Description

Summary

Impac Mortgage (IMH) entered the year as a $6 stock. A temporary boom in refinance activity

in tandem with an announced acquisition drove the stock towards $14. After announcing

“blowout” earnings a few days ago the stock surged another 50% to $21.

I believe IMH is an extremely timely short. There is always a tradeoff when investing to balance

exhaustive thoroughness with nimble timeliness. The thesis below indicates why IMH is likely

overvalued by around 50%. There is a window to take advantage of a price spike caused by

people who I believe fundamentally do not understand this company. In that spirit, I hope that

readers will forgive a consequently more rapid analysis and documentation than I would

normally perform. I hope to flesh out this analysis over the next few weeks but wanted to

highlight the opportunity created by momentum buying for those willing to jump in on the basis

of this first pass.

Background

Impac Mortgage is one of the few non-bank mortgage originators to survive the 2007-2008

residential lending crisis. Although the company previously maintained a portfolio of mortgage

loans, today it is pursues an origination for gain on sale strategy. In early 2015, IMH closed a

transformative acquisition for CashCall which shifted their origination base from

wholesale/correspondent to quasi-retail via a centralized call-center operation.

On April 23, Impac reported blowout earnings of $2.92 for 1Q15. Retail bulls seized upon this

number with the more “sober” ones viewing sustainable quarterly core income around $1 after

stripping away a DTA revaluation tax benefit. With the stock around $14, IMH appeared as a

fast growing company trading around 3.5x earnings. Buy buy buy!

Current earnings are highly inflated vs. normalized numbers

A major driver of Impac’s 1Q15 blowout was clearly the mortgage refinance boom sparked by a

combination of decreasing interest rates and the FHA’s reduction of Mortgage Insurance

Premiums by 50bps. IMH achieved a Gain on Sale margin of 1.64% in 1Q15 (vs .79% in the

previous quarter albeit with some of that due to a shift in retail/wholesale composition) on

originations of $2,285MM. Impac’s business is predominantly refinance driven and the MBA

Refinance Index jumped from around 1400 in 4Q14 to levels between 2000-2800 in 1Q15.

The latest MBA refinance forecasts call for a decline in refinance activity from an estimated

1Q15 index level of 150 towards 100 by 2H15 with further declines towards 90 into 2016. The

reasons for this are twofold. First, refinance activity is extremely rate sensitive and even a

slight pickup in mortgage rates can sharply curtail activity. Second, there is the burnout factor.

Even if rates don’t rise, at a certain point everyone who can benefit from refis at a certain

interest rate level has already done so. Unless your core macro bet is for another material

decline in long term interest rates from here, there is limited fuel to keep this refi boom going.

If we haircut 1Q15 origination levels by 30% and GOS margins downward by 25% then Gain on

Sale revenue declines by ~$18MM from $37.5MM to ~$20MM. But this underestimates the

bottom line impact. From Q414 to 1Q15, IMH doubled originations with only a 20% rise in

expenses. From this we can infer that this is essentially a fixed operational cost business

(although there is some risk that this analysis is skewed by some strange merger accounting).

Thus, this estimated volume/margin haircut eliminates ~70% of 1Q15 pre-tax income!

Next, Impac generated $2.7MM of real estate services revenue in 1Q15. This revenue is

directly tied to Impac’s declining legacy portfolio and is not run-rate income worthy of a

multiple. Using historical data and company projections indicating a 25% decline rate one

should strip the $2.7MM from run-rate revenue and instead add back a runoff value of $10-

$30MM to the run-rate “continuing operations” company valuation.

The combination of these two factors brings adjusted 1Q15 pre-tax earnings to ~$3.5MM. For

the sake of a rapid analysis (see aforementioned caveats on timeliness!) lets just conservatively

assume IMH never pays taxes again rather than try to parse through their $164MM DTA. This

results in ~$1.25 annualized EPS accounting for dilution from IMH’s $20MM in the money

convertible bonds. Using an 8x PE (this is an ultra-cyclical commoditized mortgage originator so

that’s probably generous) and adding back $20MM for the real estate servicing runoff yields a

total value of $11.70 or 45% below todays level. If anything, I believe I am being generous to

Impac with my estimates and multiples here.

But wait there’s more…

That $11.70 target doesn’t take into effect the impact of several other negative factors creating

further downside optionality.

First, there is a cloud of litigation hanging over Impac. The 1Q15 10Q is not yet released but the

2014 10k reveals several potentially significant litigation matters. Among them is a Rescap

claim. I won’t pretend to be up to speed on each procedural twist and turn of this litigation

going back to faulty originations in the 2005-2007 period relative to many RESCU scholars in

this forum. Potential exposure of IMH to Rescap is in the $50-$100MM range ($6.50/shr at the

midpoint) although IMH defenses related to liability shielding under asset purchase agreements

could prevail. Impac also faces additional indemnification claims from Countrywide, Merrill,

UBS, and Deutsche Bank. Given how thinly capitalized Impac is, any meaningful litigation

recovery against Impac could be a massive blow to the company.

Next, there are some serious questions about the logical consistency of Impac’s disclosures.

Lets examine the transformative acquisition of CashCall. Acquisition consideration consists of

$10MM in cash, $6MM in shares, and a projected $124MM of contingent consideration. The

contingent consideration is determined by a formula based on CashCall operating earnings over

the next three years (70% 2015, 55% 2016, 45% 2017). We can use this formula to back into

projected CashCall average annual earnings of ~$80MM over the next three years. That’s

$80MM versus a total purchase consideration for $124MM. Even if we allow that Impac can

use their DTA to enhance after-tax profits, they are still paying ~1.5-2x pre-tax income for

CashCall. Does that make sense? What kind of business sells itself for 1.5-2x pre-tax earnings?

There is nowhere near enough disclosure to figure out what is going on here but either these

numbers are wrong or Impac really did make a transformative acquisition for 1.5-2x pre-tax

earnings. Call me skeptical but if that is the case then I err on the side of questioning the

value/sustainability of the business purchased rather than believing IMH got the deal of the

century – especially as CashCall’s prior owners are taking cash not stock as their payment.

Third, Impac will be raising capital in the near future. Their 1Q15 release states that they will

require $25MM of debt and/or equity to make those contingent cash payouts and fund growth.

Risks

Interest rates and/or government policy could keep refis going much stronger than I

anticipate. While its hard to see a further significant decline in mortgage rates, strange

things can happen There is a reason the short JGB trade was called the “widowmaker.”

Organic growth could strengthen. Impac is currently filling a role in the mortgage

ecosystem which most players have abandoned in the post-2008 world. Certainly no

major financial institution is going to take the regulatory and public opinion risk of

seriously competing for marginal quality loans in today’s environment. In some sense,

Impac is the perfect entity to go after this market. It has almost no capital and thus can

take an asymmetric bet that its originations don’t come back to haunt it in the form of

repurchase putbacks. Thus, there is a risk that Impac could see consistently strong

demand and margins fuel its bottom line even if the overall refi market shrinks. Maybe I

am underestimating the upside when IMH expands CashCall’s operations to new states.

Still, I estimate that Impac has an adjusted book value around $3. Lets say that this is

the rare unicorn of a business able to produce ROEs of 50%. Eventually we would

expect a flood of non-bank entrants. After all, this is bulk mortgage production – the

quintessential definition of a commodity business – and this is a general environment

where tons of capital is sloshing around looking for decent returns. Impac certainly has

no moat in brand, technology, product, or anything else. The market for unconventional

mortgage origination may be temporarily dislocated but industry structure means that

superior medium-long term profits are highly unlikely even in a bullish refinance macro-

environment.

Q15 is likely to at least optically be another strong quarter before results decay in the

second half. It should be noted however that under the contingent earn-out, only a

fraction of reported earnings actually accrue to common equity-holders versus the prior

owners of CashCall. That distinction may not matter to the Twitter chart-trading crowd

over the short run.

After its recent pop, IMH is flirting with the possibility of Russell inclusion. Strange

things happen to stocks on the cusp of Russell inclusion with the potential for

exaggerated price movement in both directions. Short sellers should at least be aware

of the risk for a short-term technical squeeze if IMH makes the index, and risk-manage

appropriately.

Conclusion

Base case fundamental value: $11.70 (45% downside)

Litigation exposures create additional downside optionality

Short case enhanced by questionable financial disclosures and an imminent capital raise

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Normalized earnings emerge in 2H15 timeframe

Adverse litigation results

Capital raise pricks momentum bubble

show sort by

			2015	2016
Price:	21.02	EPS	0	0
Shares Out. (in M):	12	P/E	0	0
Market Cap (in $M):	245	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0
Borrow Cost:	Tight 15-50% cost