Returning to PHH Corp

On September 19th I received an email from a friend (hat tip @VermeulenGold) that an activist investor, Orange Capital, had taken a 5% position in PHH and written a letter to management outlining their recommendations on creating shareholder value.  I immediately took a position in the stock.

In order to describe why I acted so quickly, let’s go back to why I sold PHH in the spring.  There were two reasons.  One was my concern that gain on sale margins would compress significantly – a concern that remains valid today (and could still be my undoing with the stock).  The other was that there just didn’t seem to be a catalyst to realize the valuation gap that I saw.

Now, with that catalyst having materialized, I want to be along for the ride.

I wrote about PHH over a year ago.  I described the company as having Joel Greenblatt type of spin-off potential.  The company had two disparate businesses with little in common.  There were aspects of the one business that clouded the accounting of the other.  And one of those businesses, mortgage origination, had a not well understood but valuable asset in the mortgage servicing rights that were held.

Now that I have had a chance to read the Orange Capital letter in full, I am happy to see them draw similar conclusions.  I added to my position in the company on Monday.  It’s a 4.5% position.

The Orange Capital Letter

I would recommend reading the letter in full, it is available here, but briefly, these are the four initiatives suggested by Orange Capital:

1. Create a captive finance vehicle which would own a significant stake in the Company’s newly originated and existing excess MSRs
2. Hire a financial advisor to pursue a tax-efficient sale or IPO of Fleet Management
3. Immediately commence a share repurchase program or tender offer for $150 million of the Company’s common stock
4. After resolving outstanding repurchase obligations and securing new financing for newly originated MSRs, offer to exchange the 6% convertible notes due 2017 for a combination of cash and common stock

Orange Capital provided the following intrinsic valuation of the company.

Clearly, a realization of anywhere between the $35 to $47 equity value that Orange Capital sees in a reasonable time frame would make PHH a worthwhile investment.

Is the Orange Capital Valuation Realistic?

I would propose that valuing Fleet, which produces a steady stream of free cash flow, at 8x pre-tax earnings is conservative. Below I have reproduced the Fleet segment income statement from the last 8 quarters.  Fleet is on pace for a litttle less than $1.20 per share of after-tax earnings.

Given that Fleet earnings have been consistent and growing for years, I believe that a 15x multiple on those earnings would be appropriate.  That would give Fleet a valuation of about $1 billion, or slightly above the high end provided by Orange Capital.  Note that Fleet’s earnings include corporate overhead allocation, so it is reasonable to assume that they approximate the earnings of a stand-alone entity.

Orange Capital is valuing the capitalized servicing book at between 94 and 112 basis points.  I’m not sure how Orange Capital is taking into account the subserviced loans, they aren’t broken out elsewhere in the valuation table but if their cash flow stream is included in the MSR estimate then the number they came up with is lower.  Assuming that subservicing is not included, Orange Capital is valuing the capitalized servicing book at a 3.2x multiple.  I think that multiple could increase to 4x as rates rise and more clarity is gained on the pre-payment and default characteristics of the loan book.

It’s also worth noting that in the Orange Capital letter it was implied that PHH management is sympathetic to the realization of value from its existing mortgage servicing rights book.  So we may hear something about that sooner rather than later.

When the servicing segment is taken together with the mortgage origination segment, and compared to what is a fairly similar operation at Nationstar, PHH appears to be valued absurdly low.  I did a comparison between Nationstar and PHH last year in this post.  Below I’ve updated that comparison using second quarter results.

While I understand that Nationstar has been growing their business at a far faster rate than PHH, I think that the valuation discrepancy between the two companies is out of line.  Remember that I am comparing the overall market capitalization of PHH, so not subtracting anything for the value of Fleet.  The difference is so stark, I have wondered if I am missing something.  Maybe I am, and please tell me if that is the case.

Conclusion

I added a position in PHH after the news from Orange Capital, and increased the size of that position on Monday after examining the company more closely over the weekend.  On Monday there was also news of a second major shareholder, as Senator Investment Group reported a 7.6% position.  There is a brief description of Senator here.  I’m not sure if they have activist inclinations or not.

My position is a little bit larger than usual, but that is because I’m comfortable with the liquidity of the stock, and because the nature of the situation is very event-driven; I will hopefully wake up one morning and find news that one or more of the initiatives suggested by Orange Capital is being implemented and the stock will immediately react higher.

As for the risks, one risk is the ongoing performance of the origination business, which is unlikely to produce very good third quarter results, though this will hopefully be balanced by out-performance of the mortgage servicing book.  The other big risk is that management ignores the calls for change, which has been done in the past.  This could happen, and it would be nice to see more activist investors getting involved.

Like many of my investments, the pieces are all there, and there appears to be a catalyst that can put them together.  Now we’ll just have to watch and see how it plays out.