May 7th, 2012 by aboveaverageodds
The investment analysis below is our fifteenth in our ongoing series of guest posts, and is brought to you by friend of the blog Lane Sigurd. Lane‘s background is in oil & gas, and he author’s one of my favorite new blogs (the outstanding) Reminiscences of a Stock Blogger. I mean with a tag line like “moneyball without the ball” you know its good.
Lane and I have gone back and forth for almost a year now swapping ideas and digging for value, and it wasn’t long before I realized that not only did I love the way the guy thinks, but that we shared a similar addiction to the pursuit of misunderstood or under-appreciated value in the small and micro cap space. So a friendship was born and this is yet another example of a guest post that’s been a long time coming.
So with that said, let me introduce you to Lane’s latest on PHH, a write-up that we’ve been planning to co-release for a couple of months now and should help outline why we feel it’s pretty hard to lose here given the rock solid downside protection and the likely spin (or divestiture) of its fleet business at some point within the near to medium term. While not official, a close reading of the tea leaves (recent changes at the executive level, undeniable strategic and financial logic, etc. etc.) suggests we’ll see one sooner rather than later, and in the process provide shareholders with a high probability catalyst that would unlock substantial embedded value by forcing the market to assign a value to the companies market leading fleet operations. I don’t know about all of my readers preferences, but while I like cheap, I like cheap a whole lot more when its coupled with a high probability hard catalyst, and that’s what I think we have here.
If we’re right about all of this then (really, even if we aren’t), the asymmetry of an investment at or around today’s price is hard to ignore, as I think a spin should cause the stock to roughly double upon consummation, and any normalization in MSR multiples and housing generally could cause it to promptly double again as (1) servicing costs normalize (2) interest rates rise, and as a result (3) TBV is written up to reflect the true value of it’s long duration, high quality servicing annuity (fwiw, I think one could argue that the servicing cash flows are worth much more than say the normalized 4x-6x historical multiple given where we are in the cycle but that’s a discussion for another day and ultimately irrelevant to the thesis at this valuation).
Again though, with interest rates at a 30 year low (and more importantly, at the zero bound) they have nowhere else to go but up, which we would remind readers that this will start to choke off (1) any material refinancing activity (which shouldn’t consist of much looking forward as is given its reasonable to assume that most everyone that hasn’t refinance by this point probably can’t/won’t and (2) the slow drip of MSR related write downs that have been a constant headwind to this business for a very long time. The takeaway then is that PHH has already come through the worst of a multi-decade storm and given the valuation, the market has yet to take notice.
Add it all up, and it seems like this indeed has all the trappings of a classic Greenblatt style home run. Enjoy!!!
I swear its the name of a book, not the punchline of an infomercial
You Can Be a Stock Market Genius was written by Joel Greenblatt in 1999. It is an oft recommended book by value investors. The recommendations, however, generally come with the following caveat, or something similar in effect: “Now I know the title is awful but…”
If you can get past the cheesy title and into the meat, the book provides an investor with a wealth of knowledge, focusing on areas of the stock market that are overlooked by most investors, and explaining how you can find value there.
One opportunity that is discussed at length in the book is the spin-off. A spin-off typically occurs either when the company feels that the sum of the parts is greater than the whole, or when a bad business is overwhelming the perception of a good business. Usually a spin-off involves two or more businesses that are mostly mutually exclusive from one another.
The basic premise of the spin-off is that the underlying businesses will be realized for a higher value separately then they are being realized for together. In his book, Greenblatt focuses on the inefficiencies with the spin-off process. In many cases investors of the original security will be more interested in one of the resulting securities than the other. In some cases the spin-off will result in one entity that is far smaller than the other, and institutions with size limitations on what they can hold will be forced to sell. These reasons lead to a lot of selling pressure over a short amount of time, which can depress one of the spin-off companies and lead to a good value situation.
I want to focus here on the basic premise of a spin-off; that the businesses that underly the parent company are undervalued as a whole, and that often there is money to be made simply from the recognition of value brought about by their separation. The intent of the spin-off is to create value, and often times it works. There are plenty of examples of company’s whose stock popped on the announcement of a spin-off or divestiture. With investors being more able to focus on the simpler business structures of the resulting spin-off companies, the value is more readily perceived.
The Spin-off Potential of PHH Corp
I believe that PHH Corp is an ideal candidate for a spin-off or a divestiture that would create significant value for shareholders. Moreover, even if a spin-off never happens, the value is there to be realized and the market appears to be in the process of reevaluating its worth.
PHH is involved in two businesses that, from what I can tell, have very little efficiencies with one another apart from the fact that both involve money.
- Mortgage Origination and Servicing
- Fleet Management Services
When I became interested in PHH Corp a few months ago it was because of the Mortgage Origination and Servicing segment. PHH is one of the few large originators out there that trades publically. I learned about the company while reading a 13G filing from Hayman Capital, the investment management firm run by Kyle Bass. Bass took a 7.9% stake in the company.
My initial investment analysis focused on the servicing and origination segment of the business. I was pretty sure I could see the value that Bass saw, and I will get to that in a minute. I bought the stock soon after and watched it do well for a couple of weeks.
Well at some point my procrastination was overridden by my curiousity and I thought I better take a look at this Fleet Management business. To be honest, I didn’t even know what Fleet Management was. What I was shocked to learn was not only that Fleet Management is a solid, growing business, but that an argument could be made that its value alone could be worth a large percentage of the PHH market capitalization. I can imagine a scenario where the Fleet Management business is spun off or divested from the mortgage business, with the result being a significant realization of shareholder value.
What is Fleet Management?
The best definition I could find as to what the business of fleet management is all about came from wikipedia:
Fleet management is the management of a company’s vehicle fleet. Fleet management includes commercial motor vehicles such as cars, vans and trucks. Fleet (vehicle) management can include a range of functions, such as vehicle financing, vehicle maintenance, vehicle telematics (tracking and diagnostics), driver management, speed management, fuel management and health and safety management. Fleet Management is a function which allows companies which rely on transportation in their business to remove or minimize the risks associated with vehicle investment, improving efficiency, productivity and reducing their overall transportation and staff costs, providing 100% compliance with government legislation (duty of care) and many more. These functions can be dealt with by either an in-house fleet-management department or an outsourced fleet-management provider.
Its a fairly simple business, and one that has proven to be consistently profitable even through one of the worst recessions ever.
The hidden consistency of Fleet
I went back a few years and looked at the earnings numbers on the PHH Fleet business:
Average earnings from Fleet over the past 6 years have been $0.83 per share of PHH. Even in the depths of the 2008-2009 recession Fleet delivered respectable earnings.
The Fleet business continued its operational performance in the first quarter of this year and looks ready to break above a $1 per share in earnings for the first time since 2007.
Think about that for a second. Here you have a business that has shown the ability to earn money consistently, even through what was probably the worst recession of our generation. It could quick likely earn $1 per share of earnings this year. Earnings have grown in the high teens for the past 3 years.
What would you value such a business at? 12x earnings? 15x earnings? Maybe more?
If you use either of those multiples on the average and peak earnings numbers, it becomes clear that the Fleet business is worth something not too far away from the current stock price. Or in other words, when you are buying PHH you are buying the mortgage business for very little.
Moreover, as one would expect, the Fleet Management business is going to improve along with the economy. As per last year’s 10-K:
The fleet management industry continues to be impacted by the relative strength of the U.S. economy. As the U.S. economy improves, we expect to see continued improvement in the industry. We believe that improvement in the economic conditions will be reflected in continued growth in our service unit counts.
If the US economy is indeed improving, the Fleet business could turn out to be a cash generating machine.
This all leads to the speculation of whether there could be a spin-off or sale of Fleet from the rest of the company at some point. A sale of Fleet would provide the cash needed by the servicing business to grow and allow PHH to continue their correspondent lending business at higher levels. A spin-off would most likely realize value for shareholders, as the value of each individual business would be more easily identified.
There was a question on the Q4 conference call that alluded to the possibility of some sort of divestiture. Management did not deny it, saying only that it wasn`t an appropriate topic for a public forum. On the fourth quarter conference call the CEO, Glenn Messina, was asked about the possibility of bidders to the Fleet business (as well as the mortgage servicing business). His response was:
As it relates to anything regard to Fleet or Mortgage, this public forum is not the place to have any discussions about anything like that. I’m focused on maximizing shareholder value. We’ve laid out our four strategies and that’s what we are going to be pursuing.
That certainly is not a no.
But wait, there’s more!
So a spin-off or sale of Fleet is certainly a possibility. But that is the not the only source of value hidden within PHH. PHH is in the business of mortgage origination and mortgage servicing. The company breaks origination and servicing up into two distinct segments.
Mortgage origination basically consists of finding a person that needs a loan to buy a home, showing that person a list of mortgage options of how they could finance that loan, qualifying the borrower for loan guarantees such as those from the GSE’s, processing the loan (doing all the paperwork) and passing it through to the eventual lender institution (usually to Fannie, Freddie or a bank that will either keep it on their books or sell it to another investor). PHH takes a cut in the process, or anorigination fee, that is typically between 1/2% and 1%.
Mortgage servicing happens after the loan is made. The servicer is responsible for determining how much the borrower owes and collecting that amount. If a loan is not being paid then the servicer takes on additional responsibilities such negotiating a workout upon default, looking after the foreclosed property and such. There are also other contingent responsibilities such as taxes and insurance, depending on the specifics of the servicing agreement.
The natural hedge of servicing and origination
PHH refers to the servicing and origination businesses as a natural hedge of each other. Why? Because they are inversely correlated with respect to interest rates.
Let’s say interest rates fall. What happens? People that have mortgages at higher rates refinance those mortgages. That’s great for the origination business. They are writing up refi’s and taking in the fees.
Not so great for the servicing business. When a mortgage is refinanced the right to service that mortgage no longer exists. Of course this can be mitigated if PHH is able to originate the refinance and thus takes on the servicing rights for that refi so the old mortgage servicing right (MSR) is replaced with a new one. PHH has proven to be quite good at “recapturing” loans in this manner. But there’s no guarantee.
When rates go up and the opposite situation occurs. Origination suffers, no one is refinancing at the higher rates. But mortgage servicing rights are not being lost either, and PHH is collecting cash on these rights for longer.
There are a number of developments happening in the mortgage business right now from which PHH stands to benefit.
Origination: Generating consistent earnings, but needs to grow
Since 2008 PHH has had a steady stream of earnings from the mortgage origination business. However, probably not surprisingly in the current environment, they have not been able to grow the business substantially. Below are earnings of the business over the past 5 years, as well as for the first quarter of this year.
I believe there are a few opportunities in the origination space that could change the growth profile of the business The first is if the company could take advantage of the pricing opportunity that exists in correspondent lending.
So first of all, what is a correspondent lender?
Consider the following. Imagine a mortgage broker who develops significant business volume, earns the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.
This has been a business the big banks have traditionally taken a large piece of. Until now. In August Bank of America reported that they were exiting the correspondent lending business. Ally Financial, who lends through GMAC, retreated from correspondent lending back in December before recently announcing that they would get back into the business on a limited basis. Met Life announcedthat they were winding down their origination business entirely in January.
This isn’t small potatoes. The above 3 companies were in the top 12 correspondent lenders by volume in the third quarter.
There are rumors others are leaving the business. I thought this quote from a Mortgage News Daily article was spot-on:
One can just hear large lenders talking in their boardrooms. “Do we really want to be in this business, given the regulatory, legal, financial, and public relations issues? Where the value of servicing has dropped dramatically in the market, and could drop further depending on Basel III? Where the mortgage insurance tax deductibility has gone away? Where every week brings a new lawsuit – when will we have more attorneys on staff than originators?”
Its a low margin, highly competitive business. But the opportunity is that it could become less so with some of the big players moving on.
In the 4th quarter PHH announced that they would be reducing their own correspondent lending business. But even at the time of the announcement they hedged their bet, saying they would remain opportunistic and take advantages of periods of high margins. With so many other large lenders cutting back or completely exiting from the business, its a good time to be opportunistic.
Here is what management said about the correspondent business on the Q3 2011 conference call:
Yes I’m going let – yes the answer to the question is yes, we think there are better opportunities but once again we’re really pretty opportunistic in that channel. So we pay close attention to margins in that channel. As you know it’s probably the most cost competitive channel, it is the most cost competitive channel that we operate in and we’ve seen some really strange behavior in that market in terms of where margins are being priced. Some of our competitors are in the market, when they are in the market they’re very aggressive in terms of their pricing and then they back off and they’re out of market and that’s why we stay really opportunistic in that market.
On the Q1 2012 call, when questioned about the outlook of the correspondent business going forward, management began to change their tune. CEO Glenn Messina said the following:
Right now we think by year end we’ll probably ramp it down to about 20% of the total, but yes, I do want to caution everyone. Last quarter I talked about managing the correspondent operations to a cash budget, and given where margins are today, cash cost origination tends to be very low.
So within the right quality parameters, and we’ve established defined quality parameters around who sells loans to us and the quality of their originations, we may flex up or down depending upon what the cash cost originations is.
So basically what Messina is saying is that margins are so good right now that while we originally figured to be ramping down correspondent lending,we would be crazy to do that in this environment. Analysts have already ratcheted down estimates for the origination business as a whole based on expected declines in the correspondent segment. PHH is in a good position to now beat those estimates.
Signing up new partners
The second possible growth vehicle for the origination business is a continuation of the success they had in the latter half of last year in signing up some big partners for their origination business. From the Q3 CC:
We also made significant progress in growing our nationwide sourcing footprint over the past two quarters signing five new private label accounts. The new relationships include Barclays which we mentioned on last quarter’s call and today we’re pleased to announce that we’ve added Ameriprise and Morgan Stanley Private Bank along with two other financial institutions all as new PLS partners.
PHH did also lose one significant client in Charles Schwab last year, but overall the company expects to gain significant production from the new clients over and beyond the lost ones:
We expect the five new PLS accounts in the aggregate based on their 2011 production and taking into account ramp up time and anticipated launch schedules to produce about 7 billion in closing volume in 2012, about double what we predicted for Schwab.
There haven’t been any further announcements of major partnerships since the third quarter. I imagine that these relationship get reviewed close to year end, so we will just have to wait and see. Given the propensity for the big banks to scale back and outsource their mortgage business, it seems reasonable to me that PHH will be able to grow its book through further relationships.
HARP II could provide some short term support to origination
The HARP program has helped far fewer borrowers than its proponents estimated — roughly 894,000 borrowers since Aug. 31, 2011. — and many less than the estimated 11 million U.S. homeowners who owe more than their homes are worth.
Why was it a failure? A few reasons:
1. Put back risk: Basically when a bank participated in the original program they were worried that they would get stuck with the original mortgage. I think what happens here is that to rewrite the original loan to new terms, the loan is going to be scrutinized. The banks and other underwriters know that the quality of many of those original documents are sketchy at best and they would rather not have to pull out the skeletons.
2. LTV Limits: This is probably the biggest problem. The original HARP program dealt with current loans with LTV’s of 80-105. That was expanded to 125 in 2009, but that still wasn’t enough. I was surprised by that until I read this:
This should have a big impact in certain parts of Nevada, Arizona, and Florida where many borrowers owe more than 125% of the value of their homes. In Nevada, for example, two thirds of all loans backed by Fannie Mae are underwater, and half of all loans are above the 125% loan-to-value cut-off.
3. Appraisal costs: the borrower had to have an appraisal done to qualify for the original program. That appraisal could cost $400. Borrowers were reluctant to take this cost on when there was no guarantee they would be accepted by the program
HARP II aims to correct these mistakes. The LTV limit is gone. Appraisals are no longer required. And banks are protected against the put backs.Says Brian Ye, analyst at J.P Morgan Chase & Co:
“We are of the opinion that there are enough changes to the program that bank servicers could really change their behavior, and this could be one of the first times that the administration has under-promised and over-delivered,”
There is one particular element of the new program that helps out PHH is that servicers get a head start over third party originators. I confess I don’t know just what of impact this is going to have, but it is interesting and potentially significant, so I think its worth mentioning. Servicers like PHH have been writing borrowers up for the program since the beginning of the year. A third party originator cannot submit any documents to Fannie or Freddie until March. This was done to entice the banks into the program, but the corrollary is that a company like PHH has been able to capture business up front without the competition.
More information on the new HARP program can be found here.
Will HARP II work?
This is, of course, the big question. The program is aimed to attract two million borrowers by the end of 2013. This would be a little more than twice what the original program attracted.
However if the program works, and if JP Morgan turns out to be right and the administration “under-promised”, there is certainly a lot of room for upside. According to CoreLogic:
10.9 million, or 22.5 percent, of all residential properties with a mortgage were in negative equity at the end of the second quarter of 2011. Eight million borrowers with negative equity, or nearly 75 percent of all underwater borrowers, have above market rates. The disparity is even greater for those with severe negative equity. More than 40 percent of borrowers with 125 percent or higher loan-to-value (LTV) ratios have mortgages with rates at 6 percent or above, compared to only 17 percent for borrowers with positive equity.
Apart from the obvious fact that these numbers show just how staggeringly bad housing has become, if you prefer to see the glass half full those numbers also suggest that there are a lot of borrowers out that could benefit from a program like this.
Mortgage Servicing Rights and the Mortgage Servicing Disconnect
I wrote a long article on Seeking Alpha (The Opportunity in Mortgage Servicing Rights) describing the factors that have caused the mortgage servicing industry to fall into disarray. I am not going to repeat that thesis in detail here. To summarize its conclusions by way of analogy, the opportunity in the mortgage servicing industry right now is similar to the opportunity in correspondent lending. Many of the traditional big players in the industry are getting out of the business and that has left a void. The void has caused servicing valuations to collapse and has opened up the potential for servicers like PHH to take on new business.
PHH Corp is perhaps not the best way to play the valuation gap in servicing rights. There are other companies like Newcastle Investments, Nationstar Mortgage Holdings, and Home Loan Servicing Solutions that are actively purchasing 3rd Party portfolios of servicing rights on the cheap, and in my opinion stand to gain substantially from their eventual reversion to historical norms.
PHH, on the other hand, does not buy servicing rights outright from 3rd parties. They do, however, keep the servicing rights of the mortgages they originate, and they do perform subservicing of portfolios owned by others. It is perhaps in the subservicing business where PHH can take advantage of the exit of other large players, developing new relationships as subservicer. Right now the subservicing business is a fairly miniscule component of the overall servicing revenue (a little less than 3% of total fee revenue in the first quarter) so I am going to leave this as a possibility, but not one to count on.
The other potential opportunity for PHH lies with the effect rising interest rates will have on its existing servicing portfolio.
Interest rates have done nothing but fall for more than 20 years.
At some point this trend is going to reverse. Rates are going to head upwards. David Einhorn published an interesting opinion piece this week in the Huffington Post. He argued that the Federal Reserves policy of zero interest rates and quantitative easing is counter-productive; that it is not enticing risk adverse investors into stocks. He goes on to argue that if the Federal Reserve were to allow interest rates to rise, you would see investors begin to shy away from the bond market, as what has been a one way winning trade for 20+ years would show signs of waning.
Falling interest rates have been a plague on the mortgage servicing industry. Every time a borrower refinances, the servicing right associated with the original mortgage ceases. This has put companies like PHH on a treadmill of generating originations to replenish their servicing pipeline, and forced them to work hard to recapture the borrowers that are looking to refinance.
When interest rates begin to head back up, the opposite scenario is going to prevail. PHH is going to be left with a servicing portfolio that is chaulk full of low interest rate loans that will not refinance for years. Everyone who can refinance their mortgage will have already done so. Meanwhile, the quality of the loans being originated since 2008 is some of the highest it has ever been. No one has dared make a risky loan in the current environment.
There are 3 risks associated with holding a mortgage servicing right. The first risk is the risk of refinancing. The second risk is the risk of default. The third risk is the risk that the house is put up for sale. We are in an environment where the first two risks are likely to be lower going forward than they have been for quite some time. A rise in the risk of the house simply being sold implies an economy that is recovering. Thisis probably a positive for PHH, as higher home sales will drive it origination business.
The end result is that the servicing portfolio that PHH owns is going to be generating cash for longer than it has in the recent past. This is going to help PHH grow its portfolio further, for the simple reason that the portfolio won’t have as much turnover.
A brief look at the effect of mortgage servicing rights on tangible book
Another effect of rising interest rates is that which it will have on the book value of the servicing assets.
PHH provides an estimate of its tangible book value every quarter as part of its investor supplementary material. Below is the estimate at the end of the first quarter as well as at year end 2011.
The company is trading at a reasonably significant discount to tangible book, which in itself says something about the unrealized value. But if you look at the book value a bit closer, you realize that there is a lot of hidden value within the assets on the books.
Baked into shareholder equity is the value of the mortgage servicing assets that PHH carries on their balance sheet. The servicing asset was carried at $1.3B at the end of the first quarter. As I already explained, this asset is marked to market every quarter based on interest rates and the perceived threat of prepayment and default of the mortgages underlying the asset. The asset represents the future value of servicing an unpaid principle balance of $149.6B in mortgages. According to the latest earnings release, the average yearly fee that PHH receives for servicing those mortgages is 30 basis points, or about $450M of servicing fees per year. A simple ratio comparing the current value of the servicing right ($1.3B) to the expected income of that portfolio ($450M) tells you that PHH is valuing their servicing portfolio at about 2.9x its yearly servicing income.
I’ve done a bit of research into the matter, and while right now mortgage servicing rights are selling at multiples of anywhere from 1x to 3x the yearly income, in the past servicing rights sold at 4x to even 6x yearly income. Once servicing rights return to the mean, the book value of PHH will rise substantially. At 4x servicing book value would rise byapproximately $450M to $34 per share. At the high end of 6x book value would be $50 per share.
Another way that higher rates help servicing revenues
There is another rather obscure way that higher interest rates are going to improve earnings at PHH. As part of the mortgages that PHH services PHH is charged with managing escrow accounts that are used to hold funds designated for taxes and inusurance. PHH receives a benefit for these services by way of receiving the interest on these accounts. The interest benefit is recorded under the Mortgage Servicing segment accounting item Mortgage Interest Income.
Beginning in 2008 mortgage interest income collapsed. Since then it has fallen to a fraction of what it was pre-2008.
Taking a look at the PHH 10-K for 2008, when the collapse began, PHH said the following about the reduction in mortgage interest income.
Mortgage net finance income decreased by $86 million (89%) during 2008 compared to 2007, primarily due to lower interest income from escrow balances. This decrease was primarily due to lower short-term interest rates in 2008 compared to 2007 as escrow balances earn income based on one-month LIBOR.
As interest rates rise, the interest associated with these escrow accounts are going to rise substantially. In 2007 one month LIBOR averaged around 5.3%. In 2011 it averaged around 0.3%. When (perhaps if) the economy finally begins to show some strength, LIBOR rates will rise. To give a sense of this affect on PHH, in 2007 PHH was pulling in almost $3/share worth of revenue from these escrow accounts. In 2011 that had dropped to $0.30 per share.
The Fannie put back
Since 2007 PHH has had a continual drag on its mortgage servicing income caused by the put-back of mortgages from Fannie Mae. Over the past couple of years Fannie Mae has been reviewing their loan book for the periods from 2005-present and looking for any breaches in contractual terms, poor underwriting or defective documentation. When it finds a mortgage that has one of these flaws, it puts it back on the lender.
PHH can fight these repurchase requests, but only up to a point. Bank of America has been probably the most vigilant in fighting Fannie, and in return Fannie decided not to renew their contract to buy loans from BoA. Fannie holds the trump card in this battle, and so PHH is going to be pretty much stuck with paying up for many of the repurchase requests put back to them.
Since 2008 PHH has been taking significant writedowns due to the repurchase requests including a big charge at the end of the most recent quarter.
The topic was discussed in depth on the first quarter conference call. Messina had the following comments:
Based on our ongoing discussions with the GSEs, we believe that by the end of 2012, they may be substantially complete with their review of our seriously delinquent and defaulted related to origination years 2005 and prior, and by the end of 2013, they may be substantially complete with their review of our seriously delinquent and defaulted loans related to origination years 2008 and prior.
Almost 78% of our standing repurchase requests at quarter end are related to the 2005 through 2008 origination years. Given the results of the first quarter, our ongoing discussions with the GSEs, we believe it’s reasonably possible that future losses related to repurchase and indemnification requests may be in excess of our recorded foreclosure-related reserves.
Assuming that the elevated level of repurchase demands that we have recently experienced continues through the end of 2013, and the company’s success rate in defending against such requests declines, and that loss severities on repurchases remain at current levels, the estimated amount of possible losses in excess of our foreclosure-related reserves is $140 million.
The bottom line is that repurchase requests are likely to be a drag on earnings for the next two years. The company is outlining $140 million in addittional charges, presumably broken up over the next 7 quarters. This works out to about $20 million a quarter, which is fairly consistent with the level of charges over the past 3 years.
When core earnings matter
Whenever a company publishes core earnings you have to look good and hard at why they are doing so. You never know what they might be trying to gloss over by eliminating some of the more unsavoury elements of the income statement.
PHH reports core earnings every quarter but they do so for a very good reason. Core earnings are a far better representation of the company’s profitability than are GAAP earnings.
The problem with GAAP earnings is that they are obscured by changes in the mark to market value of the mortgage servicing right portfolio. The accounting nature of the servicing right is such that PHH has to write up and down the mark to market value of each right with changes in interest rates. A servicing right is in many ways no different than an interest only mortgage security. The biggest risk is the prepayment of the security and with most mortgages this risk is closely tied to interest rates. When rates go down mortgage servicing rights have to be written down in value to reflect this increased risk of prepayment.
The fluctuations on the income statement caused by these mark to market moves are huge. Up to $400M in some quarters, which for a company the size of PHH (there are only 55M shares outstanding after all), leads to massive moves up and down. If you look at quarterly GAAP earnings over the past couple years they look like a scatter chart. Below is a chart of earnings from the mortgage servicing segment that includes the effects of the mark to market adjustment. With interest rates having fallen so precipitiously in the last few years, PHH has had to take pretty massive GAAP writedowns on their servicing portfolio. Below are the before tax earnings per share from the mortgage servicing segment. Much of the swing is the result of the mark to market adjustments to the servicing portfolio.
The reality of the mortgage servicing right is that as long as the company is replenishing the existing pool with more rights from new originations and recaptured refinances then its losing to payoffs, its all good. As I already noted, PHH is doing that and then some.
The core earnings number that PHH reports is quite simply GAAP earning less this mark to market effect. And if you look at that core earnings over the last few years you can see that they have have been growing consistently and that the current stock price of $17 is not expensive relative to earnings.
So what did Bass see?
Let’s review the core elements of the thesis with PHH:
- The company is trading at about 65% of a tangible book value that perhaps undervalues the servicing assets by 25-50%
- Core earnings, which are a relevant metric of company profitability, are over $3 per share and growing
- The Fleet business itself has the potential to earn $1 per share in 2012 and provides a reasonably steady earnings stream even during recessions
- There is upside potential for PHH to take advantage of the current disconnects in the mortgage market, both in servicing and in originations
- The potential of a divestiture or spin-off of Fleet from Mortgage or vice versa
The downside is that the stock has moved well off its lows and that because of the sensitivity of the mortgage business to overall economic activity, the share price is volatile. Bass bought his shares at around $10 and in full disclosure I bought most of my shares in the $12 range, though I have added recently with the break-out above $16. While I can’t say for certain that PHH will eventually divest the Fleet business, I think that the story has enough elements that even if they don’t, there is plenty of room for upside appreciation in the share price.
PHH Corporate Presentation
I think this (Ryan here) is a situation where it helps to understand recent changes in context of history, and I think its actually critical to putting all the pieces together and connecting the dots, so I would recommend heading over to Value Investors Club and reading the handful of older write-ups for further context and understanding, as well as the Pennant Capital 2009 proxy statement embedded below.
14 Responses to “Investment Analysis: The PHH Corporation (PHH) – You too Can Be a Stock Market Genius”