PHH Corporation (PHH, Financial) was incorporated in 1953 as a Maryland corporation; from April 30, 1977 to February 1, 2005 it was a wholly owned subsidiary of Cendant Corporation, but after February 1, 2005 PHH started operating independently. PHH is a leading non-bank mortgage originator and servicer of U.S. residential mortgage loans. Through its subsidiaries, it provides outsourced mortgage banking services to a disparate set of clients, including financial institutions and real estate brokers, and is focused on originating, selling and servicing residential mortgage loans. As per the survey of Inside Mortgage Finance, PHH Mortgage stood as the sixth-largest mortgage loan originator with a market share of 2.9% for the year ended December 31, 2014. The success story is not finished here; it is the fifth-largest retail mortgage originator with a 4.7% market share for the nine months ended September 30, 2014. Inside Mortgage Finance also reported that PHH Mortgage was the 8th largest mortgage loan servicer with a 2.3% market share as of December 31, 2014.
Operating Segment:
PHH has two operating sources of segment
- Mortgage Production
- Mortgage Servicing
Mortgage Production: In Mortgage Production, it generates revenue through fee-based loan origination services and the sale of the loan into the secondary market. PHH generally sells all the loans it originates within 30 days.
Mortgage Servicing: In the Mortgage Servicing segment, it generates revenue through contractual fees from its servicing rights as a percentage of unpaid principal balance or from servicing agreements, which are typically an amount per loan serviced.
Recent changes in the business and PHH outlook
Sale of Fleet Business: Prior to last year, the organization had indulged in two disparate businesses:
- Mortgage servicer and originator.
- Commercial vehicle fleet management operation.
There was no reason for a mortgage servicer to own a fleet management solution company, and it tried to sell off its fleet business in 2007 to GE & Blackstone who would then separate the two pieces; eventually the deal fell through as the recession began, but the justification remained for a split of the company.
In June, the company announced an exhaustive agreement to sell its fleet business to Element Financial Corporation for approximately $1.4 billion in cash. PHH recorded an after-tax gain of approximately $300 million on net proceeds of $821 million. PHH recorded an after-tax gain of around $300 million on net proceeds of $821 million deal. That seems to be quite a large cash infusion for a company with revenues around $1 billion, and management announced that it will use these funds for its share repurchasing of $450 million including $200 million in an accelerated program, redeem its 2016 9.25% senior notes (which was recently concluded) and reinvest $350 million in the company to reorganize operations as well as building out the mortgage banking and servicing segment.
The sale of the Fleet business allows for a complete capital structure overhaul and has resulted in lower unsecured debt outstanding and a possible net cash position, even after it pays $500 million in taxes on the sale of the segment. Total unsecured debt ended the year at $860 million, well within its targeted range of $750 million and $1 billion. The next issue that is coming due is not until June 2017 with 6.0% convertible notes worth $245 million.
Recovery in Mortgage Production: PHH Mortgage production segment usually originates prime mortgage through relationships with third parties that includes wealth management firms, regional and community banks. This is the business that has provided significant headwinds over the last five years as the regulatory environment and costs of origination skyrocket their expense structure resulting in a capital-destroying operation, Additionally, production volumes collapsed in the post-recession period but now thanks to lower interest rates they are fueling a refinancing boom along with an overall recovery in the housing market.
Since last year, the company has been losing money on an absolute basis and will continue to this year as the Production segment has traditionally been its largest contributor to profits. Since 2012, the business has seen revenue drop by 62% while pre-tax income went from $475 million to a negative $135 million.
In the fourth quarter, total closings were $9.4 billion, a 1% decline from $9.5 billion in the year-ago quarter. Total loan margin has been moving higher hitting 291 bps, up 13 bps from 278 bps last year. This is a positive step and possibly a signal that the downward trend of the past two years within industry origination volumes and refinancing volumes may be over.
Re-engineering and re-negotiating PLS contracts
Recently PHH allocated $200 million which it has earned from sale of its fleet business to re-engineering department. As the company is going all in on mortgage business, many lenders and servicers step out from the market as new regulations surge up the cost of compliance cost, due to which many banks had to bear an extra cost of $194 per mortgage last year. PHH's current face of company has a leaner operation model with less supporting infrastructure, but now it is re-engineering it and trying to bring up a new model for itsbusiness which would be much more scalable with higher profitability and help it to cover the earlier losses.
The new model will build on two pieces:
- Expenses reduction to better align the economies of the business with the current volumes.
- Renegotiating its PLS contracts.
With the new approach management is anticipating that it will generate annualized operating benefits of $175 million over the next two years.
The prime centerpiece of the initiative is the renegotiation of its PLS contracts with its largest clients. These agreements are quite complex, and the company needs to address the poor pricing economies along with better risk-sharing policies. During the second half of last year, it made significant progress on this front with approximately 50% of 2014 total PLS closing volume at or near the end of negotiations. For the remaining, it has mutually agreed to extend its negotiations to address the unique requirements as well as potentially expanding the scope of services to be provided.
And the remaining percentage, it's made significant progress on clients representing approximately 30% of total PLS clients. It anticipates completing these negotiations by the end of the second quarter. For the clients representing the last 20%, it remains highly engaged, and it continues to work diligently with an expectation of concluding these compromises as soon as possible. Still, being able to renegotiate 80% of these contracts to better pricing levels should materially boost revenue and profitability within the business starting this year. We do not think this is adequately reflected within the share price and investors wait until more color is released from management.
Growth tailwinds and initiatives should boost results
The growth initiatives are partly a restructuring of the organization itself to better align it for scale – which we partially addressed above – but also directed at growth, both inorganic and organic, to achieve faster scalability. These initiatives are expected to be completed by the end of 2017. It intends to invest up to $150 million in select growth opportunities over the next two years to enhance scale but also to diversify its revenue streams.
We also believe that management will address the under penetration of its existing PLS partners with an opportunity to increase penetration. These partners' large base of affluent customers in addition to new relationships with regional and community banks should drive better scale and a return to solid profitability. This could be affected by the ongoing negotiations, but we think given the sharp progress they have made in the last six months that the market is not fully recognizing this benefit for several more years.
In aggregate, the growth initiatives could generate up to $175 million in additional annualized operating profits. The question is one of timing, and it appears that it could take until 2017 to realize that level of profitability. We believe, given the current mortgage market especially among originators and servicers, that inorganic growth investment is a high probability which could accelerate that by at least one year. Inorganic growth like that could leverage its fixed-asset base and expand its retail mortgage market presence while growing its servicing portfolio. The recent sale of the Fleet business and right-sizing of the capital structure allows it the flexibility to engage in such acquisitions.
Mortgage Servicing Business:
The mortgage servicing business is undergoing in to a transformation phase as it shifts the business model toward fee-based sub servicing; in 2014, it signed contracts with seven new sub servicing clients and on board around 28K loans. I think that these contracts will provide a strong flow of sub servicing loan growth in near term as well.
As it right-sizes and streamlines this business towards a scalable fee-based model, the profit per loan serviced should increase markedly. There are multiple profit opportunities for the segment including reducing the delinquency rate of their total portfolio, reducing foreclosure-related expenses and in relation, REO charges related to VA no-bid loans, and increased interest income on the growth and re-engineering initiatives.
Now PHH is in a prime position for inorganic or acquisition-related growth opportunities, because of the cash they get from the sale of its fleet management business. This would be a good opportunity for the company to use its servicing platform and exploit the leverage and profitability potential of the business. The company will likely target market-focused retail platforms with strong compliance and regulatory frameworks already in place where it can leverage its existing infrastructure.
While the total loan servicing portfolio remains around $230 billion in UPB at year end, I think UPB doesn't need to grow fast in order to begin significantly benefiting. As the business model shifts away from the capitalized portfolio and towards sub-servicing, we see the profitability of the segment even at stable UPB beginning to be more appreciated by the market. In the fourth quarter, increases in the subservicing UPB were offset by decreases in the capitalized portfolio. The decline in the capitalized servicing portfolio was driven primarily by volumes of saleable closings and the sale of newly created and existing MSRs.
I also believe the MSR portfolio is valued very conservatively with a CPR of approximately 11%, down from 12% in the sequential quarter. One of the avenues to higher profitability we noted was a reduction in the delinquency rate which we deduced will start materializing this year on the back of the sale of their high-delinquency Ginnie Mae portfolio. The fair value of the MSR rights uses a 5.0% weighted-average delinquency rate, which is nearly 100 bps above the actual rate.
Strong Valuation
Post sale of fleet management business, PHH has completely transformed its capital structure and cash position. In 2012, the PHH ended its financial year with $829 million in cash and equivalents compared to $6.55 billion in outstanding debt for a net debt position of $5.72 billion. With the sale of the fleet management business a large chunk of debts ended up with it, and now the picture has completely changed after the company paid some more of its debt now PHH have $1.26 billion in cash and equivalents while only $1.74 billion in outstanding debt, for a net debt position of just $480 million.
Management acclaimed that, in its fourth-quarter call, it needs only $100 to $125 million for minimum working capital, $50 to $75 million cash is required for interest rate hedging activities, around $125 to $175 for contingent liability and rest of the $350 million for re-engineering initiatives and growth. The company completed an ASR worth around $200 million last quarter and expects to repurchase $250 million more of their common throughout 2015 opportunistically. That leaves around $300 million unaccounted for which I deduce that will be used to purchase inorganic growth in their production business or MSR on the mortgage servicing side.
Very few analysts believe that the company has little sell-side, however; as per our analysis it is a good time for the long-term prospective buyers to invest in the stock. We deduced that the company’s new initiatives will bring pre-tax, operating income around $225 million and $175 million respectively.
Some more expected benefits starting this year include a reduction in foreclosure expenses as it sees fewer delinquencies, a large reduction in interest expense from the lower outstanding debt, higher interest earned on its $3 billion in escrow holdings, PLS contract re-negotiations most of which will start benefiting PHH this year, mortgage market expansion, and share repurchases.
According to fair valuation the stock is valued at $41 per share using a multiple of 9.5x, its peer group average is 10.2x although the direct competitors like Ocwen (OCN, Financial), Walter Investment Corp (WAC, Financial) and PennyMac (PFSI, Financial) all trade sub-10x (average 9.2x) with PHH at 9.1x despite being the best positioned and most conservatively run of the bunch. We deduced that the share will be move on the back half of this year as the company begins to really see traction in the items in the above bridge. The most obvious and immediate items being the PLS contract renegotiations which are nearly 80% complete, a reduction in foreclosure expense, and the share repurchases. As this occurs, we think earnings will turn positive and grow quickly. Fiscal 2015 should be slightly positive at around $0.10-0.25 per adjusted share but in 2016, we think the company can earn in excess of $2.50 per adjusted share on its way to our $4.33 estimate for 2017.
The market appears to be tumescence, all the mortgage servicing companies in together with recent troubles at Ocwen and others tainting the industry. The Consumer Financial Protection Bureau has been all over Ocwen, the largest of the non-bank mortgage servicing companies which we think has depressed the sentiment within all names in the industry. That has drastically affected the forward P/E of the peer group which according to Bloomberg has fallen by over one-third its historical average.
I think this has shunned street coverage of some of the smaller names given the lack of visibility, heightened regulatory and compliance risks, and legal uncertainty. However, we think the business is near its nadir and that these issues, while they will always be present, will slowly recede as their earnings power shines through. The downside from here appears fairly contained as the housing market strength and massive share buyback should provide a floor to the price.
Catalysts
I believe that the shares will begin to move sometime in the second or third quarters when real evidence of traction in their return to profitability, and eventually much stronger earnings power, is released. The first hurdle will be completing the PLS renegotiations which we think will largely be completed when they announce first quarter earnings. This is a large overhang to the shares which upon completion – and completion to us is 80-90% or more renegotiated – should boost the share price.
A second hurdle will come later this year when the re-engineering initiatives start to have more particularization. As we noted above, the company estimates the probability of generating pre-tax operating income of $225 million on these initiatives. Given the shift to retail and the cessation of high-cost correspondent lending, we wouldn't be surprised if this turns out to be low. Even at $225 million, this would be a huge boon to the company as it only generated $202.8 million in total operating income last year and $525 million at its zenith.
Lastly, I think the overall sentiment to the industry will abate in 2015. The frequency of foreclosure is diminishing significantly aided by a recovering housing market. The current market is healthy and growing well, which should create an organic tailwind to the business adding nearly $50-60 million in net earnings this year alone in addition to $12 million in lower foreclosure expenses. The company has set aside a large amount of reserves to guard against repurchase requests even though requests have hit a record low.
Conclusion
I ponder that negative sentiment within the non-bank mortgage servicing industry allows for the mispricing to occur. With negative earnings, the stock also doesn't screen well. The inner mechanics of the business are difficult to understand which also compounds the weak pricing. We think that will all change starting in a few months and progressing on through 2016 and into 2017. As the bridge to $4-plus earnings power begins to get realized, we think the shares will respond accordingly. Our work suggests the price will hit $40 per share in the next year to 18 months for upside of 60%.
Disclosure:
I don't have any investment in the aforementioned stock, nor do I get paid from the aforementioned stock company to write, and I have no plans to invest in the stock for the next 72 hours.
The above details are taken from the company filings 10K and an article of author Alpha Gen Capital is considered while writing this article.
