Description

PHH Corporation (“PHH”) represents a compelling opportunity to make a significant return in a short period of time with very low risk in my view.   I believe there is a strong possibility PHH is sold in the coming months at a price that should range between $35 to $40 per share, compared to the current trading price of $28, representing 25-40% upside.  PHH was originally posted by pgu103 in July 2005 and that write-up provides a good overview of the business.  Since then, PHH has gone through an accounting restatement relating to its January 2005 spin-off from Cendant and the stock has languished in the mid-to-high $20s for the past year and a half.  The Company has replaced its CFO and management has not spoken with the investment community in almost a year.  As the restatement process draws to a close, I believe recent analyst and press discussion of a possible sale will come to fruition.

Brief Background

PHH was spun off from Cendant in January 2005 and it consists of two businesses:  a fleet services company and a mortgage servicing and origination company. 

The fleet business is the second largest provider of vehicle management services in the U.S. and Canada.  The Company manages over 615,000 vehicles on behalf of corporate clients.  For example, PHH leases a fleet of small vehicles to clients like Merck and DuPont and charges fees for leasing/financing the vehicles as well as maintenance and accident management services.   PHH has been consistently taking share in a relatively flat industry and it currently has a strong backlog of customer wins without any material customer defections.  PHH’s market share is 11% in this business, second to GE who has 16% and the third player has 6%.   This business has been very cash flow generative and grows at a mid-single digit rate each year with reinvestment of generally no more than 50% of its cash flow.  The most interesting aspects of this business are (1) it is very steady, providing low volatility through economic cycles, (2) PHH retains virtually no credit risk on its leased fleet as any losses on vehicles reside with the client – historically the credit losses have amounted to less than 6bps and (3) PHH is able to take accelerated deprecation charges on the fleet for tax purposes, thereby creating a cash tax rate of 15-20%, enabling free cash flow to exceed net income while the assets are growing.  PHH has consistently benefited from this historically, and given its strong customer backlog, its assets will continue to grow, enabling them to reap this benefit for the foreseeable future.

The mortgage business is the 8^th largest retail mortgage originator in the U.S.   The Company provides an outsourced private label mortgage service for clients such as Ameriprise and Merrill Lynch and it maintains a relationship with the Cendant (now called Realogy) network of real estate brokerages (Century 21, Coldwell Banker, ERA and Sotheby’s) as the preferred provider of mortgages.  Simply put, PHH provides the people and the backbone to offer mortgages to customers of their clients in exchange for a fee.  Generally, PHH securitizes those mortgages and sells them off and retains the right to service those mortgages.  PHH records production income on the sale of the loans based on the value of the mortgage servicing rights (the discounted fees it is owed to service/administer the mortgage) and then PHH records servicing income over time as the present value of that servicing asset is converted to cash.  PHH’s mortgage business has suffered over the past few years as pricing has been competitive and they failed to reduce costs quickly enough to compensate for lower pricing on lower volumes.  As a result, PHH’s mortgage business will be about break-even for 2006, but should return to profitability as cost-cutting measures begin to take hold.

In early March 2006, PHH announced that it would not be filing its 10-K on time due to certain errors primarily relating to goodwill and tax adjustments from the Cendant spin-off.  After a painstaking eight month restatement process and the removal of the CFO, PHH finally filed its 2005 10-K in November 2006 and it is currently in the process of completing its 10-Qs for 2006.  The net result to the restatement process was a reduction in tangible book value of about $1 or 4%.  The operating results of the business were unaffected.  At the time of the restatement, the Company also announced that it expected to be about break-even in 2006 as losses on the mortgage origination business and the costs of the restatement offset strong fleet services performance.

Why I Think PHH Will Be Sold

Cendant originally tried to sell PHH mortgage in 2004 and it was widely believed that a deal well above book value with Countrywide was very close.  However, the deal fell through and Cendant decided to put the mortgage business together with the fleet business and spin it off into a public company as part of a broader Cendant restructuring.   Since going public, PHH has lost the confidence of many shareholders and the board was forced to remove the CFO.  As I stated earlier, the management has not engaged in shareholder communications (i.e., no conference calls or meetings) since the announcement of the restatement.  Recently, there has been some analyst and press speculation that PHH may currently be exploring strategic options.

I think the following are the key considerations that strongly support the speculation around a sale:  (1) I would strongly suspect the board is fed up with this Company, its management and the share price, (2) the Chairman of PHH is a former investment banker and very deal savvy, (3) the two businesses have no strategic reason to co-exist, (4) the time when a post-spin sale would blow its tax-free nature is elapsing in one month (generally around two years from spin) and (5) there should be significant strategic and private equity interest well above the current price.

On the last point, I think the fleet business would make a great acquisition for a private equity firm given its strong, steady cash flows and it would also make a very logical acquisition for GE who has been rolling up this space and should be able to extract significant synergies.  On the mortgage side, consolidation has been prevalent this year:  Wachovia / Golden West, Wells / Wamu servicing portfolio and several investment banks acquiring subprime originators (First Franklin, ECC, Saxon).  I think PHH would be interesting to an acquirer looking to grow either origination or servicing market share.  A more aggressive operator should be able to turn the origination business profitable and the servicing business should generate steady cash flow.  Likely buyers include Countrywide, Wells Fargo, JP Morgan Chase, Citi, etc.  There is also the potential for a financial buyer to buy the mortgage servicing asset and run it for cash.

I also think it is possible for a private equity firm to buy the entire business and later sell one or both businesses for strategic prices in the future.  It is also possible that GE or CFC would buy the entire company despite their interest predominantly lying in only one of the two operating segments.

Valuation

For the fleet business, the 2005 pre-tax income was $80 million.  Assuming a 6% growth rate, the pre-tax income should be around $90 million in 2007.  Based on a 17.5% cash tax rate (middle of the range), the free cash flow should be around $74 million or $1.38 per share.  Given the low risk nature of this stream, I would think a reasonable multiple range would be 13x-15x or $18 to $21 per share.   Interestingly, PHH runs the fleet business overcapitalized in my opinion with only around 70% debt to assets despite virtually no credit risk, and therefore a buyer could lever this business considerably more and pay an even higher price than my indicated value range. 

For the mortgage business, I believe the most logical way to value the business is based on its book value which mainly consists of mortgage servicing rights.  It is important to note that PHH does not hold a portfolio of loans so therefore credit is not an issue here.  PHH’s current mortgage book value is around $17 per share, of which $3 – 4 is likely excess capital due to below industry-average debt levels on the mortgage servicing rights.  I think the relevant range here for a buyer would be somewhere between 1.0x – 1.3x book value given the challenges facing the mortgage market (this business is not currently making money but in an up cycle, their business mints money, and a buyer could gut the origination business through the downturn to make a modest profit and run the servicing business for a considerable profit).  This would imply a value range on the mortgage business of $17 to $22 per share.

In summary, I believe a very reasonable value for PHH is as follows:

                                                            Low             High

2007 Fleet FCF / Share                       $1.38    -     $1.38

Multiple                                                   13x    -       15x

Fleet Value / Share                                 $18     -      $21

2006 Mortgage Book Value / Share       $17     -      $17

Multiple                                                  1.0x    -     1.3x

Mortage Value / Share                           $17    -      $22

Total PHH Value Per Share                  $35    -     $43

Low Downside

Importantly, I believe the downside in PHH is extremely limited for the following reasons (1) overall tangible book value is $26 per share, just below the current price, (2) no fleet or mortgage credit risk, (3) strong free cash flow generation in fleet, (4) overcapitalization of the mortgage and fleet business, and (5) several potential strategic and financial buyers for all or pieces of the company.

Concerns

The biggest risk to PHH that I can see is a significant and continued deterioration in mortgage profitability, which could erode equity value in the Company.   I don’t believe this to be a major concern for the following reasons:  (1) the current valuation implies the mortgage business is trading at only around 50% of book despite its overcapitalization, (2) the Company has recently started aggressively cutting costs, which it was hesitant to do immediately after separating from Cendant and (3) the mortgage servicing business should generate significant cash and profits through a down cycle as profits in this business increase with rising interest rates.

Catalyst