that the Senior Preferred Stock will have to be voided in any favorable decision. 

 “With simple logic the entire premise of this article can be refuted.  Your premise is that if the 2012 third amendment sweep "agreement" is found to be unlawful and Bill Ackman wins, he will still lose because the companies will still owe 187.5 billion toward the preferred stock and would have to pay the 10 percent dividend as well the commitment fee from their earnings.

You neglect to mention that since the 2012 sweep they have paid almost 100 billion in dividends at 100 percent”

The comment is based on two related but separate premises. First, the Net Worth Sweep caused GSE’s to overpay by a large amount compared to if they just paid the 10% dividend. Second, if Ackman wins his lawsuit, that over-payment would be applied toward reducing senior preferences. 

It’s the second point that is in question here. Note that Ackman also made this assumption in his May 2014 Ira Sohn presentation.

 

Looking at slide 99, Pershing Square estimated ~$6-7bn and ~4bn of combined dividend to Treasury preferred in 2014 and 2015, respectively. Consider 10% on outstanding balance would amount to $19bn, it’s clear that Ackman assumes the over-payments would be used to reduce Treasury preferred principal balance and thus dividend amount. Also note that the ability to repay treasury preferred is a material part of his thesis on how GSEs will build capital.

First, what is the overpayment amount?

Quantifying the amount of overpayment is pretty straight forward. In Ackman’s latest filing, he calculated the amount GSE’s should have paid with the 10% dividend against the amount they actually paid under the Net Worth Sweep. The difference pointed to combined over payments of ~ $130bn consisting of ~$80bn from Fannie and ~$50bn for Freddie.

Were the Senior Preferred redeemable before the 3^rd amendment?

If Ackman wins then ~$80bn of overpayment would be returned to Fannie - no chunk change given FNMA’s $23bn market cap. So Fannie would obviously not be worthless in that scenario. But could that amount be used toward redeeming Senior Preferred principal?  

Going back to Fannie's 10K for 2011 (before the Net Worth Sweep), I find the following: 

"We are not permitted to redeem the senior preferred stock prior to the termination of Treasury’s funding commitment under the senior preferred stock purchase agreement. Moreover, we are not permitted to pay down the liquidation preference of the outstanding shares of senior preferred stock except to the extent of (1) accrued and unpaid dividends previously added to the liquidation preference and not previously paid down; and (2) quarterly commitment fees previously added to the liquidation preference and not previously paid down.”

So the Senior preferred stocks are redeemable when Treasury's funding commitment is terminated. When could that happen?  see below (emphasis mine):

“The senior preferred stock purchase agreement provides that the Treasury’s funding commitment will terminate under any of the following circumstances: (1) the completion of our liquidation and fulfillment of Treasury’s obligations under its funding commitment at that time, (2) the payment in full of, or reasonable provision for, all of our liabilities (whether or not contingent, including mortgage guaranty obligations), or (3) the funding by Treasury of the maximum amount that may be funded under the agreement.

In addition, Treasury may terminate its funding commitment and declare the senior preferred stock purchase agreement null and void if a court vacates, modifies, amends, conditions, enjoins, stays or otherwise affects the appointment of the conservator or otherwise curtails the conservator’s powers..”

So technically these preferred stocks were not redeemable even before the 3rd amendment. This would support Carney's statement that even if the 3^rd amendment were to be repealed and Fannie get back its $80bn of overpayment, it would STILL be on the hook for about $12bn of senior preferred dividends per year. This also means FNMA will not be accumulating capital if you use Ackman’s $10bn run rate net income. (That $80bn still sit on the balance sheet as capital, but just not adding to it)

On the other hand, the senior prefs can be redeemed if the funding commitment is terminated, either voluntarily (unlikely) or due to a broader challenge to the conservatorship (more likely)

The Need for Wider Focus

A commentator on Investor Hub widens the issues:

“(John Carney) is missing the point. The filing eluded that the conservatorship agreement was a guise for receivership, and the conservatorship agreement should be null and void. This would erase the 79.9%. This would erase any dividends owed. This would erase the conservatorship!”

I’m not a lawyer. But based on the non-redeemable nature of the senior prefs, it does seem that for shareholders to pay down the Sr Prefs and accumulate capital, they will have to challenge the conservatorship at a more fundamental level than just the Net Worth Sweep. This is a harder task. The Net Worth Sweep may be obviously unjust, but the initial decision to put GSE’s into conservatorship is harder to question given the circumstances back then. Looking at Ackman’s filing, the “Prayer for Relief” section looks pretty vague and I’m not sure what exactly he is asking for. The "Preliminary Statement" section is pretty focused on the Net Worth Sweep though.

Clearly Ackman assumes that these senior preferred can be paid down despite the legal language saying otherwise.  Given 1) I’m not a lawyer and  2) Ackman has armies of them, I’m probably missing something but I’m unsure what that is.  

From what I’m seeing though, the ability to redeem senior preferred is an important issue. GSE’s can’t redeem the senior preferred stocks unless the lawsuits goes further than 3^rd amendment and perhaps invalidates even the initial conservatorship.  Otherwise GSEs will likely have trouble meeting the treasury preferred dividends, as lower reserve releases and winding down fixed income arbitrage business will both reduce earnings.

Recent Buys - Putting Cash To Work

I went on a shopping spree the past 2 weeks putting cash to work as the market went from plummeting to small leaks downward. For the most part, this is more about buying quality companies that I’ve been eyeing for a while rather than seeing specific catalysts or levers to boost earnings. For some of these companies, I’m actually looking for the market to go down further so I can buy more.

Here are some bullet points for each.

·         Nielsen (NLSN)

o   Not cheap but you’re buying an established monopoly in TV and part of a duopoly in digital along with comScore. Advertisers trying to measure effectiveness across multiple platforms (TV, online, mobile…etc) require a single currency and Nielsen is it.

o   The company recently started integrating its Online Campaign Rating (OCR) system into Google’s DoubleClick. Although comScore has a lead in digital, Nielsen’s unique proposition is allowing Google to measure online video against TV viewership - an important first step toward taking advertising dollars from TV.

o   Buy the dips.

·         Wells Fargo (WFC)

o   As the king of mortgages, WFC stand to benefit from any rebound in industry volumes, which are at a trough. Citi and Bank of America recently settled, giving hope that the regulatory troubles are starting to subside, and industry is talking about a new non-agency RMBS frameworkto revive that market.

o   Aside from mortgages, WFC is also #1 in auto loans. And they’re expanding their card business by teaming up with Amex. Talk about keeping the good people together. (Btw the 2 companies share the same founders).

·         American Express (AXP).

o   The legal issue with Department of Justice is overblown. The DOJ case is really about the smaller merchants. The guys who would steer customers away from Amex is probably already doing so - I mean how would you even catch those guys?  And besides what can merchants really offer to steer AMEX customers?  A 1% discount?  That’s not going to sway customers who use AMEX as their first card out of the wallet.  Even if DOJ wins and AXP cut prices, they’ll likely get more volume. (Keep in mind AMEX is already signing up merchant acquirers to acquire small merchants)

o   Slow growth and weaker consumer spending are threats. This one could actually face existential threat down the road with payment tech evolving.  If it breaks below technical support of $84 I will cut my losses.

·         Citigroup (C)

o   This is a turnaround story, so what’s the plan?  First, Citi has to get through the CCAR process. This will not only lift some overhang but allow them to return capital and boost ROE. Second, continue to wind down its CitiHoldings legacy business as it adds to risk and detracts from ROE. Thirds, management talked about improving their efficient ratio. I certainly don’t doubt there are lots of fat to cut here! If anything litigation expenses should naturally come down.

o   Citigroup would benefit if interest rate goes up. Also, don’t forget Citi does have one of the best credit card franchises out there along with JPM. Here’s a better, more detailed write up on SA by Weighing Machine.

o   I would strongly consider cutting my losses if more setbacks arise or stock falls below the $46 support level.

·         McDonalds (MCD). 

             There are no catalysts - if anything near term headwinds. This can go lower and I will be buying. As a big consumer of fast food I just love this company. Consider what you’re getting with $93-$94/share:

o   Best real estate portfolio in the business. I like Wendy’s sandwiches better, but I end up eating at McDonald's a lot more. Why? MCD is usually at more accessible locations (and tend to be cleaner).

o   Global brand recognition built with massive advertising dollars and history. Arguably the brand recognition hurts them because people identify them with junk food. But hey not everyone’s a health nut.

o   One of the few companies in the world that can legitimately claim a “culture”, as high level executives routinely come up the ranks starting from cashier. Franchisees have restaurant experience and goes through Hamburger University training. 

o   History of using creative solutions to improve results - drive-thrus, breakfast, increase franchising…etc.  Great financial flexibility with high ROE and cash flows.

o   In terms of current initiatives, MCD have great coffee. I actually prefer their iced-coffee to Starbucks’ version. McDonalds got the formula down on the ice coffee – exactly the right amount of milk and sugar regardless of location.

CVS Caremark’s Integrated Model Shows Its Strength

I recommended both CVS and ESRX in my post about PBMs here.  In my opinion, the market action on 8/6/2014 for Walgreen (WAG), Rite Aid (RAD) and CVS Caremark (CVS) demonstrated the strength of CVS’s vertically integrated model – i.e combining PBM with retail pharmacy. On that day both WAG and RAD fell off a cliff, while CVS prices remained relatively flat.

  

Why CVS stock held steady as WAG and RAD suffered

WAG crashed not just because of no tax inversion in its Alliance Boots deal, but also because it adjusted guidance downward. Specifically, WAG cited reimbursement rate pressures and generic cost inflation – these happen to be headwinds that RAD is also facing (and discussed extensively in the last earning call). On the other hand, CVS actually came out a few days earlier saying that these headwinds are models and already built into their guidance.

To understand why CVS can better handle the issues that its peers are facing, it’s important to understand what “reimbursement rate pressure” means. First, RAD’s FY1Q15 transcript specific attributed reimbursement rate pressures from PBM’s “MAC” lists and plan mixes (emphasis mine).

“We're always dealing with a competitive reimbursement rate environment. Things that can develop differently than our plans would include just a mix of business amongst and within plans, so migration to narrow networks and business moving between different types of plans can have an impact on reimbursement rates. We also still have certain contracts that are not in a kind of guaranteed rate. We call those MAC contracts. So those can be a little bit more volatile”

And later on:

“…So I'll go back to kind of two basic examples. The first one would be around some contracts, we saw more volatility than we expected. So we might have a contract where on generic drugs, there is a proprietary MAC list that PBM uses. They don't often provide us their proprietary MAC list. And so they have some flexibility to adjust generic drug cost as they go. So sometimes we have a little bit difficulty getting good insight as to how that's going to behave over time…”

“Another situation would be we might have a contract with a PBM where we're in different plans. One is a very narrow plan. One is a medium plan and one is the broad plan. And we might see as we come through into the fiscal year gradually as there's utilization that the PBM has migrated patients from the broad plan, which has the highest reimbursement rate, to either the middle plan or the lowest reimbursement rate plan. And we call that a change in plan mix. And so we saw some of that activity as well. Those things tend to develop over time. “

For background, MAC (Maximum Allowable Cost) contracts basically allow PBMs to arbitrarily define pricing to their benefits. Note that Rite Aid said they’re not even privy to PBM’s MAC lists! Given the lack of transparency I can see how pharmacies would be hurt by this type of contracts. Here are a couple good links on the topic.

Don’t Get Caught By PBMs’ MAC Mousetraps

A CBO paper with good background on drug pricing

Let’s move on to Walgreens. WAG also referred to reimbursement pressure from these MAC prices in its June call:

David Larsen - Leerink Swann & Company: “Hi. With respect to the reimbursement pressure, aren't the generic rates typically set at a max price, and aren't those fixed so that the pressure is really the cost of the generic at the higher inflated rate and the difference between that and the fixed mac price or do those prices actually shift around or are they fixed? Thanks.”

Greg Wasson - President and CEO: “So, every contract is different. But you’re right, it's kind of a general abstraction that’s more or less true, but the thing is that I guess the key thing I alluded to earlier is that the indexes that those are based on don’t always immediately reflect the changes in that inflation, and so that’s the disconnect. But again I think we’re working this from many different angles.”

In the WAG/Alliance Boots call on 8/16/2014, Walgreen also attributed reimbursement rate pressure to Medicare Part D business (“Med-D”). 

“…probably most significant impact was the negotiation and the reimbursement in the fiscal or calendar 2015 Med-D books of business. Those plans have really, really challenged us. We are in preferred positions with Part D plans. We think it's a strategic investment to grow market share with a lucrative senior market. But there were significant margin step-downs in the Med-D contracts beginning in 2015. Combine those two and that's what we're looking at and trying to be realistic as we forecast out the next couple of year

Note that Medicare Part D businesses usually run through a PBM, either because a payer hires a PBM or the PBM directly manages the plan (both Express Scripts and CVS have their own PDP plans). While a big part of Part D reimbursement pressure comes from the government, PBMs/plan sponsors further control prices with preferred pharmacy networks.

So here it is. The reimbursement pressures that hit RAD and WAG, whether it's the MAC contracts and PDP plans, are tied to pressures that PBMs exert on the pharmacies. CVS, on the other hand, runs one of the largest PBMs. Lisa Gill from JPM got to the crux of the issue in WAG’s call:

“And then, kind of a bigger question, as we look into your largest U.S. competitor, they own a PBM, they don't seem to have the same reimbursement pressure that you're having today, any thoughts around perhaps owning a PBM in the future?”

At which point Walgreen basically avoided the question.

Well hedged exposure to increasing drug usage

The above discussion highlights how CVS has a supply chain “hedge” between its PBM and retail pharmacy business. There’s more. CVS is a winner no matter how customers access their drugs and even healthcare services. Its Maintenace Choice and Specialty Connect offerings both provides retail and mail access, while the MinuteClinic shifts services between hospital, clinics, and pharmacies.

So CVS has a portfolio of product and services that makes them channel agnostic (mail order vs retail, PBM vs pharmacy, clinic vs pharmacy or even home service). In another words, a well hedged exposure to increasing drug usage. 

Valuation reasonable but not particularly attractive

CVS trades around $76-78/share (~17.7x 2014E and 15.7x 2015E earnings). Here are the consensus expectations for CVS. Earnings per share are supposed be grow at over 10% CAGR but the underlying revenue and net income are only growing mid-single digits. This is because CVS boosts earnings per share with capital management actions. I think valuation is reasonable as a defensive play, but investors who simply look at EPS growth and argue for a higher multiple are effectively treating share buybacks as free lunch.

 

Sources: 2014 investor day, Bloomberg.

Finally, a word of caution about MinuteClinics. Although the service generates lots of excitement in the market, it is not yet contributing to the bottom line. Minute Clinic is a great idea but Walgreens and Rite-Aid are already copying this. Walmart actually goes even further and tries to offer primary care. I suspect that customers will be the main beneficiaries as opposed to shareholders. Let’s say someone just moved out of the city where they were frequent customer of CVS MinuteClinic. In the weekends are they going to commute into the city just to be a loyal CVS fan?  Or would they go to the nearest Rite-Aid?  I believe the latter. For this reason the rapid expansion of MinuteClinics can turn into an arms race just to maintain competitive positioning. In other words, MinuteClinic can turn out to be maintenance capex as opposed to growth capex.

Week ending 8/1/2014: OCN, HLSS, and managed care

I have been all over the place the past 3 weeks due to the earning season and because I’m trying to expand my circle of competence. Here I will comment on OCN, HLSS, and managed care.

Ocwen (OCN)

Lawsky probes Erbey

Fundamentally, earnings (and expenses) actually came in better than I projected. 1Q14 already saw big expense increases so I’m not sure why the market was surprised by that. Still no news on the WellsFargo MSR transfer but that’s actually not too material to the long term thesis.

What is this “long term thesis” then? As in any business: 1) sustainable volume and 2) price/margins. In my Seeking Alpha article earlier this year, I envisioned a scenario where banks get in the habit of transferring delinquent loans to handful of special servicers (OCN/NSM/WAC). The development of a consistent “flow” mechanism is what drives sustainable value in my “normalized” scenario. The second thing is this “delinquent flow” needs to provide a sufficient margin – this will be a function of industry structure. In the 2Q14 call management explicitly referred to this vision as well.

The problem is getting a steady flow of delinquent loan business requires better customer service, reputation, compliance, and generally business goodwill. Frankly, as a shareholder I have been frustrated with the lack of progress here. The customer service topic deserves its own article so I won’t get into that here. But suffice to say improving service will require higher cost (at least in the short term).

I think the stock market is being short sighted here. Institutional shareholders should be holding management accountable for better customer service and compliance, even at the expense of lower margins. Only then can OCN achieve its vision and upside.

Note 1: At 26.7 per share this is a bargain! Now, investing in OCN requires some faith on how the entire industry is going to change. No matter how much sense this idea of delinquency flow transactions seems to make, the industry is just not there yet, so there’s definitely an element of speculation.

Note 2:  OCN talked about exercising their clean up calls, which coincidentally is the name of this blog. I need to dig deeper here but I would think the value of those calls are already priced in when they paid for the MSRs. 

Home Loan Servicing Solutions (HLSS)

This has very much moved in sync with OCN, which makes me wonder if the market understands what the company does. HLSS is a liquidating asset by nature so the best way is to model cash flows in a runoff scenario, assume it hit 0 one day and calculate the IRR. In my analysis I got a nice single digit IRR. Yes, additional MSR transfers from Ocwen can provide some bonus but I’d be surprised if many institutional investors counted on that to begin with. I also don’t get the high short interest in this name (short interest 8% of float and 16 days to cover). At this price shorts are paying out 8-9% in dividend yield, clearly there are better ways to short mortgage servicers (assuming that’s what shorts are trying to do)?

The biggest risk here is management getting adventurous with non-traditional assets. The latest creativity came from reperforming loans (RPL) where HLSS takes a small amount of credit risk. This is still a small portion of the overall portfolio but will likely increase as OCN exercise its clean up calls. Until then, the vast majority of HLSS’s assets still consist of servicing advances which have zero credit risk and very low interest rate risk.

Managed Care companies

Managed care organizations (“MCO”) stocks took a real beating last week despite solid earnings and guidance outlooks. The pressure actually started building a week earlier when WellCare slashed its guidance by half (on Florida MMA, negative reserve development and other charges). On 7/29/2014, Aetna beat consensus earnings but its commercial medical loss ratio (MLR) came in at 80.6%. Apparently this is worse than expected (market expected MLR to improve yoy instead of deteriorate) and managed care stocks tanked.

The market is worried about utilization trend deteriorating, given the strong numbers seen in hospital volumes and prescription drug trends. Wellcare’s guidance cut and AET’s higher commercial loss ratio were seen as a potential inflection point. The sentiment on managed care got so negative that when Wellpoint reported the next day with a “beat and raise” plus solid loss ratio, its stock fell more than 4% before recovering!

Does this make sense? My problem with the increased utilization theory is this: even if there is increased utilization and higher costs, why wouldn’t MCOs build that into the next round of price increases? Longer term profitability does not depend on cost trends, but rather pricing power, which is in turn based on industry structure, availability of industry capital and competitive rivalry, none of which have seen observable changes. Yes re-pricing to higher cost trends will suffer from lags that could impact the next year, leading to lower guidance and EPS estimates. But for investors with long time horizon, higher cost trends should not be a worry.

I also heard that empirical/historical data shows that we’re at a point in the economic recovery cycle where cost trend accelerates. Well if the pattern is so well known, does this not in fact help managed care companies argue for higher prices?