Walker & Dunlop, Inc

I'm Kelsey Duffy, Senior Vice President of Investor Relations at Walker & Dunlop, and I would like to welcome you to Walker & Dunlop's third quarter 2022 earnings conference call and webcast. Hosting the call today is Willie Walker, Walker & Dunlop Chairman and CEO. He is joined by Greg Florkowski, Executive Vice President and CFO. Today's webcast is being recorded and a replay will be available via webcast on the Investor Relations section of our website. At this time, all participants have been placed in a listen-only mode, and a line will be open for your questions following the presentation. If you have dialed into the call and would like to ask a question at that time, please press star nine on your phone. If you're accessing the webcast on your computer, please click the raise hand icon on the bottom menu bar of the webcast screen. This morning, we posted our earnings release and presentation to the investor relations section of our website. These slides serve as a reference point for some of what Willie and Greg will touch on during the call. Please also note that we will reference the non-GAAP financial metrics, adjusted EBITDA, and adjusted diluted earnings per share during the course of this call. Please refer to the appendix of the earnings presentation for a reconciliation of these non-GAAP financial metrics. Investors are urged to carefully read the forward-looking statements language in our earnings release. Statements made on this call which are not historical facts may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements describe our current expectations, and actual results may differ materially. While current DUNLAP is under no obligation to update or alter our forward-looking statements, whether as a result of new information, future events, or otherwise, and we expressly disclaim any obligation to do so. More detailed information about risk factors can be found in our annual and quarterly reports filed with the SEC. I will now turn the call over to Willie.

Thank you, Kelsey, and good morning, everyone. W&D delivered exceptional service to our clients during a volatile and challenging third quarter. $17 billion of total transaction volume was very strong and is thanks to our people, brand, and the use of technology in everything we do. I've been CEO of Walker & Dulles for 15 years. I've seen a lot. The housing boom and bust, the great financial crisis, dramatic regulatory changes, new administrations, a pandemic. And I've watched this amazing company deal with adversity, adjust, and continue growing. W&D shareholders should be confident in three things. Number one, our scaled lending partnerships with Fannie Mae, Freddie Mac, and HUD provide our clients with much-needed countercyclical capital during times of market dislocation. Number two, our business model, which includes consistent servicing and asset management fees, along with escrow income that expands as rates rise, has consistently outperformed in down markets. And number three, our disciplined credit culture on loans we originate as well as our own balance sheet will allow us to expand while others contract over the coming months and years. We have no greater insight than anyone else on how the markets will evolve over the coming quarters, but we are better positioned than any competitor firm in our industry to continue providing solutions to our clients, maintain our exceptional team, and continue investing towards our five-year growth plan, the drive to 25. $17 billion of total transaction volume in Q3 generated total revenues of $316 million, down only 9% from Q3 of last year. In this rising rate environment, every deal, whether a sale or a refinancing, is under pricing pressure. Spreads on our agency lending remain compressed as we work closely with Fannie Mae and Freddie Mac to make deals work for our clients. Good news, we closed a lot of financing in Q3. Bad news, we saw a steep decline in our non-cash mortgage servicing rights revenue and net income. This pricing pressure is solely due to interest rate increases, and it will abate the moment rates stabilize. To underscore this point, in Q3 of last year, the capital markets were flooded with competitors lending at tight spreads and low rates, and our average gain on sale margin was 165 basis points. This year, in a quarter when competitors withdrew, our average gain on sale margin was 123 basis points, down 25%. That pricing compression is due to the 10 year treasury jumping over a hundred basis points during the quarter and our need to adjust prices to meet our client's needs. When the Fed stops dramatic rate increases at every meeting, spreads on our agency lending should normalize and our average gain on sale margin will recover. Our scaled and enduring partnerships with Fannie Mae and Freddie Mac provided much needed counter cyclical capital to the multifamily market during the quarter. Year-to-date lending volume with the GSEs is $13 billion. And as you can see on slide four, $9 billion of volume with Fannie Mae is 17% market share, keeping us on track to be Fannie's largest lending partner once again. Two additional comments on pricing deals to win. First, we added $1.8 billion of loans to our servicing portfolio in Q3, and the average servicing fee increased from 24.6 basis points to 24.7 basis points, as payoffs had lower average servicing fees than the new loans we added. Second, we get paid for our risk via our servicing fees. So tighter servicing fees would hopefully correspond to lower risk. The weighted average loan-to-value on the risk-sharing loans we originated in Q3 was 57%, down from 61% last year. We feel extremely good about the loans, credit quality, and customer service we delivered in Q3. And as soon as rates stabilize, our servicing fees and capitalized MSRs should revert to historic averages. Cash revenues and earnings continued to grow in Q3. Adjusted EBITDA expanded to $75 million, up 4% year over year, while adjusted EPS, which strips out the impact of non-cash items, was up 5% to $1.55. These numbers are reflective of W&D's terrific business model. As banks, debt funds, and CMBS lenders pulled out of the market in Q3, our capital markets group had a surprisingly strong quarter with $6.6 billion of debt brokerage volume. Similarly, as multifamily sales volumes fell precipitously, off 17%, according to RCA, our property sales team closed $5 billion of volume, down only 5% from last year. These numbers are truly exceptional in comparison to our competitors' published numbers for Q3 and show the ability of our bankers and brokers to deliver for our clients in challenging markets. We expect to see softening in both of these executions in Q4, but feel very good about our team's ability to continue growing market share in 2023. All of our teams excelled for our clients in Q3. According to Bain & Company, The most relevant question to determine customer service is, would you recommend this product or service to a friend? The answer to that question on a scale of negative 100 to positive 100 is your net promoter score. The average net promoter score in the financial services industry is 44. Walker & Delop's net promoter score is 91, over 2x the industry average. And beyond providing exceptional customer service, we continue to use technology to identify and attract new clients to Walker & Dunlop. In Q3, 69% of our refinancings were new loans to Walker & Dunlop, and 30% of our total transaction volume was with new clients. Rising rates and economic headwinds may curtail business volumes in the short term, but Walker & Dunlop's service level and use of technology position us exceptionally well to continue to outperform going forward. We built or acquired complimentary businesses in affordable housing, research, small balance lending, and appraisals over the past three years. Zellman and Alliant are two major 2021 acquisitions, contributed nearly $30 million in revenues in Q3, and are both on budget for 2022. Hindsight is always 20-20 vision, but it speaks volumes about W&D's M&A strategy that our two largest recent acquisitions were not pro-cyclical, such as expanding our banking or brokering operations, but rather enduring, consistent business models that perform in good and bad markets. And Geofi, the largest technology investment we've ever made, is focused on accelerating the growth of our small balance lending and appraisal businesses. All of these investments get us very excited about W&E's future growth. Our servicing portfolio grew to $121 billion, up 6% over Q3 2021, and generated $76 million of income on the quarter. 89% of the servicing fees in our portfolio are prepayment protected, and as Greg will explain in a moment, the escrows inside that portfolio earn more and more as rates rise. When the great financial crisis in 2008 and pandemic in 2020 hit, our first concern was credit. Would W&D suffer significant loan losses? The answer was no due to W&D's credit culture and the strength of multifamily as an asset class. Today, as we look at our portfolio and the fundamentals of multifamily, the answer is no once again. We have an exceedingly clean book, thanks to our team and credit discipline. We have no credit exposure to office, retail, or other commercial real estate asset classes. We have no credit risk on construction loans. We did not make nor carry credit risk on any CLO loans. And the weighted average debt service coverage ratio in our at-risk servicing portfolio currently sits at 2.32 times. Let me put that into context. Our minimum debt service coverage ratio on new loans is 1.25 times, and the overall portfolio currently sits at 2.32 times. Credit is not a concern. I will now turn the call over to Greg to discuss our Q3 results and financial outlook in more detail, and then I'll come back with thoughts about 2023 and beyond. Greg?

Thank you, Willie, and good morning, everyone. Our $17 billion of transaction volumes this quarter generated total revenues of $316 million, down 9% from the third quarter of last year, and diluted earnings per share of $1.40, down 37% compared to last year. As a result of the spread in pricing dynamics Willie just described, our non-cash MSR revenues dropped 38%, despite nearly flat Fannie Mae volumes. The decrease in MSR revenues caused our operating margins and return on equity to fall below our target ranges at 17% and 11%, respectively. Our value proposition includes navigating challenging markets on behalf of our clients and closing the deal that works for them. And this quarter, we were able to deliver for our clients when they needed us most. Importantly, our agency lending grows our servicing portfolio and increases our long-term stable cash revenues, which occurred yet again this quarter as the servicing portfolio increased to $121 billion. As a result, our cash revenues expanded and our adjusted EBITDA grew 4% to $75 million and drove 5% growth in adjusted earnings per share to $1.55 this quarter. A further benefit of our servicing portfolio is the $3 billion of escrow earnings we hold. Sharpe increases in short-term rates disrupted transaction volumes, but dramatically increased our escrow earnings. This quarter, escrow earnings increased nearly 800% to $18 million compared to only $2 million in the year-ago quarter. Another contributor to growth in adjusted EBITDA and adjusted EPS is the acquisitions of Alliant and Zellman. On a combined basis, these businesses generated nearly $30 million of primarily cash revenues this quarter, highlighting the benefit of the investments we made in the stable subscription revenues of Zellman and the assets under management at Alliant. In the first quarter of 2022, we introduced segment financial results to provide more transparency into our operating structure and overall financial performance. As shown on slide seven, our capital markets segment, which drives transaction volumes, generated revenues of $183 million this quarter, down 27% compared to last year. Expenses for the segment fell 8%, largely due to lower variable commissions from lower transaction-related revenues. which helped produce break-even adjusted EBITDA for the segment this quarter. A little more than 60% of compensation costs are variable for this segment, mitigating expected declines in transaction-related revenues for the rest of this year. We are confident our team will continue to deliver strong GSE and HUD volumes due to the counter-cyclical nature of the capital, but recognize our debt brokerage and property sales teams will face pressure as liquidity from banks and other executions pull back. Our long-term outlook for our capital markets team remains unchanged despite the headwinds, and we will continue making investments to sustain our long-term growth objectives for this segment. Our SAM segment includes the performance of our servicing activities and asset management businesses. As shown on slide eight, revenues for our SAM segment grew 40 percent this quarter, or $39 million, due to increased servicing fees, escrow earnings, and revenues from Alliant. The growth in revenues generated 69 percent growth in operating income, and 30 percent growth in adjusted EBITDA. The revenues within our SAM segment are resilient and growing. Our loan servicing portfolio is generating over $300 million of annual recurring revenues, and the prepayment-protected duration of the portfolio is nearly nine years. Our long-term strategy to grow our assets under management is paying dividends, as our $17 billion of assets under management earned $83 million of revenues year to date. Lastly, short-term rates continue to increase, and escrow and other interest income will continue to drive growth in cash and adjusted EBITDA. Our corporate segment represents the corporate G&A of our business and also includes our corporate debt expense. As shown on slide 9, the net loss for this segment decreased $3.4 million, or 11% this quarter, while adjusted EBITDA increased 3% from the year-ago quarter. A few things to highlight. Total compensation costs were down $10 million as we made downward adjustments to our company bonus and performance-based equity accruals this quarter on our revised outlook for 2022, which I'll explain in a moment. Those downward revisions were offset by a $7.5 million increase in interest expense on our corporate borrowings as our term debt is indexed to SOFR. During the quarter, we also restructured our legal entity organizational chart and repatriated the intellectual property acquired from GFI earlier this year. The impact of which was an overall reduction in future tax liabilities of about $6 million or approximately 20 cents of diluted EPS, which reduced our consolidated annual effective tax rate to 14% this quarter. This was a one-time benefit of the restructuring and our annual effective tax rate will return to its normal level of about 27% next quarter. Year to date, total transaction volumes are up 27%, but operating margin and return on equity remain below our target ranges at 22% and 14%, respectively, due largely to the declines in non-cash revenues we began experiencing in the second quarter. Our year to date diluted EPS is $5.13, down 10% compared to the same period last year. Year-to-date adjusted EPS is up 10%, reflecting our business's ability to generate cash, even as the transaction markets slow down. Over the last 90 days, rapid increases in interest rates and fears of a global recession impacted transaction volumes and caused servicing fees on new loans to remain at lower levels. We expect servicing fees on new loans to remain at current levels for at least the rest of 2022, and we do not expect transaction activity for our broker and investment sales transactions to rebound until interest rates stabilize. As shown on slide 10, we are now projecting diluted EPS will be down between 15% and 20% this year. Notably, year-to-date personnel expenses, a percentage of revenue is 48% in line with last year. Our variable costs will adjust downward in line with any decline in transaction revenues in the fourth quarter. And that, coupled with the strength of our servicing and asset management revenues, give us confidence that we will deliver growth in adjusted EBITDA in 2022 in the mid to high single digits. We are not making any adjustments to our ROE or operating margin targets, but expect to perform at the lower end of the ranges. As we look ahead, we reviewed our operating costs and have been actively reducing expenses based on our outlook for slower transaction volumes next year. These reductions will largely impact our G&A costs, and most will not be realized until next year. We are not immediately reducing headcount, but we have significantly curtailed our planned new hires and begun more selectively backfilling positions. As you can see on slide 11, we operate an efficient business, generating over $900,000 of annualized revenue per employee at the top of our peer group by a wide margin. Importantly, over half of our compensation costs are variable, causing compensation expense to naturally adjust downward for any declines in transaction revenues. We are in a service business, and we believe that our people and culture differentiate us, as reflected in the Net Promoter Score Willie outlined. We do not intend to disrupt the quality of that service by reducing headcount, and we believe our business model and access to counter-cyclical capital allow us to invest in our people to not only continue growing market share in the coming months, but take advantage of the opportunity when transaction volumes rebound in 2023. We ended the third quarter with $152 million of cash on the balance sheet, in line with the end of Q2. We prioritized investing in the business this quarter and used capital to pay down principal on our outstanding debt, fund co-investments to grow our asset management business, bring on three new property sales teams, and fund obligations under our purchase agreement with Alliant. Given the number of opportunities to invest nearly $50 million back into the business this quarter and our desire to maintain a strong cash balance, we did not repurchase shares. We continue to generate a healthy amount of cash to fund our operations and invest in the business. And yesterday, our board approved a dividend of 60 cents per share again this quarter, payable to shareholders of record as of November 25th, 2022. We will have returned nearly $100 million of capital to shareholders this year through a combination of share repurchases and dividends. And we continue to prioritize this closely with investments in the business. We face a challenging macro backdrop, and several of our operating metrics like diluted EPS, operating margin, and ROE will remain under pressure in the near term due to lower servicing fees on new loans and lower transaction volumes. Our ability to generate cash and growth in adjusted EBITDA is not tied to the transaction markets. Our servicing portfolio provides over $300 million of annuity-like cash flows. And as shown on slide 12, our escrow earnings are growing and fully hedge our floating rate debt. As Fed funds has now reached 4%, our escrow earnings will generate between $100 million and $115 million of annualized revenues, more than offsetting increases in floating rate debt expense, and providing between $55 million and $70 million of annualized operating income. We also have a healthy balance sheet with $711 million of corporate debt, and we continue to maintain a strong cash position. Our corporate debt to adjusted EBITDA has declined from 2.4 times at year end to just over two times today, largely from the continued growth in adjusted EBITDA. We have a resilient and diversified business model that will continue to generate strong cash flow despite the uncertain macro environment. We remain focused on managing costs to operate an efficient platform while investing in our business to create long-term profitable growth. I will now turn the call back over to Willie.