Description

PennyMac Financial Services (PFSI) is a a high-ROE, rapidly growing mortgage company focused on loan origination, loan servicing, and asset management.  Mortgage REITs have received a lot of attention on VIC since they sold off during last Spring’s interest rate spike - Rasputin998’s write-up of MFA included an excellent overview of the space and several others have been posted in the past nine months as well (ZFC, TWO, EARN, NLY, CIM).  PFSI is a derivative play on that theme - it is a related company to PennyMac Mortgage Investment Trust (PMT), a high quality and growing mortgage REIT focused primarily on distressed whole loans.   PFSI receives half of its overall revenue from managing and providing services to PMT, giving the situation similarities to the GP/LP model common in the MLP market.  I don’t believe that dynamic or the company’s likely growth are being fully appreciated by the market – the company IPO’d in May 2013, only trades $1.5 mm/day, and tis currently valued at 11-12x 2013 earnings.  While I think PMT is an attractive investment as well, insiders own significantly more of PFSI than they do of PMT.

History and Structure

PennyMac was launched in 2008 by Stan Kurland and several other senior executives from Countrywide, with backing from Highfields Capital and Blackrock.  Kurland previously spent 27 years at Countrywide, most recently serving as President before resigning in 2006 after having a falling out with Angelo Mozillo.  In 2008 and 2009 Pennymac raised money to buy distressed mortgage assets and also began building out an in-house servicing operation to work out the loans.  In 2009 it listed PMT, a mortgage REIT that has since grown to $1.5 B in equity and almost $3.8 B in mortgage assets, the majority of which are distressed whole loans.

The company’s structure is a bit complicated for tax purposes - PFSI is a holding company whose only material asset is an interest in Private National Mortgage Acceptance Company, LLC, the original entity formed in 2008.  15% of the overall economic interest was listed via PFSI in May, and that has since increased to around 25% as insiders have converted additional private shares to common PFSI interests.  For simplicity’s sake I’ve focused on the #’s of the overall company in this write-up, instead of using the minority interest’s stake. 

Business Overview and Growth

PFSI’s largest revenue stream is its mortgage origination business.  Its focus here is on “correspondent lending”, which is the practice of acquiring loans from smaller mortgage originators and then securitizing them.  Pennymac is the 4^th largest player in the correspondent space, according to Inside Mortgage Finance, after Wells Fargo, Chase, and US Bank.  For conventional mortgages, PMT acquires and securitizes the loans, keeping the Mortgage Servicing Rights (MSR), with PFSI receiving fees for providing fulfillment activities and for “subservicing” on an ongoing basis, which means that they actually perform the servicing required by the MSR.  For government-insured mortgages PMT initially acquires the loans, but than PFSI buys them at cost plus a small sourcing fee, securitizes, and keeps the MSR.  PennyMac also has a small retail lending operation where they source loans directly, a higher margin business than the correspondent model.  Origination generally is fairly volatile and not a great business, but Pennymac has an experienced team that is rapidly growing its share as large banks are largely being forced to pull back in the space (see table below).  Compared to stand-alone originators PFSI has another advantage in that it effectively has a captive and permanent capital vehicle in PMT which funds its origination activities, as opposed to having to rely on credit facilities. 

PennyMac is also growing its share of the mortgage servicing market, although off a lower base – for the first three quarters of 2013 it had a 0.54% share, compared to 0.28% in 2012 (source: Inside Mortgage Finance/Merrill Lynch).  Servicing is typically a more predictable revenue stream than origination, and also helps protect the overall business from interest rate risk, as rising rates leads to less refinancing activity, which means a company like PFSI can collect their fees for a longer period of time.  There are clearly synergies across the business segments - for example the company keeps the MSRs generated from its origination business, and also performs servicing activities for loans acquired by PMT.   

I think PFSI’s asset management business is a hidden jewel since the majority of its fees come from managing what is effectively a permanent capital vehicle that can raise additional equity in the public markets.  PennyMac does manage two private mortgage funds as well, which are PE-style vehicles that were launched during the crisis, but PMT represents about ¾ of the total AUM and is likely to represent the majority of assets going forward.  PFSI gets a 1.5% management fee on assets up to $2 B from PMT, 1.375% from $2-5B, and 1.25% above $5 B.  PFSI also charges an incentive fee (which is not always the case for managers of mortgage REITs), which is a tiered structure that is paid out quarterly if the company meets performance hurdles based on rolling four quarter ROE metrics – PFSI collects 10% of gains between 8-12%, 15% of gains from 12-16%, and 20% of gains above 16%.  The asset management business is extremely high margin – on ~$40 mm of YTD revenue through Q3 the company generated almost $34 mm of pre-tax income (almost a quarter of the overall profits, despite being only 13% of revenues).  I believe this segment of the business deserves a high multiple, and the value could grow dramatically if PMT is able to continue to raise additional capital in the equity market.    

Overall PFSI’s business has grown rapidly across all segments, as seen below - the asset management piece has grown as well, although an outsized incentive fee earned in 2010 obscures that somewhat:

PMT

While PennyMac has received some criticism for the complicated structure between PFSI and PMT (see “Dueling Jobs (and Big Paydays)” in the New York Times from May 2013), ultimately I believe PMT is one of the better Mortgage REITs out there and PFSI’s outcome is closely tied to the success of PMT.  Since it’s launch in 2009 PMT has delived an 81% total return to shareholders (in the article above Gretchen Morgenson forgets to include dividends when she quotes the total return as 32%), while also growing book value in excess of the dividends it’s paid out.  PMT is less reliant on leverage than most of its peers given it stays away from the agency carry trade game that most of these companies are involved in.  It also participates with PFSI in certain origination and servicing activities and therefore has an operating business component to it – it is similar to Redwood Trust in that way, and you can see below that the market has rewarded those businesses with the highest multiples of the group.  Finally PMT is less sensitive to a spike in interest rates than most of its peers – in the table below I calculate and rank each mortgage REIT by the hypothetical return they would have generated during Q2 of 2013 (the “taper tantrum”) if they were private funds that didn’t have to pay dividends (so change in book value + dividends paid out).  As you can see most mortgage REIT’s were down – which makes sense given most are basically levered bets on agency mortgages – but PMT was actually up for the quarter. 

All of this makes it likely that PMT will continue to raise capital in the future, which will greatly benefit PFSI through the increased services it will be able to provide.  Since its IPO PMT has raised an additional $200 mm in 2011, $600 mm in 2012, and $250 mm in 2013. The 2013 raise might be the most impressive, since it was completed in August, shortly after the interest rate spike and selloff in the mortgage REIT space.     

Strong Alignment

PFSI’s management team and financial backers are strongly aligned with shareholders.  For example Stan Kurland owns $146 mm of private shares of the company, compared to $14 mm of PMT.  Most of the senior executives also have large holdings of private shares (several in the $10-$20 mm range) and similar ratios between the two entities.  Highfields and Blackrock still own $343 mm and $234 mm, respectively.  Even if all they wanted to do was cash out those stakes, they would need to increase the profile and liquidity of PFSI – only 25% of the private shares have been listed, and those #’s above are all  private shares which have not yet converted to the pulicly traded comon shares.  Of the 25% that has been floated, Omega Advisors, Blackrock, and Bridger Capital own about 1/3 of the outstanding shares.  Omega bought in the IPO for $18/share, while Bridger appears to have also been in the IPO and added to its position in January. 

Valuation

The company is trading between 11-12x 2013 earnings (assuming all of the shares were common with a 37% tax rate).  I believe the market is throwing PFSI in with stand alone mortgage originators and servicers, which typically have low P/Es, and ignoring the quality of the asset management business and the benefits to PFSI from its relationship with PMT.  For example both JP Morgan and Merrill Lynch are basing their price targets off of single digit forward P/E ratios, and according to Factset the stock is trading at 8.1x and 6.3x the consensus 2014 and 2015 earnings estimates.  I wouldn’t put much faith in any single estimate, and it’s hard to predict the precise #’s of the company because they can vary greatly depending on the cyclicality of the origination business, but overall I believe the company warrants a higher multiple than these.  Even if the multiples stay the same, the company’s expected growth will likely provide a reasonable return from here.   

One additional point is that the asset management business by itself could be worth a meaningful portion of the current market cap if PMT is able to raise additional equity.  According to a Credit Suisse report from January, the median forward P/E for traditional mutual fund companies is 17x 2014 earnings and 15x 2015 earnings.  While PFSI’s fees are likely to be more volatile because they include incentive fees, its asset base is far sticker and its more likely to raise capital in the future than the average mutual fund in my opinion, so overall I don’t think it’s crazy to use mutual funds as a comp for the asset management business.  PFSI generated ~$34 mm of pre-tax income on an asset base of around $1.8 B for Q1-Q3 of this year, or about $45 mm annualized.  If you think the asset base can double from that level over time (and they already raised $250 mm in Q3), and put a 15x multiple on the resulting after-tax earnings, you get to around $850 mm in value from the asset management piece alone.  This is just one small example but I think it’s a reasonable possibility that the company grows several fold over the next five years, and it’s a business model that largely benefits from scale.   

Risks and Summary

PennyMac has a complicated and somewhat messy structure, which combined with the team’s history from Countrywide have created some negative views towards it.  At the end of the day I believe the team knows the mortgage space extremely well, has an impressive track record at both PMT and PFSI thus far, and is highly incentivized to make both vehicles successful.  Kurland made plenty of money at Countrywide and could have retired as a result, but instead put his reputation on the line building PennyMac.  The backing of sponsers like Highfields and Blackrock, in addition to large shareholders like Lee Cooperman at Omega – the largest outside shareholder of PFSI, who also bought almost 3% of PMT last quarter – gives me additional comfort that the company will manage the potential conflicts inherent in its structure. 

The origination business by itself is volatile and exposed to interest rate risk, but PFSI has built a diversified, high ROE model by combining origination, servicing, and asset management and building a permanent capital vehicle alongside them to which it can provide these services.  Overall I believe paying 11-12x earnings for a rapidly growing company with an experienced and strongly aligned group of insiders is likely to lead to an attractive outcome for shareholders from here.  

Catalyst