This column was originally published on RealMoney on Nov. 17 at 10:36 a.m. EST. It's being republished as a bonus for TheStreet.com readers.
Quick question: What do you ask yourself about a stock in your portfolio that has gone up 18.5% year to date and has appreciated at a compound annual rate of more than 20% for the past 25 years? Well, besides wondering why you don't own more of it, two ideas come to mind.
First, after the stunning price appreciation, how expensive is it? Second, is the underlying growth likely to continue?
You may be surprised to learn that, despite the heady share-price gains,
trades at only 8.4 times consensus 2007 EPS estimates. This is well below the 2007 P/E multiples of 13.2 for
, 10.5 for
and 12.0 for
J.P. Morgan Chase
. These are, in order, the top four U.S. residential mortgage originators for the first half of 2006, from Countrywide at No. 1 to J.P. Morgan Chase at No. 4.
Of that group, Countrywide is the most sensitive to housing, but it even trades at a discount to most of the homebuilders. Unlike the homebuilders, though, for which Wall Street is projecting huge earnings declines in 2007, Countrywide is expected to increase earnings per share by more than 10% next year. Its current 8.4 multiple is well below its historic growth rate of earnings (29% compound net earnings growth for the past 10 years) and is below its targeted long-term growth rate of 15%.
The Housing Factor
It might not be surprising that Wall Street questions the sustainability of Countrywide's earnings. It seems like everyone has proclaimed that the housing market is set for a significant decline, if not an outright collapse. A decline in housing doesn't necessarily cause a major problem in the mortgage market, but it will likely slow the volume of originations and possibly disrupt the subprime mortgage market.
Countrywide looks well prepared for a slowdown in mortgage originations. It has enacted a $500 million annualized expense-reduction campaign, which it said would be complete by the end of 2006. This is a significant effort, as it represents around 7% of 2006 noninterest expenses.
As well, the company has implemented a $2.5 billion share-repurchase plan, of which it expects to complete $1 billion to $2 billion in the fourth quarter of this year. Buybacks are appropriate when the stock is not highly valued and investment opportunities are relatively limited, as would be the case for Countrywide in an environment with lower mortgage-origination volumes.
The bigger question is whether Countrywide is prepared for a worsening of credit, particularly in the subprime mortgage segment. As with any financial company, there are reams of statistics to examine, but perhaps the most important is its exposure to Pay Option ARMs.
A Pay Option ARM is an adjustable-rate mortgage with an interest rate that changes monthly and payments that change annually. The borrower can choose among various payment options, including one that is below what would be paid in an interest-only mortgage. Such a choice would result in negative amortization, which means that the loan's principal would increase during this period.
Monthly payments cannot increase by more than 7.5% per year unless the principal balance of the loan is 115% of the original loan amount or five or 10 years have elapsed since the loan was made. In both cases, the loan will become fully amortizing (that is, interest and principal payments will be made like a traditional mortgage). This reversion to full amortization is referred to as a "reset" or "recast" and can result in a very substantial increase in the monthly mortgage payment for a borrower.
Countrywide holds $35.4 billion of Pay Option ARMs, of which $29.6 billion are in negative amortization. This high ratio is not surprising, as the lower-payment option is what attracts borrowers to this loan. To date, the total amount of negative amortization -- that is, interest income booked by Countrywide that has not yet been collected in cash -- is $471 million, or 76 cents per share pretax. This is significant, and the per-quarter negative amortization could be 20 cents per share for the next few quarters.
That said, there is a meaningful offset. Most critics of these loans assume that a very high percentage of these borrowers will wait until the reset date, experience the huge shock in the monthly payment and default. This is not happening for two reasons.
First, borrowers are becoming more educated about this payment shock and are looking to refinance ahead of it. Second, the low interest rates right now and the tremendous capacity in the subprime mortgage market allow borrowers to refinance. Countrywide posted a fascinating slide on its Web site in its presentation at the Merrill Lynch Banking Conference this week, showing that two-thirds of those loans with resets on or before Dec. 31, 2007, have already been refinanced into other loans. Without a recession (and I'm no economist), the Pay Option furor appears overblown.
Countrywide's management, led by Angelo Mozilo, co-founder and CEO, has guided the company successfully through several credit cycles. When an investor is concerned about credit exposure, continuity of management is very important. This management team has built a valuable franchise that is inexpensive relative to its peers.
Finally, Countrywide is the largest originator of U.S. residential mortgages, with 15% market share.
Bank of America
is No. 6, with roughly 5% market share.
In a recent conference call, Bank of America said it was likely to consider disruptive strategies in mortgages, like it has with
online trading. I look forward to learning more about what Bank of America plans in this product area, but an event occurred last week that piqued my interest.
Countrywide has a bank subsidiary that invests in mortgage loans it originates and provides warehouse lending to other originators, funded by deposits it accepts. Last week, Countrywide announced it was going to apply to the Office of Thrift Supervision for a thrift charter, changing the entity from a bank to a thrift.
There are legitimate reasons for this, namely moving from two regulators (the
and the Office of the Comptroller of the Currency) to one (OTS) and possibly preferring the OTS' regulation going forward.
There's another twist: Bank of America is almost at the nationwide cap on deposit market share (9.2%, just under the 10% maximum). This was an issue when Bank of America acquired MBNA America last year. Countrywide has around 0.9% deposit market share. Both companies appear to be trying to grow deposits. If Countrywide is a thrift, the market-share test would not apply if Bank of America were to acquire Countrywide, unless the thrift subsidiary was to be integrated into Bank of America's bank. Ask your friendly bank regulatory attorney for details.
saying Countrywide will be acquired by Bank of America, but it isn't a bad idea. It could happen when Mozilo retires in December 2009, or sooner if Bank of America's disruptive strategy does not pan out. When a franchise as valuable as Countrywide has been built, if it were to be sold, it should be available to all bidders.
At the time of publication, Capone and/or his fund was long Countrywide, although positions may change at any time. Joe Capone is a managing member and founder of SMaRT Financial Partners LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Capone appreciates your feedback;
to send him an email.