Comments on mortgage industry (page 1 of 3)

United States
• Tenet Healthcare a value buy in the hospital sector

Last week's data came out better-than-expected. In October, existing home sales rose 6.07% m-o-m to 5.77M, while consensus expected 5.35M, as low mortgage rates lured buyers. New home sales decreased less than expected to 1,007K (-4.46% m-o-m), while consensus expected 990K. It is expected that total sales for this year would probably reach a new record due to the lowest mortgage rates in at least three decades (source: Bloomberg). For this year, the Mortgage Bankers Association is predicting total mortgage origination volume to exceed $2.4 trillion, reflecting a 19% increase from 2001. For next year, they expect strong volumes to remain through the first half and gradually decline in the second half of 2003, resulting in total volume of about $1.75 trillion for the year. However we would be cautious on the mortgage industry for the coming year. Mortgage rates are likely to rise in 2003. The figure below shows the yield curve for conventional mortgages.

Among the mortgage companies, Countrywide Financial Corp. (CFC, $49.30, CSFB: Not covered) remains our favourite. The company has solid fundamentals and still attractive valuation (current P/E ratio at 10x, and P/B ratio at 1.27x). The company delivers steady earnings growth (on average +20% p.a. in the last 5 years). Furthermore mortgage origination accounted for only 32% of CFC's FY01 pre-tax earnings, which should mitigate the expected decrease in mortgage origination for 2003.

The healthcare sector's performance has been lagging the broad market over the past weeks, as investors' risk appetite increased. Some of the stocks are still not cheap, however, as they remained relatively stable during the market decline in early October, thanks to their earnings visibility. The sector fundamentals however, remain sound.

For this reason we have added Tenet Healthcare (THC, $18.45, CSFB: Neutral) a hospital company to our US Buy List. Tenet Healthcare stocks dropped sharply, losing 70% of their value, after two physicians in one of the company's hospitals were accused of overbilling their patients and providing unnecessary services. The case is currently being investigated, but so far it looks like Tenet Healthcare as such, acted within the complex Medicare reimbursement rules. But as a consequence, the company is reviewing its pricing policy.

In the past few years the hospital sector has seen strong growth thanks to certain demographic developments and strong pricing power. We do not expect the sector to continue to see 15-20% annual profit growth, but the demographic development with an ageing US population, continues to be fundamentally positive for the industry. The Baby-Boomers are approaching an age where they will require more healthcare and hospital treatment. But the pricing power should not remain as strong, as the US administration attempts to cut back on the cost explosion within the healthcare system and seeks to reform the Medicare system. Cuts in reimbursement are however a politically sensitive topic and so it could be some time before the government takes any action.

Nevertheless, at the current price, we believe Tenet Healthcare shares have discounted the legal risks surrounding the two physicians accused of overbilling and we believe the stock is currently undervalued.

In order to assess the stock's fair value, we have taken a conservative approach. We have deducted 10% of the consensus 2003 full year EPS and assumed an 8% annual growth, which resulted in a fair value $39.50 in our dividend discount model.