Mr. Cooper Group Inc.

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

Mr. Cooper Group Inc. is a non-bank mortgage servicer, providing services such as loan administration and default management to homeowners, investors, and other stakeholders in the mortgage market.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Mr. Cooper operates in a complex and fragmented industry, making it a challenging business to fully understand. The company is the largest non-bank servicer of residential mortgages in the United States, meaning they administer home loans on behalf of the owners.

Business Overview

Mr. Cooper’s revenue is derived primarily from:

Servicing Fees: This revenue stream comes from servicing mortgages, such as collecting principal, interest, and escrow payments. They also collect fees for ancillary services related to mortgage servicing, including late fees, payment processing fees, modification fees and title insurance fees.
Origination Fees: Mr. Cooper also originates mortgages both for their own portfolio and for sale to third parties. The company can originate home loans through partnerships with realtors, directly to the customer or through other channels. The revenues derived from origination activities include gains from the sale of loans in the secondary market, fees for originating loans and gains from sales of mortgage servicing rights (MSRs).
Other Income: This category includes interest income from various sources as well as net investment gains and losses, mainly on their MSR portfolio. This is where some of the gains/losses from mark to market (fair value fluctuations) of the MSRs can be found. The business model is asset-light and capital-light, relying on economies of scale and efficiency to generate profits. Their primary competitive strength is built on a technology platform, servicing platform, and large and stable service portfolio that is harder for new entrants to replicate.

Industry Trends

The mortgage servicing industry is highly competitive and fragmented with a lot of non-bank and bank companies competing against each other.
The industry is very sensitive to interest rate and home values, and therefore is prone to cyclical swings.
Technology is rapidly changing the servicing market. Digital platforms are emerging as a big source of competition and can deliver efficiency.
The regulatory framework of the industry is always evolving.

Competitive Landscape

Mr. Cooper faces competition from a variety of sources:

Large Banks: Banks such as JP Morgan and Wells Fargo have their own large servicing business. They have the advantage of deposit funding from which they derive extremely cheap capital that allows them to make loans with competitive interest rates. Banks tend to be more stable and have more robust risk management models.
Other Non-Bank Servicers: There are a number of large non-bank servicers that are very aggressive and competitive. However, these smaller competitors tend not to have as strong of servicing platforms and economies of scale. Some of them tend to get into trouble and get bought out or get into bankruptcy.
Specialized Firms: Some firms focus on specific aspects of servicing, such as default management or subservicing, creating competition within sub-segments of the industry.
New entrants: As technology continues to evolve and get cheaper, more companies may try to enter the market, mainly through developing digital platforms that reduce costs and allow access to the market without much capital investment.

What Makes Mr. Cooper Different?

Scale: As the largest non-bank mortgage servicer, Mr. Cooper benefits from economies of scale, allowing it to service loans at lower costs.
Servicing Platform: They have built a proprietary, digital platform, called Xome, that enhances customer experience, and improves efficiencies in operations through automation.
Data and analytics: Mr. Cooper has invested heavily in data and analytics, which allows them to make more informed and timely decisions on managing the loans and servicing portfolio.
Proprietary Default Experience: Mr. Cooper, unlike other servicers that are just lenders, has experience with default management, having developed their platform, and this helps them perform well through the entire life cycle of a mortgage.
Customer Centric approach: Mr. Cooper has a focus on customer relationship and retention through different digital tools which allows them to have increased business and more customer referrals.

Moat Analysis | 2 / 5

Despite being the largest non-bank mortgage servicer in the United States, Mr. Cooper has a Narrow Moat. This is mainly because the industry is highly competitive, capital intensive, and very subject to changes. The main source of competitive advantage is the scale of operation and the technological platform that they have built.

Scale Advantage: Their large servicing portfolio gives them a cost advantage over smaller players, but this is not a unique resource and does not necessarily protect them against other large players.
Switching Costs: Switching costs for borrowers are relatively low, reducing customer stickiness to Mr. Cooper. Borrowers can easily find a new servicer when refinancing.
Network Effects: While the Xome platform and digital tools do enhance their business, they don’t generate network effects sufficient to create barriers for entry for new entrants.
Intangible Assets: There is some brand value with Mr. Cooper’s name, but there are no patents or regulatory licenses to protect them from competition.
Cost Advantage: They may have a cost advantage with scale, but also their interest income does not fully cover their costs, giving them negative interest margins sometimes, so the true sustainable cost advantage is doubtful.

Moat Risks

Interest Rate Fluctuations: Changes in interest rates directly affect refinancing activity, which can reduce their servicing portfolio and profitability. Increased interest rates can also negatively affect their balance sheet if the value of Mortgage Servicing Rights decreases.
Regulatory Changes: Stringent regulations can increase costs and reduce flexibility for mortgage servicers. A large part of their income from servicing comes from ancillary revenue streams, and changes in regulations regarding those streams can dramatically affect the bottom line.
Technological disruption: New technological platforms and processes have the potential to disrupt and disintermediate their business, as was seen with the emergence of digital banks and peer-to-peer platforms. They are investing heavily into tech but this creates a risk that new technologies from other players might outperform their platform.
Intense competition: Competition from other large non-bank and bank players can reduce their market share and put downward pressure on fees and margins. The industry is very cyclical and companies are in an ongoing race to increase volumes.

Business Resilience

The business model has been very difficult in the recent interest rate environment, they depend a lot on refinance activities and as rates have gone up in recent periods, volumes have declined and profit margins have compressed, as they depend more on generating income from the base servicing of loans.

Diversification: MRRTY’s operations are largely concentrated on servicing and origination activities in the mortgage market. This concentration makes them vulnerable to industry-specific downturns.
Resilience: MRRTY has shown a resilience to stay afloat through difficult times. They have made a lot of cost savings and streamlined their operations, but still they struggle to achieve sustained profitability. Their large size is a double edged sword, giving them the scale benefits, while also being very hard to make a substantial pivot.
Economic conditions: The business is highly exposed to overall economic conditions, particularly those related to interest rates, unemployment rates and housing values. Recessionary periods would be harmful to their business and the company would struggle to remain profitable. The nature of the business requires them to have some exposure to economic risks, which will lead to cyclicality.

Financials

Mr. Cooper’s financial statements show some key information:

Revenues: Revenue streams are very volatile, as origination and MSR valuation can swing drastically depending on market conditions. Recent years have shown large decreases in revenues as loan volumes decreased due to higher interest rates and MSR portfolio valuations declined due to the expectation of higher prepayments.
Expenses: Total expenses are heavily influenced by loan-related losses, employee compensation, and loan servicing costs. The expenses have been going down in the past years as a result of cutting down on origination staff and other cost saving measures. It is important to note that those efforts might not be enough.
Profitability: While some quarters show positive income or even profits, the business has not shown a sustainable positive income for the last years. The profits were affected by the downturn in the mortgage market, reduced loan volumes and mark-to-market adjustments in MSR portfolios.
Balance Sheet: From a financial health perspective, the company is managing its leverage cautiously, with a substantial debt and liability portion of the total capital, but the liquidity is high enough to continue to meet their obligations. They continue to try and grow their equity base with retained earnings, although negative income has not really permitted them to do that.
Key Financial Metrics
- Return on Invested Capital (ROIC) is low single digits in most years. This signifies the challenges in earning profits in a mature market.
- Operating margins have been fluctuating quite drastically, usually between 5 to 20 percent. When a company is going through a downturn and has lower volumes, margins will compress.
- A large portion of the revenues are coming from servicing and origination fees.
- Mortgage servicing rights portfolio is quite volatile and subject to sharp market fluctuations.
- They have a good amount of debt, with over $15 Billion in debt and liabilities. This is quite high and exposes them to risk.
- Book value is much higher than the current market cap.

Understandability | 3 / 5

While the basic business model of mortgage servicing is easy to grasp, several factors make Mr. Cooper’s business somewhat complicated to understand, requiring a 3 out of 5 rating.

Complex industry: Mortgage servicing involves a complex web of relationships between borrowers, investors, and other stakeholders.
Financials: The business model makes the financial statements a bit complicated. They are full of fair value adjustments from the MSR portfolio and the revenues and costs can fluctuate considerably.
Regulation: The regulatory landscape is always changing and may require expertise to understand the current rules and their implications on the business.

Balance Sheet Health | 3 / 5

Mr. Cooper’s balance sheet is not the strongest and its hard to evaluate due to the complexity of the industry, which makes it a 3 out of 5.

Debt Level: The total debt of the company is extremely high, putting pressure on the stability of the business.
Liquidity: Liquidity is currently acceptable with cash on the balance sheet to handle short-term payments. However, this can change if business conditions worsen.
Equity: The equity position is relatively low, and has not been improved due to negative income for many recent quarters, reducing the buffer to cover any negative impacts on performance.
MSR Portfolio: Mortgage Servicing Rights are valued at a point in time and are subject to fluctuations in their valuation based on interest rates. They are a big asset on their balance sheet, and therefore subject to big writedowns if the interest rates change drastically.

Recent Concerns and Management’s Perspective

Mr. Cooper has faced several challenges lately. The sharp increase in interest rates has driven a decline in loan volumes and have lowered their operating margins. The management is very keen on cost cutting and is streamlining processes, focusing more on growing their servicing portfolio instead of originations. During earnings calls, management has acknowledged the challenges while remaining optimistic about long-term growth.

Their strategy for the future is on developing their proprietary platform Xome and capturing cost savings and greater efficiency, which should lead to an improvement in earnings over the medium-long term. They believe that the housing cycle will recover and volumes will increase when rates start to decline, therefore being well placed when that occurs. They are emphasizing a “steady and efficient management of the existing service portfolio” which they believe will carry them through difficult times. They have a new CEO, Jay Bray, starting in 2015 who has a very long record of management experience in the mortgage servicing sector.

Final Thoughts

Mr. Cooper is operating in a highly competitive and cyclical market. While they have some competitive advantages due to scale and a proprietary servicing platform, these are not strong enough to form a very durable moat. However, the management is aggressively investing into technology and processes to improve profitability and sustain their positions in the market. They are not an easy business to understand, and the company is operating with a highly leveraged balance sheet, creating some risk in the event of a downturn, and these are all things you must keep in mind when considering MRRTY.