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The Investment Case and Value of Altisource (ASPS)- 9/11/09 ($13.68)

Company Background

Altisource is a company that was recently spun off tax free from Ocwen Financial (OCN) and now trades on the
NASDAQ under the ticker ASPS. Every three shares of OCN entitled investors to a single share of ASPS and the
separation was completed on August 10th, 2009. The company operates under three different segments/divisions:
Mortgage Services, Financial Services and Technology Products. ASPS does business in all 50 states and 4 other
countries. While its client list contains more than 75 companies, ASPS relies primarily on OCN and American
Express (AXP) for the majority of its revenues. Specifically, relationships with OCN and AXP generate about 2/3rds
of total revenue. Accordingly, one of the reasons for the spinoff is to pursue diversification of this customer base.
Management believes that as a separate entity ASPS is more likely to cultivate relationships with third parties.
However, in the near future there is no reason to believe that ASPS will not still be very dependent on OCN and
AXP for business.

As of December 31st, 2008, the company had 2534 employees, including 651 in Mortgage Services, 1,254 in
Financial Services, 479 in Technology Products and 150 in Corporate. The number of employees has likely
decreased a good deal since then as ASPS has been very proactive in terms of eliminating positions within the
struggling Financial Services division.

Mortgage Services

It is important to immediately point out that ASPS is not a mortgage servicer. This particular division is more of a
consultant to and supporter of mortgage servicers, mortgage originators and third parties who purchased mortgages
from other institutions. This last group includes hedge funds and insurance companies that may be in need to
substantial assistance in the handling of these assets, especially if the stress in the housing market continues.
According to company filings, this segment offers the following services: “due diligence, valuation, real estate sales,
default processing services, property inspection and preservation services, homeowner outreach, closing and title
services and knowledge process outsourcing services.” Most importantly however, it offers soup to nuts support for
mortgage products, starting with origination and including disposition of repossessed real estate assets. There is no
question that this has the potential to be a growing and valuable business. As the vast number of foreclosed and
distressed properties on the market increases, the infrastructure of servicers and owners of whole loans will be
further taxed and there will certainly be some incentives to outsource to capable counterparties.

6 Months Ended
Segment Breakdown FY 2006 FY 2007 FY 2008 30-Jun-09
Mortgage Services
Revenue $59.7 $64.3 $55.0 $41.7
COGS 43.8 44.2 36.4 23.8
Gross Profit $15.9 $20.1 $18.6 $17.9
Gross Margin 26.63% 31.26% 33.82% 42.93%

SG&A $8.3 $7.9 $5.0 $3.7

SG&A % 13.90% 12.29% 9.09% 8.87%

Operating Income $7.6 $12.2 $13.6 $14.2

Operating Margin 12.73% 18.97% 24.73% 34.05%

Related Party Revenue % 52.09% 63.14% 75.64% 78.90%

% Total Company Revenue 61.80% 47.66% 34.29% 45.13%
Sources: Capital IQ, company filings, and additional calculations
As shown above, this segment has traditionally had the highest operating margins and has been an important
revenue generator. However, it is important to note that as of the most recent 10-Q filing, close to 79% of the
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Mortgage Services’ revenue was derived from the relationship with OCN. While that may be better than being
dependent on a more fickle third party, it is important to understand the post spin-off arrangements between ASPS
and OCN. The two companies have signed long term service contracts of up to 8 years for both mortgage servicing
and technology. Specifically, ASPS has the first opportunity to bid on any contract that OCN is trying to fill. Further,
OCN is obligated to accept ASPS’s bid if ASPS is willing to match the price offered by a third party. They also have
signed some short term contracts for human relations, accounting and risk management during the transition period.

Given these agreements, the first concern that comes to mind has to do with the price of these contracts. When ASPS
was part of OCN there was no guarantee that the rate OCN paid ASPS was the same as the rate that was charged to
third parties. Even post spinoff investors have reason to be wary of transactions that are not necessarily arm’s length.
However, in recent filings, ASPS and OCN have addressed this concern. Specifically, the companies claim that the
rates ASPS has agreed upon with OCN are consistent with those that ASPS charges third parties. Also, they assert
that the rates are similar to market rates, those charged by competitors and those gleaned from conducting industry-
wide surveys. Accordingly, while there is obviously customer concentration risk (hence the need to analyze OCN as
a counterparty), ASPS’s relationship with OCN, its rights under the contracts, and the market-based rates seem to
mitigate the possibility of and damage caused by the defection of its largest customer.

Finally, it is necessary to address how this segment generates revenue. As opposed to generating a flat consulting-
like fee, this division receives payment for each service it provides. In other words the volume of services is the
most important driver of revenue. Since this division charges individually for each property inspection, title search
and real estate asset sold, the fact that the number of such transactions may continue to increase bodes well for ASPS
when it comes to its offerings to third parties. In terms of revenue recognition, when it comes to property and
mortgage based services, ASPS realizes revenue as the service is actually provided. On the other hand, in terms of
default processing the company recognizes revenue over the period in which it assists in repossession or disposition,
with full recognition occurring when either process is complete.

Financial Services

This business provides asset recovery assistance to customers in the financial services, consumer products and utility
sectors. The primary client is AXP, a relationship that produces over 50% of this group’s revenue. ASPS acquired
this account through its June 2007 purchase of Nationwide Credit Inc. (NCI), one of the 10 largest receivables
management companies in the US. NCI has had a relationship with AXP for over 30 years and the credit card
company continues to work with ASPS. The group claims to use some interesting techniques in order to improve its
asset recovery results. Specifically, it incorporates “psychological principles” in attempting to bolster efficiency.
Regardless, as shown below, whatever it is the Financial Services division specializes in, it has consistently been
unprofitable.

6 Months Ended
Financial Services FY 2006 FY 2007 FY 2008 30-Jun-09
Revenue $7.7 $41.3 $73.8 $33.8
COGS 5.2 32.3 62.6 27.9
Gross Profit $2.5 $9.0 $11.2 $5.9
Gross Margin 32.47% 21.79% 15.18% 17.46%

SG&A $3.2 $14.8 $17.2 $7.8

SG&A % 41.56% 35.84% 23.31% 23.08%

Operating Income ($0.7) ($5.8) ($6.0) ($1.9)

Operating Margin -9.09% -14.04% -8.13% -5.62%
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Related Party Revenue % 27.27% 2.42% 1.63% 2.07%

% Total Company Revenue 7.97% 30.62% 46.01% 36.58%
Sources: Capital IQ, company filings, and additional calculations

Since the NCI acquisition, this group’s contribution to total revenue has increased significantly and the dependence
on OCN has decreased dramatically. However, COGS and SG&A expenses are such that it has not been able to
achieve positive operating margins. If there is one major concern for investors regarding the business model of
ASPS (as spun off) it has to do with this segment. In the 6 months that ended June 30th the Financial Services
division generated over 36% of ASPS’s total revenue but its decidedly negative operating margins clearly drag down
the company wide margins. When this is combined with the fact that the loss of the AXP account for any reason
would cripple this division and leave it terribly overstaffed, it becomes unambiguous that something must be done to
rectify this money losing business.

Accordingly, management has started to reduce costs in this segment. As mentioned above, headcount has been
reduced and in July 2009 ASPS closed two of Financial Services’ offices; the severance and real estate costs of
which will be dealt with in Q3 2009. A reduction of infrastructure and SG&A costs seems to be prudent. However,
the headwinds facing this division may not abate anytime soon. While there are certainly more opportunities for
asset recovery, especially among AXP’s customers who are defaulting at much higher rates than in previous
recessions, the extent to which consumers are over-levered may cause recovery rates to be quite low. Since this
group generates the bulk of its revenue by charging a percentage of the amount of money recovered, the lower the
recovery rate the lower the fee. But that does not diminish the amount of time and effort spent in the recovery
process. Therefore, agents may be spending as much if not more time on recovery but receiving a lower fee as many
consumers owe money on multiple credit cards, have under water mortgages, and may no longer be employed. All
in all this is a toxic combination that may preclude this segment from reaching a profitable state.

Next, I think it is also important to point out that NCI does not look like it was profitable back in 2007 when OCN
bought the company, even before the world economy fell apart. OCN’s 2007 10-K indicates that in the period from
June 6th, 2007 (the acquisition date) to December 31st, 2007, “NCI revenues and operating expenses for the 2007
period were $35,978 and $38,400, respectively.” That’s a $2.4M loss in less than 7 months and based on the 2009
data presented above, the situation has only gotten a little better but not enough to bring this division into the black.
This of course, brings up the question of why management decided to spend $57M in cash for a company that was
not generating operating earnings. Since the most prominent members of the current ASPS management team were
involved with OCN at the time of this deal, there is no question that the ability to make shareholder friendly capital
allocation decisions will be in question going forward. All of that being said, the significant insider ownership of
ASPS shares and the apparent substantial room for margin improvement (both are discussed in much more detail
below) in this division should allay some of the previously mentioned fears regarding the NCI deal.

Further, the company has taken a very close look to see if it should recognize a goodwill impairment based on this
deal. As of 6/30/09, ASPS had $9.7M in goodwill on the balance sheet. However, according to management, even
using a 16% discount rate that apparently reflects the company’s weighted average cost of capital, no further
impairment has been deemed necessary (Note: OCN realized an impairment in the Financial Services division in
2008)

Technology Products
This division offers technology products such as REAL Suite software and applications to mortgage servicers and
originators. According to the company this includes “commercial and residential loan servicing and loss mitigation
software, vendor management and a patented vouchless payable system and information technology solutions to
manage and oversee payments to large- scale vendor networks.” Traditionally the major customer of this segment
has been OCN, which accounted for over 73% of revenue during the first 6 months of 2009. Despite this
dependency, there appear to be numerous positives associated with this segment: along with sequentially improving
margins (shown below), the products offered by the Technology Services segment cater to third parties that will
likely be in desperate need of the software’s capabilities.

6 Months Ended
Technology Products FY 2006 FY 2007 FY 2008 30-Jun-09
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Revenue $34.6 $36.2 $45.3 $22.7

COGS 28.6 27.4 29.8 12.4
Gross Profit $6.0 $8.8 $15.5 $10.3
Gross Margin 17.34% 24.31% 34.22% 45.37%

SG&A $7.0 $6.4 $6.1 $2.8

SG&A % 20.23% 17.68% 13.47% 12.33%

Operating Income (1.0) $2.4 $9.4 $7.5

Operating Margin -2.89% 6.63% 20.75% 33.04%

Related Party Revenue % 69.36% 67.68% 77.48% 73.13%

% Total Company Revenue 35.82% 26.83% 28.24% 24.57%
Sources: Capital IQ, company filings, and additional calculations

As discussed above in the Mortgage Services section, ASPS has signed long term, market-based contracts with OCN
that should provide this segment with substantial and consistent revenues. However, the products can also be sold on
a stand along basis to outside customers. Typically, fees are charged on a per loan or per transaction basis, a fact that
indicates that this segment benefits from increased volume. When IT infrastructure services are rendered, this group
charges a fee for each user who has access to the system or who is directly using the associated software. The
company claims that this structure provides the opportunity to improve margins as the delivery becomes more
efficient.

Accordingly, despite the customer concentration risk, this appears to be a potential growth segment if ASPS can
market itself well to third parties. It is logical to assume that non-traditional owners of mortgage assets such as
hedge funds or insurance companies will quickly see the benefits of all encompassing software. However, it would
not be a surprise to see marketing costs increase for this and the other two segments as there is an additional
emphasis on reaching new customers. This could definitely put pressure on margins in the short run. Also, this
seems to be an opportune time to address the fact that there could be some dis-synergies as a result of the spinoff.
All of the back office, accounting, legal, and human resource functions that were available to ASPS under the OCN
umbrella, may need to be re-created now that it is a stand-alone entity. As mentioned above, ASPS has signed short
term contracts to continue these support services over the short run, but it is unclear whether or not the company will
have to build out these departments and add to the cost structure.

Valuation

After trading down to around $10 after the spinoff, the stock has risen sharply to the current price over $13.50. As a
result, based on even some optimistic assumptions about future EPS, the stock does not look particularly cheap.

Results from first 6 months

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EPS $0.47
Annualized P/E 14.40x
Owner's Earnings $0.52
Annualized P/OE 13.02x
Unlevered Free Cash Flow ($M) 11.7
Annualized P/UFCF 14.03x
EBITDA ($M) 20.7
Annualized EV/EBITDA 7.64x
Sources: Capital IQ, company filings, and additional calculations

The above table shows the applicable valuation if the results from the 1st half of 2009 are annualized (doubled).
Aside from the reasonable EV/EBITDA figure, none of the other valuations are that compelling. This is especially
true considering that annualized 1H 2009 data is much better than pro forma full year 2008 data. Specifically, with
the same share count the company only would have only earned $.45 per share (pro forma) in 2008 and generated
$25M in EBITDA. If the trends established in the first half continue into the second half then the 2009 figures will
be substantially higher than the 2008 numbers. Having said that, for a value investor it is tough to get excited about a
company based on what look like elevated earnings. Accordingly, it is also useful to construct a more conservative
EPV analysis based on normalized EBIT:

EPV Analysis EPV Sensitivity Analysis

Conservative Run Rate Revenue $160.0 Cost of Capital Total Value Value Per Share
3 Year Average Revenue $130.6 9% $213.33 $8.89
10% $192.00 $8.00
3 Year Average GM 27.2% 11% $174.55 $7.27
Gross Margin Going Forward 30.0% 12% $160.00 $6.67
Implied Gross Profit $48.0 13% $147.69 $6.15
14% $137.14 $5.71
3 Year Average SG&A Margin 18.8% 15% $128.00 $5.33
SG&A Margin Going Forward 18.0% 16% $120.00 $5.00
Implied SG&A Cost $28.8
Current Market Cap $326.88
Implied EBIT $19.20 Current Price $13.62
Implied EBIT Margin 12.00%
3 Year Average EBIT Margin 8.42%

Normalized EBIT $19.20

*Total value= Normalized EBIT/WACC
^The reason WACC amounts up to 16% are included is due to ASPS’s indication that 16% represents the company’s WACC
Sources: Capital IQ, company filings, and additional calculations

As the above table illustrates, based on some generous but potentially realistic margin assumptions and run rate
revenue, shares look quite expensive. Of course this analysis does not fully take into account the very positive
results from 1H 2009 (discussed in more detail below). Also, the fact that the company is now stand alone may lead
to different levels of profitability than previously. It is very difficult to predict the impact of items such as increased
scale or the need for higher marketing and back office expenditures. Although, it should be noted that if the
operating margin for the first 6 months of 2009 (19.32%) is applied to run rate revenue estimates, the resulting EBIT
figure jumps to $30.9M. But, even with the huge boost in EBIT and using a relatively low 10% WACC, the
EPV/share is only $12.88 and is below the current share price. Therefore, without being willing to assume that the
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results from the first half of 2009 are going to continue (and even be improved upon in the future), it is very hard to
justify arguing that there is potential upside imbedded in the current price.

Finally, even when earnings valuations are not attractive, it is important to look at the balance sheet to see if there is
a sufficient margin of safety based on the company’s assets. In this case the results don’t make the stock look any
more compelling at the current price:

Diluted Shares Outstanding (Filing) 24.0

Book Value/Share $2.73
Period End Price to Book Value 4.98x
Tangible Book Value $20.8
Tangible BV/Share $0.87
Period End Price to TBV 15.71x
Sources: Capital IQ, company filings, and additional calculations

At almost 5x book value and 15.7x tangible book, ASPS will never be confused with a Benjamin Graham net-net. In
fact, when the earnings valuations are combined with the book value multiplies, it becomes clear that the market is
pricing in substantial growth. Now, with the state of the housing and commercial real estate markets, it is very
possible that both the Mortgage Services and Technology Products divisions are going see increased demand. Thus,
revenue and earnings may continue to grow and eventually justify the multiples. However, the growth multiples
leave no room for a margin of safety and thus preclude most value investors from being more constructive on the
stock.

Profitability

Having established that shares of ASPS look too expensive for a value investor at the current price level, it is
important to analyze the data regarding historical profitability in order to ascertain whether or not this is a company
that investors should continue to monitor. Below is a chart on margins and returns:

1H 2009
Return Metrics FY 2006 FY 2007 FY 2008 2008 Pro Forma^ 30-Jun-09
Gross Margin 25.26% 28.17% 28.24% 28.24% 36.80%
Operating Margin 7.04% 7.49% 10.72% 10.72% 19.32%
Net Income Margin 5.59% 5.12% 5.72% 6.73% 12.29%
ROE* N/A 9.12% 15.14% 15.85% 35.98%
*2007 ROE is based on 2007 equity levels
*2008 and 2008 pro forma ROE is based on the average of 2007 and 2008 equity levels
* June 30th annualized ROE is based on 6 months of income and average equity between Q4 2008 and Q2 2009
^2008 pro forma data includes the add back of a non-recurring interest charge
Sources: Capital IQ, company filings, and additional calculations

From a profitability perspective, it is very positive to see the trend of increasing margins. This could be a sign of
increased efficiency and economies of scale that will only improve as ASPS is able to cultivate additional third party
relationships. The problem is that it is very tough to know what ASPS’s cost structure will look like as a standalone
company. Also, the very impressive margin increases from fiscal year 2008 to the 6 month period ending June 30th
are difficult to gauge in terms of sustainability. Looking at the data, most of the improvement appears to be coming
from revenue increasing faster than COGS and the resultant higher gross margin is helping boost operating income
and net income. As mentioned previously, there could be some pressure on gross margins going forward based on
additional SG&A spending in the form of marketing, but the truth is that the margin trends are generally very
positive. If ASPS were able to turn the Financial Services business into a profitable segment through additional
rationalization of costs, the company wide margins could even improve further. There is no doubt that the emerging
opportunities to add revenue and measures to continue to increase efficiency could lead to sustainable gross margins
in the 20-25% range. While even that margin structure would not result in the current price looking particularly
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compelling, if ASPS could establish those margins as a baseline then this absolutely looks like a company and stock
to follow on a regular basis.

Competitor Comparison: Valuation and Profitability

ASPS is unique in that it is made up of as assortment of businesses that makes it tough to find perfect comps.
However, after some digging, the competitors that emerged as relatively good comparisons were Lender Processing
Services (LPS), Fiserve (FIS) and Portfolio Recovery Associates (PRAA). While none of these is perfect, they all
have divisions and segments that compete in some way with ASPS. Specifically PRAA’s business model is similar
to that of the Financial Services business at ASPS. Next, FIS has a financial institutional services segment that is not
too different from ASPS’s Mortgage Services division and FIS offers technology services to its customers. Finally,
LPS has a technology segment that caters to the same clientele as ASPS’s Technology Products group and has a loan
transaction division that is similar to ASPS’s Mortgage Services group. Thus, out of the three, LPS looks like best
comp but FIS is not too bad and PRAA provides an interesting reference point on the margin potential for a well run
asset recovery business.

The following chart highlights the average margins and ROE of these companies over the last few years. What
immediately stands out is the extent to which the competitors have traditionally much more robust margins (aside
from ASPS’s 1H 2009 margins). This could indicate that ASPS has the opportunity to expand its margins as a
standalone company to match those of the competitors. Also included are the margins from the 1st half of 2009 so
that investors can begin to ascertain whether or not they are sustainable.

Alitsource 1H 2009 Lender Processing Services Fiserve Portfolio Recovery Associates

ASPS ASPS LPS FISV PRAA
Average Gross Margin 27.22% 36.80% 38.78% 32.78% 68.14%
Average Operating Margin 8.42% 19.32% 23.50% 19.14% 37.38%
Average Net Income Margin 5.48% 12.29% 13.83% 12.40% 22.34%
Average ROE 12.13% 35.98% 20.30% 16.24% 19.82%
*Sources: Capital IQ and company filings

It is striking how much lower ASPS’s margins have been (on average) over the last few years than those of the three
competitors. There is no way to verify this supposition, but it is possible that OCN was not paying ASPS prevailing
market rates for its services. Therefore, as those rates reflect current market conditions more and more, it is only
logical that both gross and operating margins will increase.

Starting with LPS and FIS, aside from the incredibly high ROE in 1H 2009, the margins ASPS achieved over the
most recent 6 month period look very similar to the averages for LPS and FIS. This could be an indication that the
first half result may be repeated going forward as these two companies have comparable operating businesses. At
very minimum, the average results of LPS and FIS represent guidelines for the magnitude of profitability the
management team at ASPS can strive for. Additionally, it is fascinating to contrast the margins of PRAA with those
of the Financial Services group at ASPS. Although both business do essentially the same thing (asset recovery---
except that PRAA also purchases receivables and attempts to collect on them instead of just collecting a finder’s
fee), PRAA has averaged better than 37% operating margins while the Financial Services segment of ASPS has
consistently been unprofitable. This implies that there could be a significant opportunity to turn this business around
if ASPS were able to get the cost structure right. Obviously, the management team has a long way to go on that front
but even a modest turnaround would boost company wide margins and justify the purchase of NCI.

Average Multiple
TEV/LTM Sales ASPS LPS FISV PRAA
Current 1.86x 2.21x 2.60x 3.41x
2004-2008 Average N/A N/A 2.24x 4.11x
P/E Ratio (LTM EPS)
Current 22.24x 13.95x 21.00x 15.02x
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2004-2008 Average N/A N/A 19.63x 17.89x

TEV/LTM EBITDA
Current 8.99x 8.50x 8.78x 10.35x
2004-2008 Average N/A N/A 10.14x 9.99x
Price Book
Current 4.98x 10.47x 2.61x 2.14x
2004-2008 Average N/A N/A 3.23x 3.23x
Sources: Capital IQ, company filings, and additional calculations

From a valuation standpoint, especially when it comes to earnings, it is tough to compare ASPS to the others due the
lack of trading history and the fact that ASPS was operating under the OCN umbrella. Accordingly, what it is
valuable to look at is the type of multiples the market has traditionally placed on the competitors. Unfortunately,
LPS has a limited trading history as well so very little can be gleaned from its valuation. Since this is an earnings
and not an asset value story, it makes sense to ignore price to book value for the moment. But, based on earnings and
sales metrics it appears that the following ranges are applicable: 2x-4x TEV/Sales multiples, 14x-21x EPS multiples,
and 8.5x-10.5x EV/EBITDA multiples. Therefore, once reasonable run rate sales, EPS and EBITDA levels can be
established it will be much easier to place a proper valuation range for ASPS. For simplicity, the following chart
presents a range of values per share based on the above multiples and 1H 2009 annualized sales and earnings (values
are in $US millions):

1H 2009 Annualized Value Range ASPS

Sales 2x-4x TEV/Sales Current TEV
$184.8 $369.6-$739.2 $314.68

Earnings 14x-21x Earnings Current Market Cap

$22.7 $317.9-$476.8 $326.88

EBITDA 8.5x-10.5x EV/EBITDA Current TEV

$41.3 $351.1-$433.7 $314.68
Sources: Capital IQ, company filings, and additional calculations

While based on obviously optimistic results that may not occur in the future, the chart does indicate that if the
current profitability can be sustained and ASPS is allotted similar multiples to those of the competitors, there could
be some upside in the share price as ASPS is now (hypothetically) trading at the bottom of the ranges. Also, while it
might be foolish to buy shares now based on the above sales and earnings assumptions, upon any indication that the
1H 2009 margins can be maintained, there would be ample reason to become more comfortable with the stock’s
valuation.
Insider Ownership

Insider Ownership
Name Shares % Owned
William Erby- CEO of OCN 6,146,772 25.59%
Wlliam Shepro—ASPS CEO 107,475 < 1%
Robert Stiles- ASPS CFO 0 0%
Kevin Wilcox- General Counsel and CAO 49,878 < 1%
John McCrae-NCI CEO 0 0%
Shekar Sivasubramanian- President of
Mortgage Services& Technology Products 3,333 < 1%
Total Directors 6,307,458 26.25%
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The reason it is important to understand the insider ownership structure of ASPS is to ensure that the incentives of
management are aligned with those of shareholders. In this case the fact that the CEO of OCN owns more than 25%
of ASPS shares is a major positive. This is due to the fact that OCN is still by far ASPS’s largest customer and the
cross ownership should guarantee that the two entities continue to have a good relationship. Specifically, since the
William Erby, the CEO of OCN, has such a large stake in ASPS, any concerns that the spinoff was done just to
separate OCN from a bad NCI deal should disappear.

Debt & Net Cash

One of the most intriguing aspects of the spinoff is that the separation left ASPS with no debt on its balance sheet. In
fact, aside from some operating leases, ASPS is virtually unrestrained by future capital obligations. Also, with only
$65.6M in total equity, having a net cash position over $12M provides a very nice cushion against anything
unexpected happening. Plus, the company is likely to generate $20-$25M in free cash flow in 2009. So, without
interest payments and minimal capital expenditure requirements (only $1.6M for the 1st half of the year) the
management team is going to have to figure out what to do with the excess cash flow. While the company has
indicated no specific plan to pay a dividend, it is certainly not out of the question in the future. If ASPS does decide
to pay a dividend or buy back stock, it would just be another incremental positive.

Analysis of OCN

As mentioned above, since revenue from contracts with OCN currently and will in the future make up a large
percentage of ASPS’s total sales, it is imperative to understand what kind of counterparty OCN is. Specifically, if
something happened and OCN went away, it would have an extreme impact on ASPS. Without the OCN contracts
ASPS’s cost infrastructure would likely be completely out of line with demand. So, in order to buy shares of ASPS
investors have to be somewhat comfortable that OCN is going to survive and continue to need the services that
ASPS provides. In fact, a situation in which OCN went into run-off mode would be devastating since ASPS has
signed long term contracts with OCN. Based on the current price, investors seem to be counting on this stable
revenue source along with the potential to attract third party customers to produce earnings and drive revenue
growth.

The first thing to notice about OCN is the complexity of its SEC filings. Any investor without familiarity of how to
value mortgage servicing rights and residual interests in securitizations would be best off throwing this into the “too
hard” bin. Analysis becomes even more difficult when the numerous off balance sheet QSPEs and on balance sheet
SPEs are included in the mix. In short, the inability to easily ascertain the value of the assets on the balance sheet of
OCN should make investors incrementally more concerned about ASPS’s dependence on OCN.

As a result of a lack of specialization in the particular market niche occupied by OCN, any assessment of the health
of the company is doomed to be unsatisfactorily cursory. Therefore the following analysis will simply highlight the
many concerns regarding OCN and suggest ways to hedge some of the risk associated with ASPS’s relationship with
OCN.

1. OCN recently fired PricewaterhouseCoopers as its auditor and replaced it with Deloitte &Touche.
According to the company there were no major disagreements that led to this change but switching auditors
has (in retrospect) turned out to be a major red flag in situations with other companies.

2. Along the same lines, OCN is subject to at least 64 different lawsuits accusing it of abusive collection
practices. Also, OCN and a handful of other subprime lenders were the subject of a critical report by the
Center for Public Integrity. Aside from the negative press, investors clearly have to worry about potential
fines, large settlements, or even more severe fraud being unearthed.

3. OCN has approximately $243.3M of auction rate securities based on student loans that it now categorizes
as Level 3 assets due to the lack of pricing inputs. These securities are being carried at 100 cents on the
dollar. However, many of these securities have received significant downgrades from the credit agencies
with some going from AAA to B. Therefore, at some point in the near future OCN may have write down
the value of these securities that represent about 25% of OCN’s common equity.
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

4. OCN’s balance sheet still has some exposure to subprime and Alt-A mortgages. The company services
hundreds of thousands of subprime loans, but it also owns assets collateralized by these types of loans. The
problem is that there is no telling if the carrying value reflects reality. Additionally, OCN has over $880M
of what are known as Matched Funded Advances on its balance sheet. These advances make up about 43%
of total assets and arise when OCN transfers residential loan servicing advances to its QSPEs. They
apparently are necessary when the debtor of an underlying mortgage that OCN is servicing stops paying
principal and interest, for example. At that point OCN is obligated to “meet contractual principal and
interest remittance requirements for the investors, pay property taxes and insurance premiums and process
foreclosures.” While these advances put OCN first in line to get paid back either by the borrower or
investors, it is very difficult to know if OCN will receive 100 cents on the dollar back in every case. Plus, it
is easy to envision a scenario in which contentious legal battles keep OCN from recovering these advances
if tension between investors and the servicer erupts.

Further, even though OCN does not include these QSPEs on its balance sheet, the company still has some
exposure if problems emerge. For the most part the holders of the debt issued by the QSPEs only have
rights to the assets held by these entities and cannot collect from OCN. However, apparently there is one
QSPE that has $179M in debt guaranteed by OCN and the company’s exposure includes up to 10% of that
amount. Considering the fact that close to 33% of the collateral in these QSPEs is non-performing, OCN
may continue to have issues with off balance sheet vehicles. Further, investors cannot forget that in
November 2009 many off-balance sheet vehicles may have to come onto the balance sheet of companies if
the transaction was deemed not to have been a legitimate transfer of control (Amendments to FASB
Interpretation No. 46R). The company claims to be evaluating the impact of this change, but given how
poorly these securitizations are performing, there is no telling how much damage would result if OCN were
forced to bring these on balance sheet.

The preceding items represent the most glaring concerns investors should have about OCN. The appropriate
takeaway appears to be that a purchaser of ASPS shares should attempt to hedge the exposure to OCN. With so
much of ASPS’s revenue coming from its former parent, anything that threatens the ongoing viability of OCN would
undoubtedly hurt ASPS meaningfully. Fortunately, there are a couple of options. First, investors could short OCN.
At first glance, with all of the headwinds facing the company, establishing a short position seems like a compelling
option. The stock is currently trading at about 1.1x book value after trading down to about 50% of book value in
October 2008. Despite the aforementioned red flags, the stock has rallied close to 100% from its 52 week low. So,
aside from just being a hedging option, a bet against OCN could turn out to be a profitable standalone investment.
(Note: Investors interested in this should investigate the cost of borrowing and the relative ease of getting a borrow)
Additionally, there is an options market available for OCN. There are $7.50 and $5 strike price puts that can be
purchased as either a hedge or as a way to profit from a fall in the share price of OCN.

In conclusion, it appears that the risk of OCN experiencing additional bumps in the road is very real. Plus,
considering how closely tied the fortunes of these companies are, at any point shares of ASPS could trade down
substantially in sympathy. Accordingly, investors in ASPS should be keenly aware of how the relationship with
OCN could be detrimental in terms of business fundamentals and the share price. The result is that investors should
seek an additional margin of safety in the price (or reduce the earnings multiple they are willing to pay) of ASPS to
offset the required hedging costs.

Investment Conclusion

The original thesis was that the spinoff of ASPS into a relatively uncertain market could lead to a dislocation
between intrinsic value and price. Either because of the financial focus of the company (there was a time when all
companies that were involved in mortgages were unloved) or due to institutional selling post spinoff, in theory there
was definitely some bargain potential. However, after the recent run up and based on a couple of different valuation
analyses, the stock looks to be a bit overvalued. In fact, at the current price the market is allocating some higher-end
multiples to the stock. Even given the very positive data through the first 6 months of the year, at the current
valuation the risk-reward equation is not particularly compelling. Value investors are understandably wary of
situations in which they are paying up for earnings growth.
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Accordingly, the question obviously comes up about the possibility of shorting ASPS. However, it seems very
dangerous to short a stock with no operating history as a standalone company and that appears only modestly
overvalued. Investors only have financial data that reflects conditions while ASPS was a part of OCN. There is no
telling what the next few quarters’ results are going to look like. The risk of surprisingly good performance and
earnings is especially prevalent in the case of ASPS as evidenced by the first half 2009 earnings and EBITDA
numbers that were almost as strong as the full year 2008 figures. Further, there is significant potential for increased
revenues based on the attractiveness of the offerings from the Mortgage Services and Technology Products divisions
to third parties. It seems that ASPS may be in the right place at the right time to offer certain valuable products to a
growing market. Thus, while it may be imprudent to bet on further earnings growth, in this case it is probably far too
risky to bet against it.

Therefore, this is the kind of company in which John Templeton would have employed the following strategy:
determine a conservative estimation of intrinsic value and an associated price that contains a margin of safety and
then just monitor the stock. Mr. Market has been extraordinarily fickle and in a flash of irrationality the price could
fall into an acceptable range, especially since this company is associated with the dreaded housing and commercial
real estate markets. Based on conservative estimates and the OCN dependence, a fair measure of intrinsic value is
around $12-$12.50 per share. If standalone, run rate EPS is going to be about $1 by 2010, then applying a
reasonable 12x forward multiple produces a value of $12. Similarly, if run rate EBITDA is going to be about $40M
or $1.67 per share, placing a 7.5x multiple generates a value of about $12.50. Therefore, if the stock were to drop to
about $10, that should provide a reasonable enough margin of safety to begin accumulating shares. However, if
ASPS can continue to show margin improvement and diversify its revenue sources away from OCN, then investors
can legitimately become more constructive on the stock as EPS and EBITDA would likely increase further.