An Open Letter to Nationstar Shareholders (NSM)

Dear Fellow Nationstar Shareholders:

As shareholders, we feel compelled to point out certain issues that have caused our company's common stock to fall precipitously over the past three months, well below its intrinsic value, which we firmly believe is in the mid-$30s using conservative assumptions. We will explain how we get to this valuation later in this letter.

While exogenous factors beyond management's control may have contributed to this decline, we believe that the lion's share of the value-destruction was caused by management not clearly laying out the company's strategic vision and potential earnings power, and providing inadequate explanation of the drop in both Servicing and Solutionstar's earnings and margins during the company's Q1-2015 earnings conference call .

We acknowledge, however, that the subsequently filed Form 10-Q  provided important information on some of the metrics that drove the mark-down of the MSR asset and the margin decline at Servicing and Solutionstar business segments.

In a quarter, where the company had significant earnings volatility, management changed the form of its earnings presentation, adding to the confusion, and in our view, left the impression of lack of transparency or at a minimum, lack of preparedness.

We would like to see better disclosure on how much of Nationstar's revenue and earnings decline in Q1-2015 was driven by:

1. Servicing portfolio mix (GSE, PLS and credit sensitive) since typically servicing fees collected per mortgage are lower for conforming loans.
2. A decline in incentive fees, loan modification fees and ancillary fees. We acknowledge that some of this information was disclosed in the subsequent Form 10-Q filing for the quarter.
3. Elevated levels of fines or penalties paid or servicing cost/loan in the quarter compared to previous quarters. In the subsequently filed Form 10-Q, we did see an increase of 2 bps in servicing expenses. We strongly urge management to explain how much of this increase is driven by one-time legal or other operational charges. We also recommend that as management increases share of interest sensitive servicing (using their terminology here) which has, both, lower servicing revenue and cost per loan, it provide shareholders with plans and guidance on how it will reduce per loan expenses to maintain and expand margin. It is troubling to see an increase in servicing expenses.
4. Finally, how much of the decline was due to decreases in mortgage rates and higher prepayments? Investors would benefit from better disclosures on sensitivity of MSR value to changes in mortgage rates and not have to wait for subsequent SEC filings.

Even though Servicing earnings in Q1-2015 were below expectations, management needs to do a better job of differentiating one-time events from systemic issues. Similarly, management needs to clarify how much of the margin decline at Solutionstar was driven by investments in growth initiatives versus changes in mix and how investors should recalibrate their margin expectations. 

Why we find Nationstar to be an attractive asset?

I. We believe that Nationstar will be a big beneficiary of ongoing industry consolidation, given its strong capital and liquidity position, FNMA 5 STAR rating, continuous improvement in its servicing platform and operating control environment. These advantages should manifest themselves in the form of future bulk servicing acquisitions. The company is one of the very few non-bank scale servicers with a history of efficient capital deployment and operating execution.

II. The company has already built a scalable consumer direct origination channel and needs to aggressively (in a disciplined manner, though) grow its share of originations in this channel. This will provide Nationstar a more capital efficient and profitable way to grow its servicing portfolio and business. We acknowledge that given the current lack of higher credit risk originations, this channel will increase share of interest sensitive conforming servicing. However we are not troubled by this and consider it to be a positive development that demonstrates management recognizes that given the size of the servicing portfolio, it needs to diversify across mortgage products to grow.

III. Nationstar has a scalable correspondent channel that could also be another efficient way of growing servicing balances. We recommend that the company consider beginning to acquire servicing through a flow correspondent channel. We also think that management should start preparing to originate higher credit risk non-prime mortgages through a wholesale/broker channel as that market emerges.

IV. We think that management could do a better job of providing plans and metrics on how the combination of bulk acquisitions and originations will result in $60 billion plus of annual mortgage servicing acquisitions required to grow the servicing portfolio

V. As mortgage rates rise (and we think that is likely in the next 4 to 6 quarters), the value of MSRs could increase due to an increase in duration. In a rising rate environment, the profitability of the servicing business should improve.

VI. Using conservative margin and growth assumptions, we think that the Solutionstar business has a value of $10-$13/share that currently lacks visibility. We believe management will figure out a way to provide visibility and have this value reflected in the stock price. If they are not successful, they will monetize the value of the business through some form of a strategic transaction. (Company management, at a recent investor conference, acknowledged that Soultionstar could alone account for the entire market capitalization of Nationstar.)

VII. We continue to monitor emerging legal, regulatory or other operational risks and look to the approval of recent servicing portfolio acquisitions by GSEs, other regulators and rating agencies as all positive developments. We also view the recent positive rating by FNMA as a positive indicator. Having said that this is an area that makes investment in NSM a higher risk proposition and we should note that is our analysis and models we discount the Company's free cash flows at a higher rate.

We believe NSM shares have an intrinsic value of $32-$40 per share

We value Originations segment: $12-$17 per share

Q1-2015 results were solid and the platform positions the company for growth and higher profitability in the future as long as it can manage the business by controlling both operating and rate risk.

We acknowledge that a rise in mortgage rates could decrease margins in the origination business, but the increase in servicing margins will more than offset that impact, resulting in a net benefit for the company.

Our segment valuation assumes that the company will meet its Servicing UPB growth target of 10% per annum and capture incremental 10-20 basis points of Originations market share each year. We use a conservative 18% discount rate to derive our valuation of this business.

We value Solutionstar: $10-$13 per share

This is a good ancillary business that the company has built and is developing additional products and services that it believes will distinguish it from some of its competitors and will be a source of incremental capital-light revenue.

While we are more cautious on the future growth prospects than management, we acknowledge that as long as regulatory risk and conflicts of interests can be properly managed, this business has a value of $10 to $13 per share. In our valuation of Solutionstar, we assume growth, but at a decelerating rate. Furthermore, we have used a conservative 18% discount rate in our valuation.

We estimate Servicing at NSM's tangible book value: $15.34 per share

Implicit in our valuation of this segment is an assumption that the book value of the MSR, which is a level 3 asset, and for which the company provides limited public disclosures on model inputs, is FAIR AND REASONABLE. Said differently, we are relying on the company's S.E.C. disclosures in its Form 10-K on discount rates (read yields) for credit and interest rate sensitive MSRs. We think that as long as those are reasonable, the Servicing segment on a static basis should do just fine.

* Corporate expense assumes an $80 million annual run rate and does not include interest expense since it is already reflected in the company's tangible book value.

Conclusion

1. Based on our analysis and models we think that NSM's stock at its current price is significantly under-valued. We do caution that this could be a volatile investment and if some legal or regulatory risks were to emerge it could result in a significant decline in the price of the stock.

2. We are not troubled, as some others are, with the company looking to increase its market share in conforming originations. We think this is positive and will allow the company to grow and create value as we have modeled in our origination franchise valuation.

3. We believe that the market will recognize the value of the origination franchise as the company continues to grow mortgage originations market share and reduce its reliance on the contracting bulk servicing market. This balanced approach will better position the company for profitable and consistent growth.

4. We also think that the investments in technology and infrastructure that are being made in Solutionstar will result in revenue growth in a capital light business. Our only concern here, which we will closely monitor, is how the company manages the operating risk.

5. Finally, NSM along with NRZ  will benefit in a rising rate environment providing prepayments slow and servicing cash flows increase.

Respectfully,

Taj Bindra

Alex Malinovskis

Farukh Z. Farooqi

ABOUT US:

Hill Bridge Advisors, LLC is dedicated to uncovering investment opportunities for value investors in the financial services, real estate, and structured finance markets. Our team of seasoned professionals held leadership positions at global banks and have extensive experience as operators, bankers, advisors, and investors across the financial services industry.

Taj S. Bindra - Managing Director

Taj S. Bindra has held leadership positions in major Banks and Consulting firms and is considered an expert in Finance, Risk, Capital Markets, Operations and Housing Finance. He has led and managed large U.S. businesses with thousands of associates and billions in earnings.

Mr. Bindra is currently the Managing Partner of Hill Bridge Capital, LLC a private financial advisory and a boutique investment management firm. Hill Bridge's recent clients include AIG, Morgan Stanley, Bank of America and other large financial services firms.

Prior to Hill Bridge, Mr. Bindra has held leadership positions at JP Morgan Chase (NYSE: JPM ), Washington Mutual (WAMU), and Price Waterhouse.

Mr. Bindra was Chief Financial Officer and Executive Vice President of JPM's Mortgage Division and also served on the Board of Directors of JPM's Mortgage Division, Management Committee of JP Morgan Chase's Retail Banking, and Chaired the Risk Committee for the Mortgage Division. Mr. Bindra was responsible for Strategy, Finance and Risk for residential mortgage. Over a period of 12 years, Mr. Bindra was responsible for acquisition of mortgage companies and portfolios with cumulative asset value in excess of $250B.

Mr. Bindra was an Executive Vice President and Co-Head of WAMU's Prime Residential Mortgage Business where he had direct responsibility for the Mortgage Capital Markets and the Servicing Divisions with over 7,000 employees across the United State, $750B in Servicing and $120 billion whole loan prime mortgage portfolio. He served on the Operating, Management and ALCO Committees of WAMU.

Mr. Bindra has also worked at Price Waterhouse, New Century and the University of Rochester.

Mr. Bindra currently serves on the Executive Committee of the Simon School at the University of Rochester and is actively engaged in the community. He has taught courses in Housing Finance, appeared on Fox TV and has been interviewed by the New York Times.

Mr. Bindra received a B.A. in Economics and Accounting from Shri Ram College of Commerce, University of Delhi and an M.B.A from the Simon School at the University of Rochester.

Alex Malinovskis - Managing Director

Alex Malinovskis is a Managing Director of Hill Bridge Capital. He has extensive financial services experience in Finance, Strategy, and Consulting roles at JPMorgan Chase, PHH, and Deloitte and Touche.

At PHH, as VP of Finance, Alex built and led the FP&A and Strategy groups through a period of organizational transformation which resulted in cost savings of $100MM per annum, strengthening its liquidity position, and developed a long-term strategic planning process.

As a Senior Vice President at Chase Home Finance, Alex was responsible for Financial Planning and Analysis, M&A and Strategic Planning. Alex directed the M&A process during a period of heightened deal activity in the mortgage industry, successfully completing over 20 transactions with a total value of $200B He coordinated cross-functional teams of up to 60 members engaged in due diligence reviews and transaction integration, including stakeholders from Legal, HR, Technology, Tax, and business operations.

He directly managed the planning process across Chase Home Finance, with accountability for an annual expense budget in excess of $2B, monthly forecasting and variance analysis, competitive intelligence, and benchmarking analysis and product development support.

In his 18 year career at JP Morgan Chase, Mr. Malinovskis also held a variety of positions at the corporate level in Finance, Strategy, and Planning areas.

Before joining Chase, Mr. Malinovskis was a senior consultant with Deloitte and Touche and a senior design engineer with Foster Wheeler Energy Corp.

Mr. Malinovskis holds a BS degree in Mechanical Engineering from Columbia University, an MS in Mechanical Engineering from Rensselaer Polytechnic Institute and an MBA in Finance from New York University Stern School of Business.

Farukh Z. Farooqi - Managing Director

Farukh Z. Farooqi is the Founder of Special Situations Monitor (SSM) and Principal of Marquis Research, LLC. Mr. Farooqi launched SSM in 2010 to engage with and help the value investing community find timely and actionable investing ideas.

Mr. Farooqi began his Wall Street career at Lehman Brothers in 1997 in equities research and subsequently worked at Merrill Lynch, Jefferies & Company, Kellogg Capital (Special Situations Group) and Imperial Capital. He has been cited and quoted in various media publications including the Wall Street Journal, the FT and the Daily Deal.