Description
PHH is a great risk/reward situation that is misunderstood. In fact, I missed it the first time I looked at it as it really didn’t seem compelling at first blush. I suspect others have had similar thoughts. After all, who needs another mortgage company trading at 10x earnings when you can buy Countrywide at the same price? Fortunately the scales have been lifted from my eyes…hopefully I will do the same for you as I make the case for this very compelling idea.
PHH is a Cendant (CD) spin-off consisting of two businesses: (1) mortgage operations (production and servicing) and (2) fleet management services. For those with ADD, the crux of the story is that the fleet business is worth at least $15 per share. With a $26 stock price, this implies an $11 per share value for the mortgage business which has a $19 per share book value. Further, PHH’s mortgage business has excess capital of almost $6 a share. If shareholders get that excess capital in the next year, net net you are paying $5 for a mortgage business with a $13 book value, less than 40% of book value versus a Countrywide that trades at over 2x book.
PHH stock price $26
Less: Fleet business $15
Less: Excess capital in mortgage business $6
Implied price for mortgage business 5-->Tangible book = $13
BACKGROUND
Before getting into the specifics about both businesses, a little history is in order. CD decided to dispose of these slower growing businesses to focus on its higher-growth, higher ROIC businesses such as hospitality and travel. CD shopped PHH but did not get offers that met its after-tax price expectations (CD had a very low basis in PHH). There are various rumors as to the level of bids received but nothing has been publicly disclosed. Apparently Countrywide was willing to pay north of $19 per share for the mortgage business (and that’s before factoring in the $6 per share of excess capital). There is no Wall Street coverage of PHH and the spin-off happened at the end of January 2005.
FLEET MANAGEMENT BUSINESS
PHH’s fleet management services business provides outsourced commercial fleet management services to corporate clients and government agencies through PHH Arval. Basically, Arval 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. PHH has more than 320,000 vehicles leased and over 300,000 additional vehicles serviced under fuel, maintenance, accident and/or similar management arrangements. It purchases more than 80,000 vehicles annually and serves nearly one-third of the Fortune 500. More than 100 corporations have been its clients for 20 years or more. For a more detailed description of the fleet management services, see Appendix A.
The fleet business has generated very consistent earnings and management has given guidance of $70-80 million EBT for 2005. The depreciation expense offsets the maintenance capex so the EBT number is a pretty good reflection of pre-tax free cash flow. Given the accelerated depreciation of the fleet for tax purposes, the fleet business has a very low effective (i.e., cash) tax rate. According to management it usually doesn’t pay any federal income tax and approximately $400 million of the deferred tax liability (DTL) relates to this segment. Assuming steady state growth, I view the DTL more like equity than a liability as the tax is effectively permanently deferred.
According to management, the book value of the fleet business is $400 million. In addition to the DTL, the business is financed with a $3.2 billion asset-backed facility (that is secured by net investment in fleet leases of $3.8 billion). There is no unsecured debt allocable to this business.
FLEET BUSINESS VALUATION
Given the consistent earnings of the fleet business*, a 12.5x cash earnings multiple doesn’t seem unreasonable. If we assume the mid-point of management’s guidance at $75 million and a 10% effective tax rate (which is higher than management indicates but let’s be conservative), this equals a value of $844 million for the fleet business or $16 per PHH share. A 15x multiple would be $1.01 billion or $19 per PHH share, and a 10x multiple would be $675 million or $13 per PHH share.
My base case scenario assumes a value of $15 per PHH share ($800 million) for the fleet business, leaving an implied value for PHH’s mortgage business of approximately $11 per share ($575 million).
*Pre-tax earnings of the fleet business in 2001, 2002, 2003 and 2004 were $67 million, $70 million, $75 million and $84 million, respectively.
MORTGAGE BUSINESS
PHH has a fairly standard mortgage banking operation—production and servicing. PHH originates mortgages exclusively though three retail channels: (1) Financial Institutions, (2) Real Estate Brokers and (3) Relocation.
--Financial Institutions Channel--
In the Financial Institutions channel, PHH functions largely as an outsourced mortgage company (think of it as private label) for several large financial institutions such as American Express, Merrill Lynch, PNC Bank, Northern Trust Company and Charles Schwab. If an American Express customer calls PHH, the phone is answered as “American Express” so PHH’s role is invisible to the customer. This channel generated 54% of PHH’s originations in 2004.
--Real Estate Brokers Channel--
In the Real Estate Brokers channel, PHH works with real estate brokers to provide their customers with mortgage loans. This channel is an offshoot from the CD days and PHH is still the exclusive referral of CD-owned brokerage businesses. For CD franchisees, PHH is the only endorsed provider of mortgages. In this channel, PHH also acts as a private label mortgage company for the various brokerages (e.g., for Coldwell Banker it operates as Coldwell Banker Mortgage). This channel generated 41% of PHH’s originations in 2004.
--Relocation Channel--
PHH is also the exclusive provider of mortgages offered to clients of Cendant Mobility, the largest provider of relocation services in the U.S. This channel generated 5% of PHH’s originations in 2004.
A joint venture between PHH and CD is planned to commence in mid-2005 and will handle the operations for mortgage originations from CD-owned brokerage businesses and CD Mobility. This JV should solidify PHH’s long-term participation in the CD-related businesses and will be owned 50.1% by PHH and 49.9% by CD.
--Mortgage Portfolio Characteristics--
During 2004, 60% of the mortgages originated by PHH were at a fixed rate, 62% were conforming, 66% were for purchases and 91% were first mortgages. PHH typically sells all of the loans it originates but retains the servicing.
--Servicing Business--
As of March 31, 2005, the servicing portfolio was $146 billion. The MSRs are booked at an average of 123 basis points using an assumed life of 4.7 years. The MSRs generate an average servicing fee of 33bps and are booked at a 3.8x multiple. This valuation seems very reasonable, if not conservative. Given the high mix of fixed-rate loans in PHH’s servicing portfolio, it seems very likely that these MSRs will be on the books for longer than the current valuation assumes, especially considering that the weighted-average interest rate of the portfolio is 5.5%.
MORTGAGE BUSINESS EARNINGS AND VALUATION
--2005 Mortgage Earnings--
For 2005, management has given guidance for the production side of the mortgage business to break even and for the servicing side to generate $100 to 110 million of EBT. Like the fleet business, the mortgage business also enjoys tax deferral benefits. Using a 10% cash tax rate for the mortgage business gets you $95 million in cash earnings, or about a 10% cash ROE. Assuming a GAAP tax rate of 41%, after-tax earnings would be $62 million at the mid-point of management’s guidance, or a 7% ROE. Clearly PHH has room to improve this number. Management has said that $48 billion in originations is the break-even point on the production side. At $60 billion of originations, the production segment would earn $90 million+ (management has said that for every $1 billion of originations above $48 billion adds $10 million in earnings).
One thing to note is that when PHH was spun off, CD pumped additional capital into PHH in order to satisfy the rating agencies. Management believes that the excess capital is $200 to 300 million and that this capital can be returned to shareholders in 12 to 18 months. Using management’s target debt–to-equity of 6x, I calculate excess capital to be around the upper of end of management’s range. Note that CD said it was injecting approximately $200 million of capital into the mortgage business during the fall of 2004.
--What’s the Mortgage Business Worth?--
So what is the mortgage business worth? There are several ways to look at this but a multiple of book value seems to be the most accepted metric (especially considering the screwy GAAP accounting standards for MSRs and the fact that most of PHH’s mortgage book value consists of MSRs). By the end of 2005, the mortgage business will have an approximate book value of $1.04 billion. The tangible book will be around $1 billion or $19 per PHH share. Assuming the excess capital is $300 million, using a 1.5x price-to-tangible book multiple, the mortgage business is worth $700 million x 1.5 = $1.05 billion plus $300 million of excess capital= $1.35 billion or $25.50 per PHH share. If the mortgage company is merely worth tangible book value, it is worth $19 per PHH share. For the mortgage business to only be worth book value seems like a ludicrous assumption given that the book value likely approximates the liquidation value and the business makes money. To assume that the business should trade for just book value gives no credit for the going concern or the client relationships.
Another way to look at PHH’s mortgage business is to assume that it is only 2/3 as good as Countrywide and therefore has a 15% ROE potential (vs. CFC’s 23% ROE). Based on a $13 tangible book value per share ($1 billion less of $300 million of excess capital), PHH’s mortgage business has $2 per share of earnings power. So net of excess capital, you are paying $5 per share for a mortgage business that has $2 of earnings power and a $13 tangible book value). Also, note that $2 of earnings power assumes a 40% tax rate and the cash tax rate is probably closer to 10% so arguably the business has $3 per share of cash earnings power.
WHY IS PHH SO CHEAP?
As I noted above, I missed PHH the first time I looked at it. I suspect a number of other people did as well. After all, it is easy to look at management’s guidance of $170 to 190 million pre-tax, slap on a 40% tax and arrive at EPS of $1.92 to $2.15. Maybe I’m spoiled but that didn’t exactly excite me. So the first reason it is cheap is that people have overlooked the economic benefit of the tax attributes of the fleet and mortgage businesses. Another reason is that the economics of the fleet business are not easily understood without a little digging. Then you have concern about where we are in the mortgage cycle. I would argue that given where we are in the rate cycle, the MSRs are worth much more than where they are currently booked to GAAP. Of course you also have the standard post-spin dynamics and lack of Wall Street coverage.
PHH VALUATION SUMMARY
Using a value of $15 per share ($800 million) for the fleet business and $25.50 per share ($1.35 billion) for the mortgage company, PHH is worth $40.50 per share, 55% higher than they current trading price.
Fleet business $15
Mortgage business @ 1.5x book $20
Excess capital at mortgage business $6
Total value per share $41-->58% upside
If fleet is worth 15x the upper end of management’s range, the fleet business alone is worth $1.08 billion or $20 per share. This valuation doesn’t seem like a stretch at all. Combined with the base case value of mortgage of $25.50 per share, PHH would be worth $45.50 per share, 75% higher than the current trading price.
If the fleet business is worth $20 per share and the mortgage business is worth 2x tangible book value, the combined valuation would be $52 per share.
If the mortgage business is merely worth tangible book value—again, a ludicrous assumption given that book value should approximate liquidation value--of $19 per share ($1 billion), the combined value is $34 per PHH share, or 30% higher than the current trading price.
When discussing the decision to spin-off PHH rather than sell the business, CD commented that it would have taken a $600 million tax hit if it had decided to sell the businesses. Assuming a 40% tax rate on the sale and a $250 million dollar basis in the combined businesses (total guess), this would equate to a sales price of $1.75 billion, or $33 per PHH share. Industry rumors circled that CFC was willing to pay north of $1 billion for the mortgage business alone, and this was before CD pumped in another $200 million of capital.
CATALYSTS
There are several catalysts that could unlock the value in PHH. Obviously operational improvements should be a key catalyst. As noted earlier, PHH earns a below average ROE on its mortgage business. Management has committed to focusing more on the low hanging fruit with the origination opportunities within the CD relationship. In fact, PHH recently doubled its staff that is focused on CD. The game plan is to get more people in the field to make sure the opportunities are given the appropriate TLC.
Unlocking the excess capital at the mortgage business could be another catalyst which will most likely come in the form of a stock buy-back but could also come in the form of a distribution or Dutch tender.
From a corporate structuring perspective, it’s possible that PHH could now enter into a tax free merger with someone like GE or CIT who would be interested in both businesses. Alternatively, after the appropriate waiting period for tax purposes, PHH could spin off the fleet business and both fleet and mortgage could enter into separate tax free mergers.
Then there is the plain old catalyst of time as more investors focus on the story and maybe a few Wall Street analysts pick up coverage.
APPENDIX A – DETAILS ON FLEET MANAGEMENT BUSINESS
The fleet management 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.
The leased portfolio consists of more than 320,000 vehicles, primarily cars and light trucks and, to a lesser extent, medium and heavy trucks, trailers and equipment. The majority of the residual risk on the value of the vehicle at the end of the lease term remains with the lessee for approximately 98% of the vehicles financed in North America. PHH retains residual risk on only 2% of the fleet. Net credit losses as a percentage of the average balance of vehicle leases serviced have been less than 0.06% in each of the last three fiscal years.
PHH offers clients vehicle maintenance cards that are used to facilitate repairs and maintenance payments and maintains an extensive network of third-party service providers to ensure ease of use by the clients’ drivers. The vehicle maintenance cards provide clients with the following benefits: (a) negotiated discounts off of full retail prices through PHH’s convenient supplier network, (b) access to an in-house team of certified maintenance experts that monitor transactions for policy compliance, reasonability and cost effectiveness and (c) inclusion of vehicle maintenance transactions in a consolidated information and billing database that helps evaluate overall fleet performance and costs. PHH has more than 337,000 maintenance cards outstanding in the United States and Canada.
PHH also provides 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. The accident management services provide clients with the following benefits: (a) convenient, coordinated 24-hour assistance from its call center, (b) access to relationships with the repair and body shops included in a preferred supplier network, which typically provides customers with favorable terms, and (c) expertise of damage specialists, who ensure that vehicle appraisals and repairs are appropriate, cost-efficient and in accordance with each client’s specific repair policy. More than 330,000 vehicles participate in accident management programs with PHH in the United States and Canada.
PHH also offers fuel card programs which facilitate the payment, monitoring and control of fuel purchases through PHH Arval. Fuel is typically the single largest fleet-related operating expense. By using its fuel cards, PHH clients receive the following benefits: access to more fuel brands and outlets than other private label corporate fuel cards, point-of-sale processing technology for fuel card transactions that enhances clients’ ability to monitor purchases and consolidated billing and access to other information on fuel card transactions, which assists clients with evaluation of overall fleet performance and costs. PHH has more than 315,000 fuel cards outstanding in the United States and Canada.
Catalyst
See catalyst section of discussion