Description

Walker & Dunlop (NYSE: WD) Long Thesis

Walker & Dunlop is a commercial real estate services and finance company with a primary focus on multi-family lending. The company was founded in 1937 by Oliver Walker, grandfather of current CEO William Walker, and was one of the first companies using FHA insurance to make single-family home loans. Today the company primarily originates, sells, and services a range of multifamily and CRE products. In recent years the company has also diversified into other complementary lines of business including brokering loans for life insurance companies, taking equity stakes in interim-loans, and managing pools of capital via JVs with insurance companies and other sources of capital such as Blackstone. Results have been enviable, with revenue and EBITDA growing at CAGRs of 25% and 32% since the company’s IPO in 2010. Returns on Equity have averaged ~20% over the past four years, while free cash flow and TBV/share have also experienced strong growth. Walker & Dunlop is a growth company, but it generates excess capital which management has used to opportunistically repurchase shares, and in 2018 the company initiated a dividend which was subsequently raised. We believe Walker & Dunlop represents an attractive investment opportunity not only because of its quality and past success, but more importantly the street is missing two key fundamentals aspects of the story that will allow the company to generate significantly higher revenue and earnings than consensus has modeled. Operations continue to improve and management sees a long runway for growth, yet the stock’s multiple has compressed 25% since 2017 and the company trades for 10x forward earnings. We believe the stock can return 25% per year for multiple years as WD delivers results that significantly exceed expectations and management executes on its proven growth strategy.

WD derives the majority of its revenue from the origination, sale, and service of multi-family loans. The company is one of only 25 approved Fannie and Freddie lenders, which creates an attractive ‘moat-like’ competitive environment as the likelihood of new licenses being issued is very low. Brokered loans represent a growing piece of WD’s loan origination business, with HUD/GNMA loans also contributing a small amount to the total. Mortgage servicing fees are WD’s second largest revenue line item behind originations. The company services effectively all the loans it originates for the agencies and its interim loan program, as well as a portion of the brokered loans for institutional investors. These fees are recurring and structured differently than residential mortgage servicing rights, something we’ll discuss later. The third largest revenue line item is Investment Broker Fees & Management Fees. Revenue here is derived from multi-family sales brokered through WD’s broker platform, as well as management and related fees generated through the direct investment JVs and partnerships entered by WD and third parties. Escrow earnings and other interest income is the fourth largest revenue segment, albeit <10%. Net warehouse income interest on loans is the final segment, generating a total of 2% of revenue. In total roughly half of WD’s revenue is derived from transaction-based sources, while the other half is recurring in nature.

The company’s growth strategy is based on four goals: 1) Increase market share of GSE multi-family origination, 2) Continued expansion of the capital market team, 3) Continued expansion of the investment sales team, and 4) Develop new sources of revenue, e.g. new segments, JVs, etc.

Walker & Dunlop is the sixth largest multi-family originator, behind (in order) CBRE, HFF, Meridian, Wells Fargo & Berkadia, and is the third largest originator to the GSE group (behind CBRE & Berkadia). The primary factors driving WD’s origination volumes are: 1) growth in total MF originations from a market perspective, 2) growth in the number of loan origination professionals, and 3) growth in productivity per loan originator. The company benefitted from 2010-2016 as MF housing starts grew significantly; however, WD has continued to grow its origination volume as starts have leveled off in recent years.

WD has grown its total MF market share significantly since its IPO, going from 0.7% to 6.7% share in 2018. Market share expansion is being driven by hiring team members from competitors and driving increased productivity once those hires are onboarded. Since 2013 WD has grown its team member count by 22% per year, and loan origination growth has averaged 27%, indicating an increase in productivity. Importantly WD is well ahead of its hiring goal for 2019. The “outperformance” here is being driven by discontent within the ranks at the new JLL/HFF entity post-merger. In the past three to six months alone WD has hired away teams from JLL/HFF in Houston, Miami, Portland and San Diego. This hiring increase, which we estimate to increase the headcount by 17% in 2019, will lead directly to loan growth in 2020. And if history is a guide, an increase in productivity should drive loan origination growth north of 20%, even before accounting for any MF market growth. As we look out two to three years, we see WD capturing a double-digit market share of MF loan originations.

Originations are not risk free, though. Walker & Dunlop either risk-shares or takes full risk on $35B of loans which it services. That said, WD has stringent underwriting standards and multi-family loans are somewhat counter cyclical. For example, the highest net write-off rate the company has every experienced was 6bps (0.06%), which was the result of the worst real-estate bubble in history. The loans WD originates are extremely high-quality.

Walker & Dunlop’s loan originations lead directly to mortgage servicing rights. The company services most of the loans it originates for the GSE’s and the internal interim program, as well as some of the loans it originates for third parties. Services performed include billing and collecting payments, administration of escrow funds, providing property inspections, preparing and providing periodic reports to the GSEs, investors, etc., and other related tasks. There is one key difference between MSRs tied to MF loans versus their single-family peers: MSRs for MF loans are largely protected from refinancing risk. If an owner wants to refinance, he/she must pay WD the current discounted fair value of the MSR; and, because interest rates have dropped significantly since the majority of WD’s MSRs were booked there is substantial inherent value embedded in the company’s MSRs. As of September 30, 2019, the fair value of WD’s MSRs stood at $884mm vs the net recorded book value of $697mm. Walker & Dunlop’s current portfolio of MSRs stands at $91.8B, up from $7B in 2008, and is growing at ~15% per year. The average remaining life of the portfolio is 9.8 years, providing clear visibility into a consistent stream of cash flow.

The balance of WD’s business, excluding fees generated from escrow and warehouse income, is generated through three segments: Debt Brokerage, Principal Lending & Investment, and Property Sales, together collectively reference to as its Capital Market segment. Debt brokerage represents a small but growing piece of the business. In 2018 the company brokered $8.4B of loan originations, and has grown the amount brokered by 33% annually since 2014.

Principal Lending & Investment includes interim loans, JV equity investments, and preferred equity investments. Interim loans are originated and held by WD to provide short-term bridge loans to borrowers looking to acquired and renovate MF properties who would otherwise be unable to obtain financing. WD only provides these loans to clients who have a long history with the company. These loans are a great allocation of capital given the higher interest rate WD can charge and the level of familiarity it has with the borrower. JV equity investments primarily represent the JV between Walker & Dunlop and Blackstone Mortgage Trust. The JV was formed in 2017 and is an exciting addition to the tools WD has develop to capture all aspects of the MF loan origination market. Similar to the internal interim loan program, the JV with BXMT originates, holds and finances MF bridge loans before they are eligible to be refinanced with a GSE. WD contributes 15% of the equity capital while Blackstone contributes 85%. The loans are larger than the typical loan that would fit WD’s internal interim loan program, and Blackstone makes the ideal partner to take on these larger bridge loans. These loans carry a higher interest rate than typical MF loans, WD has the same high level of familiarity with the borrower, and are big to “move the needle” for Blackstone. Then when the tenant is ready to refinance with permanent GSE financing, WD is there to execute that loan as well. The JV has increased its loan exposure in 2Q19 to $608mm from $182mm at the end of 2017. The final piece of this segment includes the Investment Management division, which was formed with the acquisition of JCR Capital in 2Q18. In this division WD acts as the GP of private CRE investment funds which typically invest in multi-family debt, preferred equity, and mezzanine equity. The target LP/investor in these funds are insurance companies, endowment funds, etc. In total the Principal Lending & Investment segment of the business currently manages $1.2B of assets. WD’s goal is to get total assets under management to $8B-$10B. The goal was originally set for 2020, which seems unlikely at this point, but shows the vision that management has for the business.

Property Sales, the third division within WD’s Capital Market segment, allows WD to offer investment sales brokerage services to owners and developers of MF properties. In 2018 the company brokered $2.7B worth of property sales and has been expanding into new market around in the country. The company recently doubled its employment in this segment, largely as a result of the JLL/HFF merger. While property sales brokerage is a profitable business, the real benefit is the potential synergy created between property sales brokerage and loan origination. The goal is to provide all aspects of the real estate transaction to capture a bigger percentage of the transaction fees. Management’s goal is to reach $8B-$10B in property sales volume.

What the street is missing:

The general equation for WD’s loan origination growth is: 1) The volume of total multi-family originations from a market perspective, especially with respect to the GSEs + 2) Growth in the number of loan origination professionals at Walker & Dunlop + 3) Growth in productivity per loan originator/growth in market share. We believe the street is missing two key items with respect to (1) & (2) of the above formula. Thus, while consensus is looking for revenue and earnings growth of 4% and 1%, respectively in 2020, we believe the company will deliver results significantly higher.

(1): FHFA substantially increased the cap on multi-family GSE lending for 2020

In 2013 the FHFA set caps on the amount of GSE backed multi-family loans issued by Fannie and Freddie. Over the past few years these caps had been held between $60B-$70B. That said, there were many exemptions to these caps which drove total GSE issuance to ~$130-$140B per year. There has been much consternation in the market regarding the future of these caps, with most expecting the caps to be reduced and exemptions removed. For example, a KBW downgrade of Walker & Dunlop in early September raised the following concern: “Downgrade WD to Market Perform.  While GSE multifamily volumes are up 20% YTD, volumes may decline in the second half to comply with the lending caps. Profitability is highest in the GSE business, particularly Fannie Mae. The 2020 housing scorecard creates further uncertainty should the FHFA move to shrink the GSE's footprint.”

Ten days later, on September 13th, the FHFA released its 2020 revised cap structure:

While the FHFA did remove the exemptions, the agency significantly increased the total amount of the caps. $200B over the next five quarters not only increases the cap for 4Q19, it increases the total issuance in 2020 to ~$160B vs the prior ~$130B-$140B, representing a 14%-23% increase. As noted in the KBW note the GSE business is WD’s most profitable origination business, therefore the company should experience strong earnings growth with the increase in originations. Importantly, in September and October of this year the GSEs pulled back on their volumes as they awaited the new scorecard. We believe this will shift some volume from 4Q19 to 1Q20, providing an even larger boost for 2020 results.

(2): Walker & Dunlop’s headcount growth is well above trend

Walker & Dunlop has been able to attract top talent since its IPO in 2010, which has resulted in a large increase in market share of multi-family loan originations. WD’s total origination volume has grown at a CAGR of 27% since 2013 versus market growth of just 8%. The company has continued to grow its team, and has especially benefitted recently from some discontent at the new JLL/HFF entity. In the past twelve months the company has been adding team members at a y/y growth rate of roughly 15%. We believe this trend has accelerated through 3Q19, and the company should hit its goal of 200-215 bankers and brokers by mid-2020. While it takes six months for a banker to rebuild their book of business, this 22% growth should directly increase originations and brokerage volume in 2020 and 2021.

In addition to the upwardly revised GSE caps, the MBA forecasts total multifamily lending to rise to $390B in 2020 from $359B in 2019, implying an increase of 9%.

We believe these two factors, plus the overall increase in market growth as forecast by the MBA, will result in Walker & Dunlop generating revenue growth of 12%-16% in 2020, versus the current consensus estimate of 7%. As we expect the company to leverage costs given this level of revenue growth, we also expect earnings to grow 15%+, which compares to the current consensus estimate of 6% growth.

Walker & Dunlop generates a significant amount of cash flow, which has allowed the company to invest in the growth of the business. In 2018 the company decided the amount of capital being generated by the business created excess capital, and thus declared its first dividend of $0.25 per quarter. The dividend was subsequently raised in 2019 by 20% to $0.30 per quarter. We expect another increase in the dividend in 2020, as well as opportunistic repurchases of stock, something the company has done over the past few years.

Management alignment is strong at Walker & Dunlop. Executive officers and directors own a combined 10% of the common stock, including CEO Willy Walker owning more than 5%. Executive officers are expected to own shares of common stock with a value equal to at least three to five times base salary, and non-employee directors are expected to own at least five times the value of their annual cash retainer. The company has reasonably aligned targets for incentives, including goals for diluted EPS, revenue, adjusted EBITDA, return on equity, and stock price appreciation. There is also a clawback policy, as well as no hedging or pledging rules.

A common pushback on CRE investment ideas, particularly those exposed to transaction volume, is the business will decline if CRE activity pulls back. While this is true for generic brokers, two aspects of WD make it much more resilient than its peers. First, WD’s MSR portfolio provides it with long-term, consistent cash flows. In most cases these fees are paid by large corporations, which is much different than their SF MSR counterparts. Moreover, the loans originated by WD have low LTVs (~67%) and are mostly (87%) protected from refinancing risk. Secondly, Fannie and Freddie were set-up by the government as the lenders of last resort. While the number of new transactions may decline in an economic downturn, there are still plenty of loans that mature and need to be refinanced in any given year. When liquidity becomes scarce Fannie & Freddie increase their share of the market, and WD is in prime position to capture that increased share. Some of the company’s most profitable loans were originated in 2009 & 2010. These two dynamics allowed WD to remain very profitable in 2008, with operating income only declining 14% in arguably the worst CRE market in history. The company then rebounded in 2009, growing revenue and operating income significantly.

Walker & Dunlop is a very high-quality company by almost any measure. With only four sell-side analysts covering the stock and limited buy-side mindshare, we believe the company has largely flown below the radar despite strong operating results and shareholder return. It is also this lack of awareness that has presented the current opportunity. The company should easily outperform the current modest expectations for 2020 & 2021 as a result of the two catalysts we detailed. Trading at only ~10x our 2020 earnings estimate, growing revenue and earnings 10%-15% or higher, and an imminent dividend raise in the near-term, we view shares as undervalued and believe the stock can appreciate 25%+ for multiple years.

Catalyst

- Significant increase in 2020 origination volumes via market growth, headcount and productivity

- Beating forward market estimates

- 20% dividend raise next quarter to $0.36/quarter