Why is PHH Corp so cheap?

Let’s just get right to it.  I don’t understand why PHH is as cheap as it is.

I have talked about this before, and I don’t want to reiterate the conclusions of my prior post on PHH (You can be a stock market genius: By Buying PHH Corp), but I do want to take a look at the company from a slightly different perspective to show that, even after the 50% run up since my original post, it remains undervalued.

This week, during one of my lunch hours, I made a comparison between PHH and Nationstar.  I was somewhat surprised by the results.   The table below lists key statistics of the mortgage origination and servicing businesses for both companies.

A straight up comparison shows that PHH is a far bigger originator (even if you assume that Nationstar will begin to turn over their interest rate lock commitments at a faster rate going forward then they have been able to over the past two quarters).  The servicing portfolios are similar.  Yet the market capitalization of Nationstar is more than twice that of PHH.

But wait, doesn’t PHH have a lot of debt?  Isn’t that the difference here?

Not really.  Let’s take a look at the debt that PHH has.

The debt here consists of three basic types:

1. Debt backed by the assets of the Fleet business
2. Warehouse lines for the mortgage origination business
3. Unsecured debt

Of these three, it is only the unsecured debt that should be compared to  Nationstar.

The warehouse lines exist with both companies and thus can be ignored.  Warehouse lines are very short term facilities intended for “warehousing” mortgages for the period from when they are originated until they are sold to a GSE.  Having a warehouse line is just a part of originating mortgages, and the bigger the line the larger the business.

The asset back debt is for the Fleet business.  The debt covers the cost of the cars, which are leased out.  In a minute I’m going to prove that Fleet is worth significantly more than that debt, but let’s just assume for a minute that the assets of Fleet only cover the debt.   Again, for a comparison to Nationstar, the Fleet debt can be ignored.

That leaves us with the unsecured debt.  There are a little over a billion dollars worth of  notes. And that is just about the same amount of unsecured debt that Nationstar has.

Thus, even after considering the debt, the enterprise value of Nationstar exceeds that of PHH by a significant amount.

What about Fleet?

The comparison above only looks at the mortgage business at PHH.  In my original post, written over 7 months ago, I looked at the historical earnings of the Fleet business and concluded the following:

Average earnings from Fleet over the past 6 years have been $0.83 per share of PHH.   Even in the depths of the 2008-2009 recession Fleet delivered respectable earnings.

So far this year, the Fleet business looks like it will significantly outpace that historical average:

My original assumption was that the asset back debt on the books was covered by Fleet.  The truth is that the value of Fleet is likely significantly more than its debts.

It’s not that Nationstar is Overvalued

I’m going to digress into Nationstar for a moment.

I bought Nationstar back in March, soon after the company’s IPO.  I saw the stock run up to almost a triple (From $13 to $36), only to see it fall to $25.  And at $25 I sold my position.

I missed the top by a lot, and it was frustrating to see those gains disappear.  Nevertheless, as I tweeted about after I sold, I felt that I needed to get out of the stock for a time to get some perspective.

Sometimes I can get too tied to a stock.  Too emotional.  I start to watch its movements up and down too closely, and feel my heart rise and sink along with the movements.  I have learned from hard experience that when this starts to happen, I need to cut and run, because it has become likely that I will see my decisions influence by emotion and make bad choices as a consequence.

This happened with Nationstar.  It happened, I think, because the stock had run up far further then I had ever anticipated, and, when it traded into the mid-30’s on what I think was mostly momentum, I got caught up in the moment and didn’t sell even though it had exceeded what I believed was fair value.

So I sold.

Since that time I have taken another look at Nationstar with fresh eyes.  I reviewed their 3rd quarter results.  And I started to buy back the stock I sold.

I did a fairly detailed anaysis of Nationstar earnings in a post I wrote called “Stepping through the Nationstar Mortgage Income Statement“.  In that post I worked through the line items in the income statement and determined which revenue and expense items should be included in an estimate of core earnings.

I have updated that work for the second and third quarter.  The results are below.

While I still have some concerns about Nationstar’s ability to convert its IRLC’s into loan sales (which is a topic that would require a post of its own, so I won’t get into here), what is clear is that the company has significant earnings power from its current level of business and that it is not trading at an unsustainable multiple.

My point here is not to get into the value of Nationstar.  It is to prove the point that the mis-valuation of PHH is not due to the over-valuation of Nationstar.  From the numbers above, I think that is clear.

So why is PHH so cheap?

The reasons why PHH is undervalued are the same ones that I wrote about PHH 7 months ago.  Earnings are obscured by mark to market valuation changes to the MSR asset.  The company runs two independent businesses that aren’t going to attract the same kind of investors.  There a lack of acceptance of the high margins that currently exist in the origination business and a lack of understanding of the mechanics and valuation of the servicing business.

There has also been the problem that PHH is not growing.  While Nationstar has been been growing its servicing balances at a rather phenomenal rate, PHH has kept their’s essentially flat year over year.  While there has been significant growth at PHH in the mortgage origination business, most of those gains have been usurped by losses from repurchase demands from Fannie Mae.

Some of these factors are going to turn in the coming year and I think we will see earnings growth return to PHH Corp.  PHH has said that repurchase demands are declining and expect them to be back to more typical levels by the end of 2013.  As the company noted on the third quarter conference call, “year-to-date results of our combined mortgage segment were negatively impacted by $201 million in year-to-date mortgage quality related cost.”  That works out to almost $4 per share in legacy charges that are going to slow down and eventually stop in the next year or two.

The origination volumes, while strong, have had some of their strength mitigated by a reduction in volumes in the correspondent lending channel.  Retail closings are up 13% year over year, but wholesale/correspondent closings are down 30% as PHH has sought to reduce their footprint in the correspondent lending channel.  This reduction in correspondent lending is mostly going to be a one-time step change, and next year correspondent volumes should stabilize.  Meanwhile the mortgage servicing business is going to be helped by the addition of the HSBC portfolio, which consists of subservicing of $52 billion unpaid principle balance (approximately 25% of existing UPB).  While PHH has perhaps not been publicized in the now sexy-servicing sector to the extent of companies like Nationstar and Ocwen, mostly because they stayed away from Rescap, they remain a player to take on servicing portfolios, particularly those that are originated for the GSE’s.

More generally, help will come from the housing recovery.  With a change in sentiment (which is something that I think we are starting to see among analysts and experts) will come anticipation of how good things could get, rather than a focus on how bad they are.  Investors will begin to look for ways of “raising their exposure to the housing sector”, and given the bankruptcies of the past 5 years, they will be left with few alternatives.

Finally, there is always the chance that my original thesis is validated, and the company spins itself apart.  I don’t think there is much question that separating the Fleet business from the mortgage business would create parts that exceed the current sum.