Be greedy when others are fearful. Be especially greedy when the worst case scenario is more than priced into the stock price. Now is an excellent time to revisit PHH .
With a stock price of $20/share, I believe you have the opportunity to buy PHH for an amount which approximates the value of its Fleet business and you get the Mortgage business for about $1.50—a business that is likely worth $20+ a share. This equates to upside of 100%. If you just capture just half of the Mortgage business’ value, it results in upside of 50% to the current stock price.
So, who wants a mortgage business these days anyway you say? Well, besides the fact that you’re getting it essentially for free, I can make a case that PHH’s Mortgage business is actually highly attractive, even without much of an improvement in the current mortgage environment.
Mortgage Business Discussion
Here’s why: PHH’s Mortgage business consists of two divisions: (1) an origination platform that operates on a private-label outsourcing model and (2) a servicing division that services prime (vs. subprime) mortgages and holds substantial prime servicing rights (MSRs). PHH actually benefits from the current dislocation in the mortgage markets in two key ways. First, as you would probably agree, most mortgage holders aren’t likely to go out and refinance their mortgages any time soon. This increases the value of the MSRs as the cash flow stream lasts for longer than expected. Given that these MSRs relate to prime borrowers and not subprime borrowers, the delinquencies are very manageable. As of Sept. 30, 2007, total delinquencies and foreclosures were 3.35% of the servicing portfolio versus 2.96% at the same time last year. Further, PHH has very little credit risk related to its mortgage business as mortgages are sold very soon after being originated.
The second way PHH benefits from the current dislocation is by gaining new outsourcing customers. It’s fair to say that anyone with a small-to-medium sized mortgage origination platform is considering ways to get out of the mortgage business. The current environment is painful and a stark reminder of how cyclical the mortgage business inherently is. One attractive option these small-to-medium sized mortgage businesses have is to outsource their origination platform to PHH and have PHH operate a private-label mortgage business for them. In fact, in a press release yesterday, PHH noted that, “So far in 2007, we have signed ten new accounts including Premier West, First Security, Signature Bank, American Momentum Bank, and First Chicago Bank & Trust. We anticipate over $1 billion in closed loans from these accounts during 2008 and are currently in varying degrees of discussion with a number of prospective clients.”
Fleet Business Discussion
PHH’s fleet management services business provides outsourced commercial fleet management services to corporate clients and government agencies. PHH basically operates as an outsourcer and handles leasing, maintenance, accident management and fuel cards for companies with large fleets.
PHH is the second largest provider of fleet management services in both the United States and Canada with an estimated 20% market share (behind GE Capital Fleet Services which has a 30% market share) and focuses on clients with fleets of greater than 500 vehicles and clients with fleets of between 75 and 500.
I wrote PHH up in July 2005 and valueguy201 wrote it up in December 2006. See those writeups for background and for more details on the Mortgage and Fleet businesses.
To roll forward the news from December 2006, valueguy201 was correct in his prediction and PHH did agree to be purchased for $31.50/share in the spring of 2007. The prospective purchasers were GE Capital Corporation (GECC) and Blackstone. GECC agreed to purchase 100% of PHH and then planned to sell the Mortgage business to Blackstone. In September, Blackstone claimed that it wasn’t able to secure the financing and may not be able to meet the conditions for closing the merger. As you may have guessed, the merger still hasn’t closed. After this announcement, PHH traded between $25 and $27/share. In October, the wheels came off the stock along with the rest of financial stocks and the stock price closed today at $20.
Fleet Business Valuation
Valuation of the Fleet business is fairly straight forward and has been validated by the price GECC was willing to pay. The approximate value is $1B and represents around 10x earnings. (You can back into the price by reviewing the proxy statement, or look at a 13D that was filed on Aug. 10, 2007 for more detail in deriving this value). The Fleet business is a good business but it is fairly slow growth. A low multiple is warranted but 10x seems a tad too conservative (but we’ll stick with it anyway).
At a $1B valuation, the Fleet business is worth $18.50/share. As most of you are aware, GECC is known as a shrewd operator and the $1B that they were willing to pay likely represents the lowest end of the valuation range for the Fleet business.
Mortgage Business Valuation
There are several ways to try to value the Mortgage business. The easiest method is one based on tangible book value. PHH’s total tangible book value as of Sept. 30, 2007 was $1.4B and Fleet probably has a book value of $400-500 million (based on a 10% equity to assets ratio, which had previously been confirmed by management and is reasonable). Using the high end of that range, it leaves you with $900 million of tangible book value attributable to the Mortgage business or $16.50/share.
Of course the million dollar question is how good is the quality of the Mortgage business’ book value. In my opinion, book value actually understates the value of the hard assets of the mortgage business (i.e., liquidation value). The bulk of the book value is represented by prime MSRs which are currently booked at 138bps as a percentage of the servicing portfolio. This ratio is low based on historical standards and is certainly low for the current environment in which prepayments are slowing and will slow further. In addition, the prepayment patterns of the underlying borrowers in PHH’s mortgage servicing portfolio are slower than the industry average. If you think about it, these borrowers are folks who took their broker’s or real estate agent’s advice and called PHH for a mortgage loan and signed on the dotted line without doing much shopping around.
The remaining large component of book value is mortgages held for sale. These are recently originated mortgages to prime borrowers and contain no subprime exposure. During the 3Q, PHH had a very small loss on the sale of mortgages in what was arguably the worst mortgage market in history.
With a $900 million valuation for the Mortgage business, or 1x a conservative book value estimate, this business is worth $16.50/share. Each $100 million of additional value assigned to the Mortgage business adds about $2/share of value.
Another thing to note is the 13D I referenced above which was filed by Pennant Capital on Aug. 10, 2007. In the 13D, Alan Fournier argues that the $31.50 price from GECC/Blackstone is far too low of a price for management to accept in the proposed buyout. Supporting his argument, among other things, are management’s own projections which were included in the proxy statement. If such projections are to be believed, management had agreed to sell PHH for 5.2x 2009 pre-tax earnings and to sell the Mortgage business at 3.5x…and that’s using a $31.50 stock price! The current stock price of $20 is 3.3x 2009 pre-tax earnings for the entire company. Look at the projections for yourself but they are certainly not hockey stickish based on PHH’s historical earnings power.
It’s not difficult to make a case that the Mortgage business alone is worth $20+/share. But if to be conservative you assume the Mortgage business is worth half that, you still get to almost $30/share for PHH, or 50% upside. The downside here is very well protected by the value of the Fleet business and the overall risk/reward is very compelling.