PHH CORP PHH
May 15, 2012 - 9:05pm EST by
frankie3
2012 2013
Price: 17.21 EPS $3.23 $2.25
Shares Out. (in M): 57 P/E 5.3x 7.5x
Market Cap (in $M): 995 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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  • Discount to Tangible Book
  • Specialty Finance
  • Mortgage
  • Fleet management
  • Refinancing
  • Management Change
  • Turnaround

Description

PHH trades 64% of tangible book value and is positioned to create shareholder value over the next year.  My target for the stock is tangible book value ($26.41/share) or 55% return.  If the company executes it strategy the company could be worth north of $30/share.
 
PHH is a leading outsource provider of mortgage and fleet management services.  It provides mortgage banking services to financial institutions and real estate brokers throughout the U.S.  Their mortgage banking activities include originating, purchasing, selling and servicing mortgage loans.  PHH also provides commercial fleet management services to corporate clients and government agencies throughout the U.S. and Canada through their wholly owned subsidiary, PHH Vehicle Management Services Group LLC (“PHH VMS”). PHH VMS is a fully integrated provider of fleet management services with a broad range of product offerings, including managing and leasing vehicle fleets and providing other fee-based services for our clients’ vehicle fleets.
 
PHH was incorporated in 1953 and, for periods between April 1997 and February 2005, was a wholly owned subsidiary of Cendant, the travel and real estate services giant now known as Avis Budget Group (CAR; N/R). Following Cendant’s decision to jettison noncore businesses in 2004, it spun off tax preparer Jackson Hewitt (JHTXQ; N/R), fuel card manager Wright Express (WXS; N/R), PHH, and the marketing services division, which included brands such as Progeny Marketing Innovations and Trilegiant. PHH began operating as an independent, publicly traded corporation on February 1, 2005.  PHH like every financial company had their issues during the credit crisis but was able to survive unlike a number of other companies in the mortgage space.  One of the main reasons why they survived is because they don't take credit risk like a subprime lender would.  PHH's risk is primarily liquidity.  PHH relies on credit lines to fund its business and US government agencies to purchase loans that it originates. 
 
PHH has two distinct businesses that are very unrelated with the exception that they both provide financial services to their customers. 
 
PHH Mortgage Business
 
The PHH mortgage business consists of two primary parts:  1) Mortgage Production (Originating loans) and 2) Mortgage Servicing (collecting monthly payments).
 
In Mortgage Production, PHH provides outsourced origination services for organizations that want to offer mortgages to their customers but do not want to commit the resources or capital in providing these services.  Example customers include Merrill Lynch, Morgan Stanley, Keybank.  If you were a financial advisor at Morgan Stanley and you wanted to assist your client in obtaining a mortgage, you would be utilizing PHH's services.  When PHH has these sorts of relationships they are referred to as Private Label Services.  Private Label Services represent 47% of mortgage production.  PHH receives fees for originating loans and also benefits from the gain on sale of these mortgages to the secondary market.  Generally speaking, the loans that are originated under this channel tend to have high credit ratings and are profitable.  While competitively priced, these borrowers tend not to shop for price as much since their financial advisor is steering them.  This channel can do well in a refinance environment or a home purchase environment.  In addition, these loans tend to "fall out" less meaning that once a loan process is started it tends to close more than a loan with a traditional mortgage broker.  The other channel for mortgage production besides Private Label Services is the Real Estate channel.  This primarily consists of the relationship that PHH has with Realogy.  Realogy is the largest owner of real estate brokerages in the US and accounts for roughly 1/4 of home sales.  Its brands include Century 21 and Coldwell banker.  This channel does better with home sales rather than refinances.  The Real Estate channel does 22% of the mortgage production volume.  The good news is that purchases are generally a more profitable loan to originate.  The 3rd channel where PHH originates its loans is in the Correspondent Channel.  In this channel, PHH purchases mortgages from small mortgage and community banks and credit unions.  It then sells the loans to the government agencies.  This channel is typically the least profitable however lately it has been very profitable due to the lack of capacity in the mortgage space caused by large banks pulling out and high demand for refinancing.  The correspondent channel represents 31% of mortgage origination production.
 
When a mortgage gets originated, PHH sells the mortgage to Fannie Mae or Freddie Mac and retains the Mortage Servicing Right (MSR).  The MSR is the right to receive payment for servicing the mortgage throughout the life of the mortgage.  The MSR is capitalized on the balance sheet and represents the NPV of the servicing fees that PHH is entitled to through out the life of the loan.  The value of the MSR can change on a quarterly basis based on assumptions of mortgage prepayments, interest rates, defaults etc.  In a declining rate environment, the MSR decreases in value.  In a rising increase in rates it increases in value.
 
The Mortgage Production segment's earning are volatile and are dependent on interest rates, home purchases and refi initiatives.
 
In Mortgage Servicing, PHH services the loans originated, and subsequently sold, by the mortgage production segment and also subservices loans for other financial institutions for a fee. Servicing the loans entails collecting payments from borrowers and remitting the principal and interest to the appropriate investors, managing escrow funds, managing delinquencies/defaults and performing loss mitigation activities on behalf of investors.  The cash revenue generated in the mortgage servicing segment consists largely of the fees received for administering both loans the company has originated and sold (~30 bp of the average UPB in 2011) and those loans it subservices for others. The other component of revenue, a non-cash item, is the changes in the fair value of the company’s capitalized mortgage servicing rights (MSRs). Mortgage servicing rights are the rights to receive a portion of the coupon interest received on loans serviced for others.  The Mortgage Servicing business is a steady cash collection business.
 
Fleet Management Business
 
PHH provides leasing and fleet services to corporations around the world.  PHH is a “one stop” provider of Fleet Management services with approximately 570,000 vehicles under management in the U.S. and Canada.  These services include vehicle leasing, fleet policy analysis and recommendations, benchmarking, vehicle recommendations, ordering and purchasing vehicles, arranging for vehicle delivery and administration of the title and registration process, as well as tax and insurance requirements, pursuing warranty claims and remarketing used vehicles.  PHH leases vehicles to clients under both open-end and closed-end leases.  PHH offers clients vehicle maintenance service cards that are used to facilitate payment for repairs and maintenance and maintains an extensive network of third-party service providers in the U.S. and Canada to ensure ease of use by the clients’ drivers.  The vehicle maintenance service cards provide clients with the following benefits: (i) negotiated discounts off of full retail prices through a supplier network; (ii) access to an in-house team of certified maintenance experts that monitor transactions for policy compliance, reasonability and cost-effectiveness; and (iii) inclusion of vehicle maintenance transactions in a consolidated information and billing database.  PHH also provides clients with comprehensive accident management services such as immediate assistance upon receiving the initial accident report from the driver (e.g., facilitating emergency towing services and car rental assistance), an organized vehicle appraisal and repair process through a network of third-party preferred repair and body shops and coordination and negotiation of potential accident claims.  PHH's accident management services provide clients with  24-hour assistance from a call center and access to relationships with the repair and body shops included in PHH's preferred supplier network, which typically provide clients with favorable terms.  PHH also provides clients with fuel card programs that facilitate the payment, monitoring and control of fuel purchases. Fuel is the single largest fleet-related operating expense.  Fuel cards provide clients with the following benefits: (i) access to more fuel brands and outlets than other private-label corporate fuel cards; (ii) point-of-sale processing technology for fuel card transactions that enhances clients’ ability to monitor purchases and consolidated billing; and (iii) access to other information on fuel card transactions, which assists clients with the evaluation of overall fleet performance and costs.

 
 
What Happened in late 2011?
 
Going back to 2009, the stategic plan for the company was to grow market share in the mortgage market.  This was led by former CEO Jerry Selitto.  Jerry was a marketing guy and not necessarily an operations guru.  Furthermore, the CFO who left in early 2011 was not operationally strong either.  PHH grew mortgage production during 2009, 2010 and 2011 primarily through the correspondent channel which typically is a less efficient and less profitable business.  By 2011, operations were not up to par and Glenn Messina was brought in.  Due to the poor planning by the CEO and having no CFO in place, PHH waited until the end of the year to raise debt for a maturity that came due in April of 2012.  They hit the market trying to raise $250mm in a term note.  Due to the fact that MF Global and Jefferies were in the midst of their issues, the high yield market for financials wasn't that great.  Management was hoping for 9% or better and it looked like they would have to settle for 10%ish.  Management balked at this and decides to only reissue $100mm of an existing 3 year MTN at about 10%.  The plan at the time was that they were going to tap the debt markets again for the another $200mm at a better time.  The rating agencies did not like the sound of that and S&P downgraded the PHH's credit rating due to the uncertainty of how they were going to raise the capital for the upcoming maturity in April and again in 2013.  This knocked the stock down and its bond yields widened further.  Then company disclosed that as a result of the S&P downgrade, Fannie Mae had the right to pull a committed "early funding" facility.  While the pulling of this facility wouldn't have necessarily caused the company major liquidity issues, it didn't help.  Since PHH sells the majority of its mortgage loans to Fannie Mae it was perceived to some investors that Fannie Mae was about to pull the plug on PHH.  This further sent the stock down and year end tax loss selling exacerbated it. 
 
Key Moves made in Early 2012 and Early signs of Success
The bungling of the refinancing caused damage that needed to be repaired.  A finance company's lifeblood is the ability to have liquidity and a low cost of capital.  At one point, PHH's 1 year bond yields ran to 15%!  PHH fired the CEO and promoted the the COO Glenn Messina to CEO.  Messina joined the company in July after a long history with GE.  Messina was charged with improving operations and efficiency at PHH.  PHH also hit the debt market with a convertible note that carries a 6% coupon.  PHH released strong results in Q4 2011 and Q1 of this year.  Part of the success has to do with Glenn's ability to streamline the mortgage operations and sell non-core assets.  The other part of the strength in the quarters come from a healthy mortgage banking market.  PHH intends to further focus on liquidity and cash flow in 2012 and is managing the growth in the correspondent channel unlike previous management.  Just recently they hired a CFO after over a year of not having a permanent one.
 
 
Key issues facing that Mortgage Industry that Favor PHH
The credit crisis knocked out major players in the mortgage industry permanently.  The industry is being rationalized.  In the heyday of the mortgage industry "anyone" could get a loan and "anyone" could originate a loan.  The resulting damage is well documented.  The mortgage industry on a go forward basis will be much more regulated and will have higher barriers to entry.  In addition, the largest banks which dominate 60% of the $10.5 trillion mortgage market are under regulatory pressure from a capital perspective (Basel III) and an operations perspective (Dodd Frank and Consumer Financial Protection Bureau (CFPB)).  Basel III is setting limits on the amount of capital that can be put towards mortgage servicing assets or MSRs.  In additon, banks are also under regulatory pressures from a mortgage servicing perspective.  The government is putting in place "consumer protection" regulations in place that banks are neither prepared to do or have no interest in doing it.  Banks do not want to further in invest in mortgage servicing (such as establishing a single point of contact for borrowers) when they do not want to put more capital in the mortgage business.  Furthermore, banks still face significant mortgage liabilities from past mortgage origination practices.  The net of all this, is that the largest banks generally are withdrawing from the mortgage market creating undercapacity in mortgage origination and servicing.  PHH is a beneficiary of this because it is a non-bank and does not have similar capital requirements as a major financial institution.  Also, mortgage origination and servicing is their main business.  They specialize in it unlike banks who also have other lending businesses.  Over the last year about $400 billion of face value of mortgages have left banks and are now being serviced at non-bank financial companies.  This trend will continue. Recently, the combination of strong refinancing demand from homeowners and a lack of capacity in the mortage industry has created high margins in originating mortgages.  Given banks reluctance to jump agressively back into the mortgage market these margins may stay elevated.

A specific example of this is how PHH just took on HSBCs origination and servicing of $50 billion of mortgages.  HSBC was trying to sell these assets to a financial institution for about a year but couldn't find a buyer.  No bank wanted additional mortgage exposure.  In addition, for such a mortgage servicing transfer to occur, Fannie Mae and Freddie Mac would have to approve the transfer.  They approved PHH which is quite a turnaround from investors' concerns that PHH was going to get the plug pulled from Fannie Mae early in the year. 


 
 
Valuation

I believe the best way to value PHH is to take a sum of the parts approach.  Eventually, the Mortgage Business and the Fleet Business could be spun or sold off creating value for shareholders so this is an appropriate way to look at it.  My approach is to take an after tax earnings multiple to the Fleet Business and a Book Value Multiple to the Mortgage Business.  Both businesses should produce a mid teens ROE although currently they do not.  In total, they should both be worth Book Value which is where my official price target is.
 
The Fleet Business is a steady and growing business.  Much of the business is fee related and is growing.  My estimates are below:
 
Fleet Management 2011 2012 2013
   Revenues 1,646 1700 1775
   Operating Expense 1,575 1615 1680
   Segment Profit 75 85 95
   Taxes   (38%) 28.5 32.3 36.1
    Net Profit After Taxes 46.5 52.7 58.9
       
Estimated Value at 8X 372 421.6 471.2
                           10X 465 527 589
                           12X 558 632 706
The range of values for Fleet are anywhere from $372mm to $706mm.  Taking the mid-point of Fleet valuation yields an estimated value of $539mm.
 
The current Book Value of is $975mm which would mean that  the Mortgage Business is valued at $439mm at the current share price.  The largest Asset in the mortgage business is the MSR referred to earlier.  It is carried at a value of $1.3 billion.  If you apply no earnings multiple to the mortgage productions segment and just assume that the Mortgage Business is worth the MSR this would leave the value of the company at $539mm + $1.3 Bln=  $1.8Bln or $31-32/share.


At this point PHH is viewed as a "turnaround" trying to deleverage trading at a huge discount to book.  The initiatives to streamline the mortgage business will make the earnings less volatile.  The Fleet business is also growing its fee-based businesses as well.  The balance sheet is becoming less bloated by shedding non core assets.  And there are further initiatives that can make PHH more of an "asset light" mortgage servicer.  An example of which is to partner with mortgage investors who will invest in the MSRs that PHH produces.  A transformation into a more predictable, asset light business would create signficant shareholder value.


Risks

There are many.  Besides the general interest rates economy etc.  PHH is also subject to regulatory pressures particularly with regards to the recently created CFPB.  The CFPB made an inquiry to PHH earlier this year with regards to its mortgage insurance premium ceding practice which it ended in 2009. 
PHH also has significant debt maturities in excess of $400mm due early next year.  While they currently have enough cash to handle the payoff without hitting the debt markets, the situation may change.


 
 
 

Catalyst

Realization that company is not as distressed as its valuation at 65% of book.
Spinout of Fleet business or getting acquired
Transformation of a business that can earn mid teens ROE.
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