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Executives

Nancy Kyle - VP, IR

Jerry Selitto - President and CEO

Sandra Bell - EVP and CFO

Mark Danahy - EVP of Mortgage

George Kilroy - EVP of Fleet

Analysts

Bose George - Keefe, Bruyette & Woods

Paul Miller - FBR Capital Markets

Jim Fowler - Harvest Capital

Mark Sproule - Scopia Capital

PHH Corporation (PHH) Q2 2010 Earnings Call August 3, 2010 9:00 AM ET

Operator

Welcome to the PHH Corporation 2010 second quarter earnings conference call. (Operator Instructions)

Today's call is also being webcast and recorded for replay purposes. The audio replay can be accessed either on the company's website at www.phh.com or by telephone at 1-719-457-0820 or 1-888-203-1112 using conference ID 4671475 beginning shortly after the conclusion of this call. It will be available until August 17, 2010. This access information is also described in the company's earnings release, and I will repeat it again at the end of our session. This call is scheduled to conclude in one hour.

At this time, Nancy Kyle, Vice President of Investor Relations, will proceed with the introduction.

Nancy Kyle

Good morning and welcome to the PHH second quarter 2010 earnings conference call. On the call today are Jerry Selitto, President and Chief Executive Officer; Sandra Bell, Executive Vice President and Chief Financial Officer; Mark Danahy, Executive Vice President of Mortgage; and George Kilroy, Executive Vice President of Fleet.

Remarks by our management team will be supplemented by a presentation that is posted on our website at www.phh.com. You are invited to follow along as we go through each slide.

If you did not receive a copy of the earnings release that we issued last night, you may access it from our website or you may call our investor hotline at 856-917-7405 and request a faxed or mailed copy.

Please note that statements made during this conference call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 as further described in Slide 2 of the presentation.

We will also be discussing various non-GAAP financial measures, including core earnings pre-tax, core earnings after-tax and core earnings per share. Please refer to our second quarter 2010 earnings release and accompanying investor presentation for a description of these non-GAAP financial measures as well as a reconciliation of such measures to their respective, most directly comparable GAAP financial measures.

Now I will turn the call over to Jerry.

Jerry Selitto

Thank you, Nancy. Good morning, everyone, and thank you for joining our second quarter 2010 earnings conference call. I'll begin with a brief review of the quarter. Sandra will then review our financial results. And I'll conclude with a summary of our outlook for the remainder of 2010.

If you'll turn to Slide 3, we had a solid operating performance in the second quarter, reporting $52 million in core pre-tax earnings, more than twice that of the first quarter of 2010 and almost twice the $28 million reported in the second quarter of 2009.

Core after-tax earnings were equally solid at $28 million compared to $16 million a year ago, as were core earnings per share of $0.52 compared to $0.28 in the same period last year.

Our quarterly comparisons are detailed on the next slide. Our second quarter GAAP after-tax net loss of $133 million shouldn't be a surprise, as it is the result of an unfavorable MSR mark of $273 million due to a 50 basis point decline in the primary mortgage rate and the flattening of the yield curve.

Combined Mortgage Services pre-tax core earnings of $39 million were more than double both the $19 million posted in the first quarter and $15 million in the second quarter last year. Core mortgage results were driven by three factors: strong purchase volume, increasing margins and lower Servicing runoff.

Fleet's pre-tax earnings were $13 million. We've seen improving business trends with the 61% increase in new vehicle orders, as we continue to improve our performance in this business segment. However, we still have additional progress to make, as earnings were down from $18 million in the second quarter 2009. Fleet segment earnings for the quarter were negatively impacted by $4 million due to an internal recapitalization and $3 million due to our mark-to-market on an interest rate cap in our Chesapeake financial.

On Slide 4, I would direct your attention to the specifics on the lower half of the slide. Mortgage originations were $10.1 billion compared to $11 billion in the second quarter of 2009. They were also up sharply from $7.8 billion we recorded in the first quarter of 2010. Recall that last year's second quarter included the effect of the refi boom that the industry experienced in early 2009.

Our Mortgage interest rate lock commitments this quarter were strong at $8.4 billion. Pricing margins were 136 basis points compared to 118 for the first quarter. In Fleet, the unit drivers of our fuel cards, maintenance services, accident management, all experienced growth in the quarter.

Turning to Slide 5, we experienced solid operating trends across both businesses. In our Mortgage operations, interest rate lock volume was up 32% in the second quarter compared to the first quarter and 22% compared to the second quarter of 2009. We believe this is due to a combination of seasonality, the homebuyer tax credit and the drop in interest rates, which appeared to have spurred additional refi activity late in the second quarter. This positive trend has continued into July, and we expect to see continued momentum in the third quarter.

Fleet reported good progress with pre-tax earnings of 63% sequentially from the first quarter. Our positive underlying trends validate core earnings as a measure of operating performance.

On Slide 6, we list the 2010 goals that we continue to work towards and our progress to date. As part of our transformation program, we said we will reduce costs by at least $100 million. At the end of the second quarter, we had achieved run rate savings of approximately $61 million. Another goal was to increase mortgage production volumes from the 2% market share to 3%, which was established to mitigate the projected decline in the industry originations. For the second quarter, we stood at approximately 3%.

Our goal for 2010 in the wholesale/correspondent business has been to selectively grow the channel to about 25% of our total volume. In the second quarter, it represented 26% of our overall volume, we believe, without changing our overall risk profile.

We have announced two new partnerships in the last few weeks, one with Lenders One Mortgage Cooperative and another with Ellie Mae, that should support continued penetration of this channel. In our private label channel, the second quarter benefited from our clients increasing their focus on mortgages.

In our Fleet business, our goal was to regain momentum, and we signed 56 new clients in the first half, representing a potential of more than 24,000 new units.

And finally, we made excellent progress on our goal of diversifying sources and duration of funding, turning over $3.3 billion in new or renewed facilities during the second quarter of 2010.

I will now turn the call over to Sandra to report further on financial results. Then I'll return with comments on our outlook for the balance of the year. Sandra?

Sandra Bell

Thank you, Jerry. Starting with our fleet business on Slide 7, free cash segment profit of $13 million included good underlying operating metrics. Relative to the first quarter, we experienced higher fleet lease income, higher fee revenues in all three service categories, and higher earnings on the fixed rate lease portfolio, as short term interest rates declined through the quarter.

The earnings improvement on the fixed rate lease portfolio was offset by higher interest expense of $3 million in the quarter due to mark-to-market declines on our interest rate cap. As you know, we fund on a floating rate basis, but have approximately 20% of our lease arrangements at a fixed rate.

The cap was purchased as part of the Chesapeake financing to protect the portfolio in a rising interest rate environment. The cap has become less valuable as current low rates are expected to remain so for a relatively long period. In addition, Fleet recorded its share of accelerated program costs related to transformations, the savings from which are expected to be realized in the second half.

Our Fleet business continues to focus on improving performance and earnings by signing new clients. As Jerry mentioned, we are seeing encouraging signs from increased vehicle orders and fee based drivers.

On Slide 8, mortgage closings of $10.1 billion were up 29% sequentially from the first quarter. We've continued to experience strong application volume into the month of July.

Slide 9 presents the latest market share data from Inside Mortgage Finance for total origination. PHH is ranked 7th overall, with 10.1 billion of volume for the quarter, which represents a market share of almost 3%. For the first half of the year, our market share totaled 2.7%, on track to reach our 3% goal for the year. As you can see, our percentage increase in volumes over the first quarter is the greatest of any of the top ten originators, and our year-over-year decline is the least.

On Slide 10, our margins in the quarter averaged 136 basis points and was down from 157 basis points we reported in the same quarter last year; they are trending positively. Capacity constraints industry wide may be driving higher margins similar to what occurred in the first half of 2009.

Slide 11 reflects the advantage that PHH commands as a result of our higher market share in retail origination versus our servicing market share. As a result, we are able to drive new volumes to offset servicing runoff. In fact, we consistently replenished over 100% of our runoff.

Given this replenishment rate, we have not had to use financial instruments to hedge our MSR assets. However, should this change, we would consider the use of financial derivatives to protect the economic value of our business.

On Slide 12, our mortgage servicing business reported a $284 million GAAP loss which included a $273 million mark on the MSR assets. Core earnings came in at a loss of $10 million as compared to a loss of $67 million in the second quarter of 2009, driven by lower prepayments and improved efficiencies.

Actual prepayments had been considerably less than modeled prepayments so far in 2010. The weighted-average note rate of 5.2% on the portfolio bodes well in a rising interest rate environment.

Our servicing business has several efficiency initiatives underway, including process improvements and loss mitigations, optimization of payments and enhancements in collections.

A few points regarding the MSR mark of $273 million. The industry experienced a significant decline in both primary and secondary mortgage rates in the second quarter compared to the first, with much of the decline occurring in the last few days of the quarter. The GAAP loss masks the solid operating performance in our mortgage business.

We should see much of the benefit of this drop in rates in subsequent periods. This quarter's results illustrate why our management team is focused on core earnings and the creation of economic value rather than the volatility of GAAP results.

Slide 13 shows our delinquency trends. PHH mortgage delinquency rates are the lowest of all large servicers. We are seeing signs of improvement with early and mid-stage delinquencies stabilizing at levels below those experienced in the fourth quarter of 2009, and 90-plus day delinquencies declining slightly.

While we added to foreclosure reserves during the quarter, these reserves, which are based on rep and warranty repurchase experience, tend to lag delinquency rates.

Slide 14 shows an update to our transformation program. We continue to be on track to our stated objectives of $100 million to $120 million in run-rate cost benefits in 2011. With $61 million of initiatives completed through the second quarter. We also spent $21 million in program costs in the first half to ensure success in reaching our run rate goal.

Before I turn it back to Jerry, a final note on our financing. In addition to the financings we completed in the second quarter, we have plans for both additional warehouse facilities as well as Canadian conduit capacity. We would expect to execute these financings over the course of the second half of this year. As we have said previously, we will also opportunistically seek to extend our maturities and diversify our funding sources as the market allows.

Now, I'll hand it back to Jerry.

Jerry Selitto

Thank you, Sandra. Our goals in 2010 were to stabilize and diversify our funding, reduce our expenses by creating a more efficient business model, increase our mortgage market share and regain momentum in our fleet business. We are delivering on these initiatives and are working towards our 2010 core earnings goal consistent with 2009 levels, which is $2.60 per share on a core earnings basis.

In addition, we indicated that we are working to deliver on our goal of an ROE of 13% based on core earnings in 2011.

Slide 16 depicts our past for the core EPS goal of $2.60. We start by annualizing our first half run-rate, which brings us to $1.50. A normalized effective tax rate of 40% gives us an additional $0.20. Lower transformation expenses and higher savings should return $0.52.

And finally, our full year market share goal of 3% should give us another $0.38, which yielded $2.60.

Before we take questions, I want to briefly address the topic of new financial regulations. While there is still many outstanding issues about how the new law will be implemented, the following seems likely to us. The level of regulation in the mortgage industry will continue to grow, which will increase cost. At the end of the day, most of the added cost will be passed on to consumers. To some extent, higher cost makes scalability and efficiency even more important than ever which may increase the attractiveness of our outsourced solutions.

Obviously, many of the regulations remain to be with and the devil will be in the details. We will continue to monitor the situation closely.

With that, I will ask the operator to poll for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we'll take our first question from Bose George.

Bose George - Keefe, Bruyette & Woods

First question was on the mortgage market share, it's impressive to see that number at 3%. But do you think you can quantify some of the benefit from the surge in purchase volume ahead of the tax credit? Are you seeing purchase volume percentages decline now since it's done?

Luke Hayden

Clearly the purchase volume effectively was pulled forward into the second quarter relative to the third quarter. So we did see a higher percentage of purchase volume in the second quarter. My recollection is, the number was somewhere around 61%, third quarter we are seeing a higher percentage of refinances than we are of purchases quarter to date. I don't have any metrics for you on the third quarter as of this time, but there is no doubt that the purchase volume did get pulled forward into the second quarter.

Bose George - Keefe, Bruyette & Woods

Just a related question, can you just some of the initiatives that you guys are doing at the Realogy channel in terms of the trying to increase the penetration over there?

Luke Hayden

Yes, as you might know, we have retooled our sales effort in a fairly significant way about mid-April of this year. We've brought in new executives, we've also brought in a number of new sales folks to deal with that channel. We are seeing increased penetration in the Realogy channel on what we refer to as buyer-controlled cash adjusted basis.

I know that's a mouthful, but the bottom-line is the Realogy channel is experiencing far more transactions that being acquired for cash as opposed to being acquired for financing. And when you normalize on that, we do see early indications that our penetration is going up.

Having said that, penetration is going up and what amounts to a decline in pieces of pie because of the increased purchases done by cash.

Bose George - Keefe, Bruyette & Woods

One last thing just on the rapid warranty costs. You guys note that they're expected to go up through early 2011. Now can you talk about, do you think that sort of reaches a burn-out point at that point and everything has kind of been put back? Like what's the trend after that?

Jerry Selitto

We do expect the demand for repurchases to abate after 2011. So we do expect it to return to sort of a more normalized level. And that will reflect the much more strict underwriting standards that have been put in place in 2007, 2008.

Operator

We'll take our next question from Paul Miller with FBR Capital Markets.

Paul Miller - FBR Capital Markets

Going back to the mortgage production again, you're saying you've seen a shift away from purchase to refi. Which is the more profitable channel for you guys?

Jerry Selitto

That depends. And I hate to give you such a squishy response, but the refi channel tends to be a little more sensitive to changes in interest rates. So specifically, refis will be more prone to not close or not pull-through. If rates trend lower, then purchase volume will.

Purchase volume is really driven by the need for the buyer and the seller to have a certain closing date in accordance with the Escrow instructions. And you lose that benefit on the refi channel. That's not to say the refi business is not profitable, because it is. It's a little more interest rate sensitive than purchase business.

Paul Miller - FBR Capital Markets

There's a lot of moving parts here, but would the gain on sale be trending down in June and July because of less purchase volume?

George Kilroy

I think one of the reasons that we're seeing an increase in our margins is that as a result of the refi volume A lot of lenders are really facing capacity issues. So margins have actually increased pretty dramatically.

So I think the answer to the question, as it continues we'll probably see margins starting to decline and become more normalized. But right now we're enjoying sort of the best of both worlds; high volume, and also high margins on that volume.

Jerry Selitto

That's correct.

Paul Miller - FBR Capital Markets

And on the market share, when you guys went out in February talking about going from 2% to 3% market share, I don't think anybody thought you could do it in the next like five months, which is very good. Now, I mean I don't think you want to stop at 3%. Is there a goal now to get to 4%, or is that something you don't want to talk about at this point?

George Kilroy

We're really driving on all of our initiatives, so the 3% is kind of a goal. But we keep on pushing and driving, and we'll just see where we wind-up at the end of the year.

Paul Miller - FBR Capital Markets

And then on Slide 16, because I just want to make sure I understand this slide, and thank you for putting it in here. But you make roughly about $0.48, and you think you can make $2.60, is that really, by just the back of the envelope, or just to make sure I'm looking at this. So I mean if you are making somewhere around $0.90 to $0.95 for the next two quarters on average, and would it be lumpy, more of it would be in the third quarter versus the fourth quarter?

Sandra Bell

There are two things going on in the second half of the year, Paul. First of all as we talked about last quarter, most of the expenses related to transformation are in the first half of the year, and most of the savings are in the second half. And yes, I would expect that to be more in the fourth quarter than in the third quarter, so that would tend to push more savings into the fourth quarter. Offsetting that of course is that the fourth quarter has less volume generally than the third quarter because of the seasonality of the purchase business. So I think net-net you will tend to see a slightly larger number in the third quarter than the fourth, but not significantly.

Paul Miller - FBR Capital Markets

And does that mean, roughly you're guiding us to like a $0.90 plus number for the third and fourth quarters?

Sandra Bell

It would be the difference between the $1.48 and the $2.60, yes.

Operator

(Operator Instructions) And we will take our next question from Jim Fowler with Harvest Capital.

Jim Fowler - Harvest Capital

Could you tell me in the second quarter what your correspondent volumes were versus your wholesale, please.

George Kilroy

The majority of our business is actually correspondent. We do very little business with brokers. So I would say that over 90% of our volume, and that's a rough estimate, is our correspondent business.

Jim Fowler - Harvest Capital

And you stated on a slide that your margins going into the third quarter were on track with the second quarter. Can you state that, are they better than the second quarter or are they equal?

George Kilroy

They're better than the second quarter.

Jim Fowler - Harvest Capital

And how do the August margins look? I know it's early, but in your locked pipeline, where do you see margins in August?

George Kilroy

At a higher level, again, I think it really is a function of industry capacity. So once industry gets purchase locked with the increased demand, we would expect that margins will become more normalized.

Luke Hayden

But the first two days of August we've enjoyed good margins.

Jim Fowler - Harvest Capital

The repurchase reserve that you have right now, what's implied in that reserve in terms of repurchase volumes and severities place?

Luke Hayden

Severity is generally around 50% and we're expecting volumes to be consistent with 2010 volumes throughout 2011. And then volumes to abate, to reflect the kind of volume numbers the company enjoyed in the early half of the 2000's.

Jim Fowler - Harvest Capital

So we will continue to see a similar repurchase reserve taken in the second half versus the first half?

Jerry Selitto

Yes.

Jim Fowler - Harvest Capital

Okay. And where are you right now in terms of the notification of the loans that you're going to be repurchasing? I know the bio activity has been recent, how are you being advised on what your volumes will be?

Jerry Selitto

Volumes on the repurchase?

Jim Fowler - Harvest Capital

Yes.

Jerry Selitto

I think we stated before that our delinquency levels are really the lowest in the industry. We are not the low hanging fruit in the industry, so we're not sort of the first call that's made. Luke, do you want to add some color?

Luke Hayden

Yes, I mean just in terms of the process we do get requests on specific loan files to provide documentation and take a look to see if there was a violation of the representation or warranty. But that's just a standard operating procedure.

I'm not sure I'm being responsive to your question. Do you want to re ask the question?

Jim Fowler - Harvest Capital

Well, I guess I'm assuming that your repurchase are going to come mostly from the GSE buyouts. So I'm wondering if; one, if that's true? And then secondly, have you been notified yet what the exact volumes will be, I'm just trying to get a sense of is your reserving accurate relative to what you're expecting or conservative or how that shakes out?

Luke Hayden

Okay. You are correct that the vast majority of the repurchases will come from the GSEs because the vast majority of our business flows to the GSEs. We do get individual loan repurchase request from the GSEs throughout the course of the year. We don't have any forward looking view from the GSEs as to what the repurchase demands are going to throughout the course of the year.

We look at our historical repurchase demands and compare that to the tentative origination and make a judgment as to what we think future repurchase demands are going to be. Well, we have no forward looking view from the GSEs on that.

Operator

And we do have a follow-up question from Paul Miller with FBR Capital Markets.

Paul Miller - FBR Capital Markets.

I know I have asked this question in the last couple of quarters, but I wonder if you get any thoughts to hedging that servicing portfolio to take some of that accounting noise out of the model?

Jerry Selitto

I think as Sandra has mentioned in her presentation, as long as we continue to see a replenishment rate, the high percentages that we've been enjoying, we really don't see the need to employ financial instruments to hedge. Again, if that were to change and we are forecasting constantly, but if that were to change we then would employ. But at this point of time we see absolutely no need to do that.

Operator

(Operator Instructions) And we have a follow-up question from Bose George with KBW.

Bose George - KBW

Just had a question on the fleet management side? It looks like some pretty positive trends over there. I'm just wondering is that reflect basically taking share from others? I assume sort of the topline of the industry is still flat or down?

George Kilroy

You know, the market itself, the way we look at it traditionally is still pretty flat and there is some exchanging of market share. But more and more, over the last year or two, we've been moving into what we maybe would have considered the unserved market that traditionally very large company owned self managed fleets that have now for one reason or another have embraced outsourcing some of their fleet businesses.

We've been very successful in picking up some of that business over the last six to 12 months. It's starting to pay of course now, and have a lot of that under radar screen as well.

It hasn't happened yet, but we have talked earlier this year about getting into the government space too more than we are than today, which is another sort of self-managed company owned section of the business that because of budget constraints and other things at the state level, they're also looking the outsource.

So we really made a push starting about a year or so ago on providing services to these self-managed fleets and it's starting to pay off for us.

Operator

And we'll take our next question from Mark Sproule with Scopia Capital.

Mark Sproule - Scopia Capital

I just have one quick question. Maybe it's a little early, but if I look at $5.15, it says you're on track for your 13% ROE in 2011. Does that imply about $3.25, $3.30 core earnings for 2011 off of your $2.60 for 2010?

Sandra Bell

Yes.

Mark Sproule - Scopia Capital

And then just as a last question, as you get to 2011 and you get past the initiatives that you put in place or continue to put in place currently, how do you think about your capital management going forward as far as the equity needed within both businesses and moving beyond potentially the improved efficiency, et cetera, from restructuring the debt and maybe utilizing the equity a little differently?

Sandra Bell

I think the way we've answered this question, I don't see any change in our strategy. We continue to look at opportunities throughout both businesses to invest our capital at greater than that 13% ROE. If we find the opportunities to do that, we will do so. And if we do not find the opportunities to do that, then we will look at opportunity to return capital to shareholders.

Operator

(Operator Instructions) And it appears that there are no further questions at this time.

Jerry Selitto

I want to thank everyone for attending our second quarter earnings call. We've concluded a solid quarter and are looking forward to the second half of 2010.

As we are all aware, a tremendous amount of uncertainty remains in terms of the macroeconomic outlook and the impact of new financial reform regulations. We at PHH are confident that we will continue to deliver on our initiatives to build a company that provides sustainable, attractive returns to our shareholders, high level of service to our customers and attractive career opportunities to our employees. Thank you once again.

Operator

This concludes the PHH Corporation second quarter 2010 earnings conference call. Once again, ladies and gentlemen, the replay will available beginning later today at the company's website at www.phh.com or by dialing 1-719-457-0820 or 1-888-203-1112 using conference ID 4671475. It will be archived until August 17, 2010. You may now disconnect.

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