Walker & Dunlop, Inc. (NYSE:WD) Q2 2023 Earnings Call Transcript August 3, 2023

Walker & Dunlop, Inc. misses on earnings expectations. Reported EPS is $0.82 EPS, expectations were $1.06.

Operator: Good day, and welcome to the Q2 2023 Walker & Dunlop, Inc. Earnings Call. Today’s call is being recorded. [Operator Instructions] At this time I will like to turn the conference over to Kelsey Duffey. Please go ahead.

Kelsey Duffey: Thank you, Ruth. Good morning, everyone. Thank you for joining Walker & Dunlop’s second quarter 2023 earnings call. I have with me this morning our Chairman and CEO, Willy Walker; and our CFO, Greg Florkowski. This call is being webcast live on our website and a recording will be available later today. Both our earnings press release and website provide details on accessing the archived webcast. This morning, we posted our earnings release and presentation to the investor relations section of our website, www.walkerdunlop.com. These slides serve as a reference point for some of what Willy and Greg will touch on during the call. Please also note that we will reference to non-GAAP financial metrics, adjusted EBITDA, and adjusted core EPS 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. Walker & Dunlop 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 disclaims 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 Willy.

Willy Walker: Thank you, Kelsey. And good morning everyone. The great tightening started by the Federal Reserve in March of 2022 has added 525 basis points to the Fed funds rate and dramatically reduced transaction volumes across the commercial real estate industry. We believe the majority of tightening is behind us and expect pricing to adjust and transaction volumes to recover in the coming quarters. In the midst of dramatically lower transaction volumes in the first half of 2023, Walker & Dunlop’s countercyclical lending businesses, exemplary credit track record and consistent servicing and asset management revenues provided us with the financial strength to continue investing in the business for long-term growth and success.

Q2, total transaction volume of $8.4 billion was down 63% in the second quarter of 2022. Yet revenues were down only 20% to $273 million. Thanks to durable revenue streams from our servicing and asset management businesses. Adjusted EBITDA was down 26% year-over-year to $71 million, again showing the strength of our nont transaction related revenues. Diluted earnings per share, which is impacted by lower non-cash mortgage servicing rights was down 49% to $0.82 per share. And adjusted core EPS was down 44% to $.98 per share. It is our hope and expectation that the first half of 2023 was the low point of transaction volumes due to the Fed tightening cycle and we continue to build back from here. Looking at W&D’s performance on a sequential basis, as shown on Slide 6 Q2 2023, total transaction volume of $8.4 billion was up 25% from $6.7 billion in the first quarter.

Driven by growth in agency lending with Fannie Mae, volume is up 64%; Freddie Mac volumes up 24% and HUD volume is up 16% on the quarter. Through the first half of 2023 the GSE has only deployed 30% or $44.3 billion of their $150 billion annual lending capacity, leaving plenty of capacity to lend as the market recovers. We continue to focus on refinancing every loan maturity in our portfolio, finding new refinancing opportunities and other lenders portfolios using our Galaxy database and placing financing on every sale transaction, our investment sales team is marketing. The multifamily acquisitions market stalled in Q2 as sellers waited for rate stabilization and cap rate clarity before putting assets on the market. Our multifamily property sales volumes were down 81% year-over-year and down 21% from Q1.

If our current Q3 sales pipeline is any indication, Q2 was the low point in this cycle for multifamily sales activity and we’re in an upward trajectory from here, but slowly. Q2 debt brokerage volume of $3.3 billion was down 64% from the second quarter of last year, yet up 40% from Q1. The banking sector had a full on crisis in Q2, with the failure of SVB, Signature and First Republic dropping capital flows to commercial real estate dramatically. We appear to have averted a meltdown of the U.S. banking system and is our expectation that banks pulling back from CRE lending will increase demand for commercial real estate debt brokerage services going forward. Private capital is coming into the CRE market to replace bank capital. Walker & Dunlop Investment Partners continues to deploy and raise private capital funds that is not only valuable to the returns and growth of our asset management business, but provides our bankers and brokers with proprietary capital to meet their clients’ financing needs.

We continue to invest in our business even after our April reduction in force. The vast majority of our bankers and brokers are still with us. Our technology-enabled businesses of small loans and appraisals continues to scale. We raised Alliant’s a 117th low income tax credit fund during Q2 and we broaden our investment banking capabilities from predominantly single family by hiring a new Managing Director focused on the commercial real estate market. We can make these investments thanks to the cash flow generated from our non-trans based servicing and asset management businesses. I will now turn the call over to Greg to discuss our financial results and then come back with some thoughts on our longer term outlook. Greg.

Greg Florkowski: Thank you, Willy. And good morning everyone. Market conditions this quarter, were generally consistent with the trends we described in our first quarter earnings call. Although our overall financial results for both the second quarter and first half of 2023 reflect an extremely different market today than during the same periods of 2022, we saw sequential growth across almost all business lines this quarter when compared to Q1 as the pace of monetary tightening has slowed and the commercial real estate market has slowly adapted. Q2 total transaction volume was down significantly, but recurring revenues from our servicing and asset management segment continued to grow and adjusted EBITDA remained strong at $71 million, a testament to the strength and durability of our business model.

We continue to focus on cost containment to drive improvements in operational efficiency. Coming into the year, we took steps to reduce annual controllable G&A cost by at least $15 million and our Q2 results reflect the full benefit of those decisions. SG&A costs are down 15% compared to the same quarter last year. We also reduced our headcount by over 100 employees in April creating $25 million of annualized personnel related savings. As a reminder, the action had little impact on our financial results this quarter due to the separation costs, but we expect to see the full benefits of the headcount reduction in the third and fourth quarters. Turning to segment operating performance, Q2 of last year reflects a very different transaction market for our Capital Markets segment than the second quarter of 2023.

As shown on Slide seven a year ago, our team had its second best quarter by volume in our company’s history. Although transaction volumes this quarter decline 63% compared to that near record quarter, total revenues for the segment were down only 42% to $126 million as we saw slight improvement in gain on sale margins across most products year-over-year. A more important comparison is the sequential comparison from Q1 to Q2, which as shown on Slide 8, saw transaction volumes increased 25% and total revenues for the segment increase 21%. The pickup in transaction activity drove an increase in net income for the segment from just above breakeven in Q1, to $16.1 million in Q2 and a 45% improvement in adjusted EBITDA to a loss of $10.3 million in Q2.

Our clients will continue to draw on the expertise of our bankers and brokers to navigate these challenging market conditions. And as they do, the financial performance for this segment will steadily improve. The servicing and asset management segment for SAM, includes our servicing activities and asset management business, both of which produce stable, recurring revenue stream. As shown on Slide 9, SAM revenues were up 14% year-over-year to $143 million due to growth in servicing fees and escrow earnings. The Fed’s 25 basis point increase last week was expected and will benefit our bottom line. Although the cost of our term debt increases with short-term rates, we also manage just over three times the balance of our term loan in interest earning assets that also grow in tandem with short-term rates.

So we will see a slight incremental benefit from the recent rates. Of note Alliant revenues were $26 million this quarter as we close $271 million of new equity syndications in Q2, bringing our year-to-date total to $407 million, 13% ahead of a year ago and putting Alliant on pace for its best capital raising year ever. As we have shared for the last several quarters, our at-risk servicing portfolio continues to perform well with only seven basis points of defaulted loans in the portfolio. As shown on Slide 11, as of December 31, 2022, the weighted average debt service coverage ratio was 2.32 times and the underwritten loan to value was 61%, reflecting a cash flowing portfolio was substantial equity cushion across the majority of our loans.

This quarter, we resolved the only defaulted loan in the history of our interim loan program. The loan defaulted back in 2019 and four years later we finally sold the property, returning $9 million to our balance sheet, while charging off the $6 million loss reserve. Although the sale improved the health of our balance sheet and had no impact on GAAP earnings, adjusted EBITDA and adjusted core EPS are both reduced this quarter by the $6 million charge off. Turning back to our consolidated results for the first half of the year, as shown on Slide 12, our total transaction volumes are down 57% year-to-date. But the stability of earnings from our SAM segment offset a large portion of the slowdown in capital markets activity. Diluted earnings per share was $1.61 down 57% from the first half of 2022.

While year-to-date adjusted EBITDA is down just 12% to $139 million; and adjusted core EPS was down 24% to $2.14 per share. Finally, year-to-date operating margin was 14% compared to 25% in the same period of 2022, while return on equity was 6% versus 16% in 2022. Our first half financial results reflect a material shift in market conditions that began impacting the market a year ago as the Fed aggressively increased interest rates. The Fed appears to be winning its battle over inflation, but it’s clear that interest rates will remain elevated for longer and liquidity supplied by large banks is likely to remain restricted in the near term. On our last call, we provided an updated range for our 2023 guidance as shown on Slide 13, reflecting the market uncertainty and difficulty forecasting financial performance this year due to the macro environment and the potential that a recovery would be pushed into 2024.

After four consecutive quarters of declining transaction activity, we’re encouraged by the sequential pickup in activity we saw from Q1 to Q2, and we’re optimistic that the pace and magnitude of interest rate changes will continue to slow and our clients will continue adjusting. However, it is still very difficult to forecast transaction activity for the third and fourth quarters. Based on what we see today, the lower end of our annual guidance range is the most likely outcome and we expect the fourth quarter to be stronger than the third quarter as the markets recover over the coming months, and our asset management businesses generate stronger fourth quarter earnings. Although our earnings and operating metrics remain under pressure due to the declining transaction volumes and tighter servicing fees, we are most focused on delivering strong adjusted EBITDA during this time in the cycle.

Our ability to generate free cash from our core businesses allows us to service our debt, invest in our people in businesses and create long-term sustainable value for our shareholders. This quarter, our cash balance increased $40 million ending the second quarter with $228 million of cash, up from $188 million at the end of Q1 due to the strong cash generating capabilities of our business and the repayment of a portion of our interim loan portfolio. We are operating in a challenging environment and we will continue to focus on building our liquidity to best position the company for the long-term and at the same time, we remain committed to our quarterly dividend. And yesterday our Board of Directors approved a quarterly dividend of $0.63 per share payable to shareholders of record as of August 17th.

Two quarters into what has been an extremely challenging year, we feel very good about a number of things. First, our business model continues to produce steady high margin cash flows that allow us to maintain profitability and build up a strong capital position despite the current market headwinds. Second, we are focused on multifamily and have access to large sources of countercyclical capital to support our transaction businesses. Third, multifamily fundamentals are holding up well from a credit perspective and our historical underwriting has us feeling very good about our at risk portfolio today. Fourth, we managed our costs to navigate the current environment, but retain the talent we need to capitalize when growth returns to the market.

And finally, our entrepreneurial spirit combined with financial flexibility puts us in a position to take advantage of growth opportunities as we continue to pursue our long-term strategy. Thank you for your time this morning. I’ll now turn the call back over to Willy.

Willy Walker: Thank you, Greg. Commercial real estate investors today are extremely rate sensitive with 10 to 15 basis points having the potential to make or break a deal. Transaction volumes will ebb and flow in the second half of the year depending on rates and capital flows. Our outlook is the following. We believe the Fed has done the majority of its work, whether it’s one, two, or even three more rate increases, the majority of their tightening is done. Second, with long-term rates determining the cost of capital to most commercial real estate deals, the timing and size of the treasury department’s new bond issuances will impact the cost of financing to commercial real estate for the next several quarters. Third, Fannie Mae and Freddie Mac have plenty of capital to provide to the multi-family industry and is our clear objective to partner with them to deploy as much of that capital as possible.

And fourth, multi-family credit particularly in our at-risk servicing portfolio where 90% of our loans are fixed rate should remain very healthy. Let me dive a little deeper on a number of those points. While the Federal Reserve has added 400 basis points to the Fed funds rate over the past 12 months, the 10-year treasury has only moved 130 basis points. A 4% 10-year treasury is a reasonable and somewhat normal interest rate to work with. It’s just the adjustment in cap rates, which will allow owners to determine pricing can only happen once financing costs stabilize. According to our research team at Zelman, multi-family cap rates adjusted to an average of 4.9% in Q2 2023 compared with 4.25% in Q2 2022. When cap rates adjusted and financing costs were between 4.75% and 5.25%, we saw transaction volumes pick-up.

This dynamic between financing costs and cap rates will continue and as the Federal Reserve’s involvement in the market diminishes rates and cap rates should stabilize and transaction volumes will pick-up. As Greg’s and my previous comments underscore, multifamily fund fundamentals and credit quality remain very strong. Our at-risk portfolio includes only multi-family loans and 90% of those loans are fixed rate with very attractive interest rates. We have only $184 million of at-risk loans maturing for the rest of 2023 and another $1.3 billion in 2024. So only 2.6% of our at-risk loans mature in the next 18 months; that is a gift to our borrowers and to the credit quality of our portfolio. While our financial performance in the first half of 2023 isn’t what we would like it to be, our business model is performing to design.

Our $127 billion servicing portfolio and $17 billion asset management businesses produce stable high margin revenues that allow us to not only maintain our banking and brokerage teams and infrastructure, but continue investing in our high growth businesses and technology. As it relates to our focus on technology, we have successfully used our proprietary data analytics and technology to win re-financings from the competition. During Q2, 60% of the re-financings we originated were new loans to Walker & Dunlop. Let me double click on that point and tie it back to my commentary on our servicing portfolio. We are using technology and our exceptional bankers and brokers to win loan re-financings from the competition. 60% of our total volume in Q2, which means we are not relying upon re-financing our own portfolio, which has very little re-financing activity over the next 18 months, which is very positive from a credit perspective.

A year ago with inflation running rampant in the Fed raising rates by up to 75 basis points per month, the outlook was uncertain and our deal pipeline started to deteriorate. Today the outlook is markedly different, while inflation is clearly still a concern, markets have begun to stabilize and transaction volume appears to have bottomed and is starting to recover. Our day-to-day focus is on executing for our clients, winning every piece of business we possibly can, and continuing to invest in our people, brand and technology to deliver exceptional long-term shareholder returns. In July, our longtime President and my partner in building this great business, Howard Smith announced that he will be retiring on January 1, 2024 after 43 years with Walker & Dunlop.

Howard has been instrumental in helping W&D grow from a small family owned business with one office to the scaled industry leading enterprise we are today. Howard’s announcement was not unexpected, and we have two exceptional leaders in Kris Mikkelsen and Don King to assume Howard’s primary duties as co-heads of our Capital Markets Group. Howard will be greatly missed, but I’m excited to see Don and Kris step into their new roles and for other members of our senior management team to take responsibility and provide leadership across the company going forward. We established our five-year highly ambitious business plan called the Drive to ’25 in 2020, knowing that the economy and our business would not remain static, and after the COVID pandemic and great tightening, those were pretty good assumptions.

What is important for investors to know is that we remain focused on the Drive to ’25 and have a pathway to achieving it. The Drive to ’25s, two major financial targets are $2 billion in total revenue and $13 of earnings per share in 2025. Given what the great tightening has done to transaction volumes, reaching the ambitious financing and property sales volume targets of Drive to ’25 is unlikely, yet not necessary due to the growth in our servicing and asset management segment. The Mortgage Bankers Association estimates that by 2025, the commercial real estate debt financing market will return to the financing volume scene in 2021. In 2021, our capital markets team closed $68 billion of transaction volume and generated $260 million of net income to Walker & Dunlop.

That team of bankers and brokers is still at Walker & Dunlop, and we have every confidence that if the markets return to 2021 levels, our people, brand and technology can deliver similar results in our Capital Market segment. And as we grow back to 2021 transaction volumes, our servicing and asset management segment will continue to outperform. After the acquisition of Alliant in 2021 and the rapid rise in short-term interest rates, increasing our interest earnings dramatically, our servicing and asset management segment is on track to generate $175 million of annualized net income in 2023, up from $105 million in 2021. So a return to 2021 transaction volumes in our capital market segment, coupled with the current net income from our SAM and corporate segments, would bring us to over $10 per share of EPS.

And as we continue adding bankers and brokers investing in growth initiatives to scale our small balance lending and appraisal businesses and raise more capital through our asset management platform, we have a pathway to achieving our Drive to ’25 financial targets of $2 billion of revenues and $13 of earnings per share. While there are no guarantees and rates, capital flows, credit quality, spreads and average servicing fees will impact our business. We have the team, business model and focus to achieve the Drive to ’25 goals. Knowing what our long-term goals are and setting our amazing team loose to achieve them is what has made this company so successful. We have an exceptional team at W&D, a diverse business model that allows us to perform in both good times and bad and the very real opportunity ahead to grow dramatically as the market recovers from the great tightening.

Thank you for joining us on today’s call. I’ll now ask Ruth to open the call for any questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] We’ll go first to Steven DeLaney with JMP Securities.

Steven DeLaney: Good morning everyone. And Willy really applaud the proactive response that management has taken in the first half to respond to this new commercial real estate market reality we have. And nice to hear that it sounds like you’ll see more, more benefit from that in the second half. So I want to get that out at the start. I guess the most obvious thing in multifamily as you highlighted Willy, is how slow or let’s say not slow, but how far below Freddie and Fannie collectively have been in terms of their caps. It looks like through June on a combined basis there’s about $30 billion of catch up, not to mention the $75 billion that we would normally expect in the second half. So like how close, I mean, do you see an acceleration there and an effort by leadership at the GSCs to try to get closer to their full year caps? And as part of that, can we expect them to cut their loan pricing relative to benchmark rates in order to try to accomplish that? Thanks.

Willy Walker: Sure, Steve, and thanks for joining us this morning. There are a couple things I think that are important to keep in mind as it relates to the agencies and the overall market. The first thing is that in the first half of 2023 there simply wasn’t a lot of demand for financing, right, acquisition, volumes fell through the floor as we just highlighted given our investment sales being down 81%, quarter-on-quarter between Q2 2022 and Q2 2023. And so there has not been a huge amount of need, if you will for their capital. With that said Fannie and Freddie have been very focused on two things, profitability and affordability. Profitability on deals that are non-affordable or market rate where it has been challenging to get pricing to a point where borrowers want to move on non-affordable financing.

So we have underscored that point to them and are very hopeful that they realize that their capital is needed not only in the affordable part of the market, but also in the market rate section of the market. The second thing I would say is on affordable Walker & Dunlop is well above our targets as it relates to supplying affordable deal flow to Fannie and Freddie. And so we benefit from that by having fed them affordable deals that allow them to meet their targets from a regulatory standpoint and therefore that frees them up if you will to price more competitively on market rate deals. And then the final thing that I would say is that there have been no portfolio transactions so far this year and I would expect us to start to see some portfolios in the back half of 2023 and into 2024.

And I think, if you look at our year-on-year, we did a large transaction in Q2 of last year – multi-billion dollar financing in Q2 of last year and that had a big obviously impact on our Q2 2022 volumes. And when you strip that out, the step down in volumes quarter-on-quarter isn’t quite as pronounced as it was. Those types of deals will come back into the market. Sellers have been unwilling to put portfolios on the market thinking that they weren’t going to get the cap rates they expected. And as we see stability in the market, Steve, I would expect we see some portfolios come onto the market. And as you know Walker & Dunlop has consistently been one of the very few providers that that teams that want to hire an agency finance team GoTo for multi-billion dollar transactions.

Steven DeLaney: That’s helpful background and I get your point about it’s not their availability of capital to lend, but the demand obviously from the borrowers who seem to be a little bit frozen at the time, I guess waiting for rate certainty. One final just cleanup thing, and this is – this week talking to a lot of the multifamily bridge lenders that reported, everybody loves multifamily as a property type, but I was surprised how many people mentioned that on a case-by-case basis, while rents are going up that operating expenses are going up significantly. And a lot of that has to do with maintenance, security, those kinds of things, and we’re hearing a lot about economic rent and the amount of drag to revenue that you’re getting from non-payers if you will.

Some of that obviously goes back to COVID. In your conversations with your loan officers and your borrowers, is this an issue in the multi-family market that needs to be kind of worked on? And is it just a municipality by municipality or is it something broader than that? Thank you.

Willy Walker: Sure, Steve. There are a couple things in that question that I think are important to underscore. The first is that we have taken very limited risk on any balance sheet lending. As Greg pointed out, we resolved one loan for 2019; that’s the only loss we’ve ever had in our interim loan portfolio. But the great majority, we don’t have any CLO exposure at Walker & Dunlop. And as we underscored in the call, 90% of our at-risk portfolio is fixed rate loans. So from a credit standpoint to W&D, we feel extremely good. The second point is that if you look at the fundamentals of multifamily, while values have come down as cap rates have gone up, cash flows off of the assets have remained very strong, a lot of that is due to fixed rate debt, right?