We have been seeing a lot of merger activity lately in the mortgage banking space. Western Alliance recently bought AmeriHome and Galton Funding, while New Residential (NRZ -1.76%) just inked a deal to buy Caliber Home Loans from Lone Star Funds. After the greatest year for mortgage banking on record, New Residential is looking to the future. What does this transaction mean for the company?
A big acquisition, yes, but is it a big bargain?
New Residential agreed to buy Caliber for $1.675 billion in cash. It will fund the transaction with $675 million in available cash and liquidity, a capital raise, and the cash on Caliber's balance sheet. Immediately after the deal announcement, New Residential announced plans for a secondary stock offering of 45 million shares at $10.10 per share, which pretty much takes care of the capital raise.
New Residential is paying about book value for Caliber, which had net income of $665 million in 2020, and a mortgage-servicing portfolio with an unpaid principal balance of $153 billion. At first glance, a price tag of $1.675 billion for that business looks like a steal. The acquirer is paying 2.5 times earnings, and getting a servicing portfolio valued at $1.45 billion. The servicing portfolio is being valued at 1.03% of the unpaid principal balance, which seems fully valued given that 29% of the book is in Ginnie Mae servicing, which tends to trade at a discount. This is because Ginnie Mae loans exhibit lousy performance characteristics (right now, 6.3% of Ginnie Mae borrowers are in forbearance versus 2.5% of Fannie Mae and Freddie Mac borrowers). Note that New Residential has 19% of its servicing portfolio in Ginnie Mae loans.
The 2020 pre-tax earnings number is also irrelevant. 2020 was a record year, and volumes and margins will fall in 2021. Since this transaction is expected to close in the second half of 2021, the truly relevant number for the purchase price is forecast 2022 earnings. Caliber is expected to earn $295 million in 2022. Based on that figure, New Residential is paying about 5.7 times expected 2022 earnings, which is about where mortgage banks are trading these days.
This deal makes a lot of strategic sense
Caliber will add a retail presence to New Residential, which makes the transaction a good fit. As interest rates rise, mortgage refinancing activity is going to fall, and the purchase business will become dominant. Having 378 retail lending locations and 1,463 loan originators makes purchase loan acquisition easier, since much of that business is driven by relationships with real estate agents. In addition, New Residential spoke highly of Caliber's investments in technology, which can cut origination costs and improve customer satisfaction.
New Residential has in the past mentioned the possibility of spinning off its mortgage origination business since the market really wasn't giving much value to it. When asked about this on the conference call following the merger announcement, New Residential didn't indicate that it had changed its thinking. That said, as a real estate investment trust, New Residential is required to distribute most of its earnings as dividends. This could end up being a constraint if it would rather retain earnings for growth investments.
Non-government lending will only increase
Overall, the transaction makes a lot of sense for New Residential, and the retail presence it's gaining will help the business as refinancing activity dries up. The price may not be as much of a wild bargain as it first appears to be, but the buyer certainly isn't overpaying and probably got the better end of the deal. New Residential is also one of the big originators in non-government guaranteed loans, and its opportunity in that segment looks set to grow as the government has decided to reduce the footprints of Fannie Mae and Freddie Mac in the mortgage market. This differentiates New Residential from peers such as Rocket or UWM Holdings, and the company has a head start on its competitors here.
New Residential also gave preliminary guidance for first quarter earnings and forecast that book value per share would be in the $11.32 to $11.42 range. At recent levels, New Residential is trading at a 9% discount to book value, and its dividend yields 7.3%. These metrics alone are pretty attractive, and the potential of a mortgage operating company spin-off gives the company a catalyst to increase shareholder value. There are a lot of ways to win here.