PHH CORP PHH
July 23, 2009 - 2:45pm EST by
will579
2009 2010
Price: 18.00 EPS $2.50 $3.60
Shares Out. (in M): 54 P/E 7.2x 5.0x
Market Cap (in $M): 979 P/FCF 7.2x 5.0x
Net Debt (in $M): 6,398 EBIT 525 625
TEV ($): 7,377 TEV/EBIT 14.7x 11.8x

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Description

 

The thesis:

PHH is a misunderstood company that is starting to benefit from a completely restructured mortgage market, a transformation of its Board and executive management, and the healing of the credit markets. The stock currently trades at 80% of an understated book value and a multiple of 4-5 times normal earnings power. Downside is negligible while upside is 3-4 times the current stock price. Longer term, significant value creation can be achieved by separating PHH into two separately traded public companies. 

Briefly stated, PHH is an outsourcing company with two businesses: fleet management and mortgage production/servicing. PHH originates mortgages on a private-label basis for investment firms, regional banks and other financial institutions. They sell the mortgages and retain the servicing rights (MSRs), creating an earnings steam that lacks any material credit exposure. The prior management team maintained a cost structure that was excessive and did not flex with market volumes. The former CEO viewed his employees as "family" and was unwilling to cut costs even as industry volumes collapsed. This led to his departure as he was removed from the Board via a recent proxy contest and subsequently resigned. We believe that the new Board leadership will create a reduced and more variable cost structure, which will drive profit in the mortgage business of $3-4 per share on a normalized basis.  The current run-rate of earnings for this business is approximately $0.80 per quarter, and the company has not yet addressed the cost structure issues. The goal is to reduce the cost structure to maintain profitability during normal mortgage markets, and allow the cost structure to flex when periods of higher refinancing activity result in mortgage production booms.

The structure of the mortgage industry is drastically different today versus three years ago as evidenced by the rankings of top mortgage originators in Inside Mortgage Finance. PHH is now the fourth largest player in a market where the top three now command significant market share.  This has led to much better margins in the mortgage business, which we believe are sustainable for the scale participants (JPM, BAC, WFC and PHH). The days of subprime and Alt-A cross-subsidies supporting traditional prime mortgages as a "loss leader" are over. PHH has always originated fully documented prime loans with down payments. In a sense, the market has come full circle while PHH never went down the path of accepting ever increasing credit risk to maintain market share.

The way the PHH mortgage outsource business model works can be thought of as follows: the lack of a mortgage broker creates the opportunity for the brand company (Charles Schwab for example) and PHH to roughly split the one point fee usually awarded to the broker who creates a loan. The PHH call center representatives do not work on commission, and have no incentive to cheat from a credit perspective to get questionable loan applicants approved.  They are paid a salary to pick up the phone "Charles Schwab mortgage services, can I help you"?

The growth opportunity for PHH in the mortgage business is to gain significant share by winning new outsourcing relationships. Their current 2% market share could easily be 10% with the right leadership. Subscale regional banks should outsource to PHH in order to exit a business in which they will never reach sufficient scale to compete with the big three (JPM, BAC and WFC).  For these banks, PHH is the only available outsourcing solution that does not involve opening up their customer relationships to a direct competitor.

The PHH fleet management business manages corporate vehicle fleets on an outsourced basis. Services include vehicle acquisition, maintenance, insurance, gas cards, disposition, and financing. Importantly, PHH assumes no residual price risk for the vehicles, and the customers are primarily Fortune 500 companies. This creates a business that is easy to finance during normal times. Unfortunately times have not been normal, and the funding cost of the fleet rose dramatically during the fall of 2008. This business has gone from generating $106mm in pre-tax income in 2006 to a run-rate of $20-30mm in 2009, largely as a result of PHH being slow to pass through the sharply higher funding costs to customers.   PHH has now finally begun to pass through the higher interest costs to customers and management believes that they can get back to $70-$80mm in annualized pre-tax profits over the next couple of years (still only 70% of 2006 profit levels).   Given that we do not believe that the recent results reflect any permanent impairment in the business, or any change in the competitive dynamics of the industry, we believe that the multiple that GE placed on the business in 2007 (11.5x EBT) is a good indication of fair value. We believe it will be a focus of the new CEO to drive the recovery of fleet earnings on a faster schedule.

Some background:

PHH was spun-off from the Cendant Corporation in 2005. There are no compelling reasons for the mortgage and fleet businesses to be operated together, as was evidenced by the attempted separation and sale to GE and Blackstone in 2007.  These businesses were basically the leftovers after Henry Silverman carved up Cendant.  Shortly after exiting the two year safe harbor window for tax-free spin-offs, the Board of PHH attempted to sell PHH to GE and Blackstone.  GE was to take fleet, and Blackstone was to take the mortgage business.  The sale was challenged by Pennant Capital ("Pennant") on the grounds that it was ill-timed and for insufficient value.  The deal ultimately fell apart due to Blackstone's inability to secure financing as the mortgage market went into free-fall.  GE was paying approximately $20.5 for the fleet business, and Blackstone was paying approximately $11 for the mortgage business, plus approximately $2.50/share in tax leakage from the deal.

Pennant, who ultimately became PHH's largest shareholder, lost confidence in the Board and recently ran a short slate of directors (Allan Loren and Greg Parseghian) against PHH's Chairman (Buzzy Krongard) and CEO (Terry Edwards).  Pennant's proxy materials go into sufficient detail as to their reasoning, but put simply, Pennant believed that the Board was tired, showed little regard for value in the attempted GE/Blackstone sale, failed to target profitability, was slow to address fleet cost issues, failed to structure proper management incentive programs, failed to understand profitability of individual clients, failed to understand and communicate normalized earnings to all stakeholders, and failed to capitalize on outsourcing opportunities.  In June 2009, Pennant's short slate won overwhelming approval and Terry Edwards stepped down as President and CEO after losing his Board seat.  A search for a new CEO is to be conducted. 

We believe that Loren and Parseghian have the proper experience to help the Board address many of the issues facing PHH.  Allan Loren has extensive Board and CEO experience having successfully turned around Dun & Bradstreet from 2000-2005.  During his five years leading the company, he grew D&B's EPS from $1.71 to $2.98 and produced a total stockholder return of 378%.  Loren was also CIO of American Express where he managed a substantial budget and reduced costs while maintaining high levels of customer satisfaction - a skill that will be very useful now in addressing how to best manage PHH's mortgage production costs and call centers.  Greg Parseghian has extensive mortgage experience, an obvious benefit here.  One area he should be able to quickly address is PHH's MSR performance.  PHH has had a series of negative surprises with its MSRs and clearly has not effectively managed (hedged) these assets.  To make matters worse, PHH basically threw in the towel on hedging at precisely the wrong time.  We think Parseghian's input into addressing proper hedging of the MSRs will be enormously beneficial.

PHH has been perceived as a balance sheet lender, a perception perversely advanced by the former CEO who, prior to and throughout the proxy contest, liked to compare PHH to various failed balance sheet lenders. You can imagine the frustration of shareholders, employees and customers who were being asked to compare PHH, which takes no credit risk, to Countrywide Financial, which was a time bomb.  Essentially Edwards used this comparison as a defense for not cutting expenses and sustaining losses. We believe that this not only depressed the stock price and fostered a substantial misperception by some investors, but also likely fed into potential mortgage customers' concerns about handing over their business to PHH. Outsourcing mortgage production is a significant undertaking for a regional bank.  The fact is that PHH is not a balance sheet lender.  It does not retain credit risk.  In this environment, where they are the #4 lender and have still had to struggle mightily to produce origination profits, regional banks without scale must be struggling even more and are likely looking to outsource this function -- and PHH is their only real option other than direct competitors.  The potential to sign new mortgage clients is there, especially now with a Board (and hopefully, ultimately with a new CEO) that can articulate what PHH has to offer as a low-risk proposition.

Valuation: $53 (upside), $35 (base), $26 (low-end)

PHH's fleet business has gone from $106mm pre-tax income in 2006 to a run rate of $20-30mm in 2009.  This has resulted from a combination of the current economic downturn as well as PHH being slow to pass through interest cost increases to customers.   PHH has now finally begun to pass through the higher funding costs to customers and management believes that they can get to $70-$80mm in annualized pre-tax profits over the next couple of years (still only 70% of 2006 profit levels).   Given that we do not believe that the recent results reflect any permanent impairment in the business, or any change in the competitive dynamics of the industry, we believe that the multiple that GE placed on the business in 2007 (11.5x EBT) is a good indication of fair value.  This equates to $17/share for fleet.

What is mortgage worth?  Due to recent MSR write-downs (a portion of which is not reflective of economic deterioration) the tangible book value of the combined mortgage operations (servicing and production) is currently around $9/share.  Given the lack of credit risk and mark-to-market treatment, that $9 TBV should be a good proxy for run-off value, if it ever came to that, putting a low-end combined fleet/mortgage value at $26.

The combined mortgage business should produce about $3/share in normalized earnings (split about 60/40 between production and servicing).  That assumes a $2T mortgage origination market, 2% share (current level), with a 40bp pre-tax margin in production and a 10bps margin in servicing.  PHH now uses a slide in their investor presentation (available on their website) which shows 1Q09 run-rate production profitability of $4.35/share at $2T in industry originations, which is more than double what we are assuming based on our estimate of normalized production margins. A modest 6x multiple on the $3/share produces about $18 in value, or $35 in total value when combined with fleet. 

However, if PHH can finally build a truly flexible cost structure (not unlike what FNF has done with the title insurance business, which faces the same volume swings as mortgage origination) they should be able to break away from the wide swings in production profitability that the company has endured.  In this case, the 6x multiple could be revalued towards 12x yielding $36 in value for mortgage, and $53 in total including fleet.  This assumes no further market share increases, which may be overly conservative.

 

Catalyst

Catalysts:

  • Hiring of new CEO, new Board leadership
  • Better articulation and execution of business strategy absent Terry Edwards
  • Investor recognition of the sustained improvement in the mortgage origination business
  • Ultimate separation of businesses
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