PHH Corporation (NYSE:PHH) Q2 2016 Results Earnings Conference Call August 9, 2016 10:00 AM ET
Hugo Arias - SVP, Treasurer and IR
Glen Messina - President and CEO
Rob Crowl - CFO
Bose George - KBW
Chris Gamaitoni - Autonomous Research
Mark Hammond - Bank of America
Fred Small - Compass Point
Good morning, ladies and gentlemen. Welcome to the PHH Corporation Second Quarter 2016 Earnings Conference call. Your lines will be in a listen-only mode during remarks by PHH management. At the conclusion of the company's remarks, we will begin the question-and-answer session, at which time I will give you instructions on entering the queue to ask your questions. Today's call is also being webcast and recorded for replay purposes.
The audio replay can be accessed by dialing 888-203-1112 or 719-457-0820 and using conference ID 5132604, or by visiting the Investor Relations page of PHH's website at www.phh.com/invest, beginning shortly after the conclusion of the call. It will be available until August 24, 2016. This access information is also described in the company's press release, and I will repeat it again at the end of our session.
At this time, Hugo Arias, Senior Vice President, Treasurer and Investor Relations, will proceed with the introduction. Please go ahead, sir.
Good morning, and welcome to PHH Corporation's second quarter 2016 earnings conference call. There is an investor presentation to accompany this conference call, including an appendix of supplemental schedules that is posted in the Investors section of our website at www.phh.com under Webcasts and Presentations.
Please note that statements made during this conference call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, as further described in Slide 2 of our second quarter 2016 investor presentation.
Such forward-looking statements represent our current beliefs regarding future events, and are not guarantees of performance or results. Actual results, performance, or achievements may differ materially from those expressed or implied in such forward-looking statements due to a variety of factors, including but not limited to the factors under the headings Cautionary Note Regarding Forward-Looking Statements and Risk Factors in our periodic reports filed with the U.S. Securities and Exchange Commission, including our most recent Annual Report on Form 10-K and Quarterly Reports on Form 10-Q, which are also available in the Investors section of our website.
Investors are cautioned not to place undue reliance on such forward-looking statements. The earnings release we issued yesterday also may be accessed from the Investors section of our website, or you may request a faxed or mailed copy by calling our Investor hotline. During this call, we may discuss various non-GAAP financial measures, including core earnings or loss pre-tax, core earnings or loss after-tax, core earnings or loss per share and adjusted cash flow.
Please refer to our earnings release and accompanying investor presentation for a description of these and other non-GAAP financial measures, as well as a reconciliation of such measures to their respective most directly comparable GAAP financial measures.
Speaking on the call today will be Glen Messina, President and Chief Executive Officer; and Rob Crowl, Chief Financial Officer. Other members of PHH's senior management team are also with us and will be available to take your questions.
I now will turn the call over to Glen Messina.
Thank you, Hugo. Good morning, everyone, and thank you for your interest in PHH.
This morning I'll first provide an update with respect to our three priorities for 2016 which include our valuation of strategic options, operating the business to preserve the value of our balance sheet, and resolving our key legacy regulatory matters. I will also provide additional perspective on the business environment, and the key factors that may impact third quarter results. Then Rob will discuss our second quarter results in greater detail.
Now please turn to Slide 4. To start I would like to briefly address the strategic review process which is a top priority for our board and the management team. Over the past three months, the Board, Management and our Financial Advisors have dedicated a considerable amount of time and effort to this endeavor and we have made significant progress. We are deeply engaged in a thorough process to assess the value of our assets and platforms with the objective to maximize shareholder value.
I can report that we remain very active and are progressing at an intense pace that balances our need for our conclusion, while considering the unique and complex nature of our business platforms and related relationships. We believe that it would not be prudent for us to provide any further commentary on our evolution of strategic alternatives until the process has reached completion any definitive course of action has been determined by our Board.
In the mean time, I can assure you that we continue to act with the sense of urgency and we look forward to sharing more information when it is prudent to do so.
Please turn to Slide 5. Our second priority is operating the business in a manner to preserve the value of our balance sheet. We expect to accomplish this by maintaining a high MRS hedge coverage and maximizing the profitability of the core business.
Our results for the second quarter reflects our commitment to preserving the value of our balance sheet. With respect to the MSR, the 10-year treasury rate closed down approximately 30 basis points since the beginning of the quarter.
Our MSR hedging actions were highly affective for the quarter resulting in a net decline in MSR value and excess of hedge gains of only $12 million. Year-to-date hedge gains have offset 87% of the $165 million negative market related change in MSR value.
Partly related to this strategy, we continue to strengthen our liquidity position as we ended the quarter with approximately $1 billion of cash and cash equivalents, up from $937 million at the end of the first quarter. Our balance sheet preservation actions combined with the sequential improvement and financial performance of our core business resulted in tangible book value per share of $22.31 only down $0.35 in the first quarter.
Now, please turn to Slide 6. Our reported net loss of $12 million and core loss after-tax of $4 million, which includes $15 million of pretax expenses related to notable items, has greatly improved in the first quarter. These results are consistent with our expectations and reflect the full benefit of our completed cost and contract re-engineering initiatives, a seasonal increase in home purchase originations and higher loan origination margins.
Total loan dollar closings increased by 30% as compared to the prior quarter and our operating leverage was evident as production segment revenues improved by $49 million while our production expenses increased by only $7 million versus the prior quarter.
Our production segment was profitable in the second quarter with segment earnings of $30 million up $10 million versus the same quarter of 2015 and up $39 million versus prior quarter. During the quarter we took the anticipated actions to exist the corresponding lending channel due to a sub-par profitability and as part of our broader strategy to substantially reduce our owned MSR and its capital requirement.
The expenses related to the exits in the correspondent lending channel were reflected in notable items and were not material. Our servicing segment reported a loss of $33 million and a core loss of $21 million for the second quarter. The segment core loss improved by $45 million versus prior year or worsened by $10 million versus prior quarter.
On servicing has resulted in a consistent drag in our overall earnings due to the persistence of a low interest rate environment and our high cost of capital. In addition, delinquent servicing expenses are up 29% on a sequential quarter basis, but down 40% when compared to the second quarter of 2015. We continue to support our options to reduce the size of our own MSR portfolio, as part of our strategic review process.
Now please turn to Slide 7. With respect to our third business priority of resolving fourth key legacy regulatory matters, we await a decision from DC Circuit Court of Appeals in the CFPB case, which we expect to receive before the end of the third quarter.
Regarding our three other key regulatory matters, while we continue to engage in successive discussions in connection with these other matters we have no updates during the second quarter that weren't any changes to our reserves or reasonably possible losses in excess of related reserves. We believe some or all of these matters will likely carry into the fourth quarter of 2016, so we cannot estimate a final resolution date.
Please turn to Slide 8. We continue to see an in-sourcing trend from Merrill Lynch and we believe this trend will continue. In the past week, we are advised of the intention to in-source additional mortgage spot. When combined with Merrill Lynch's previously disclosed in-sourcing decisions, we may now be faced with the total volume reduction of approximately 60% of Merrill Lynch's dollar closing points based on 2015 originations.
During the second quarter, Merrill Lynch application units were down by approximately 30% compared to the same quarter last year. Merrill Lynch's forecasted cumulative volume reductions is expected to have a negative impact of pre-tax earnings of approximate $13 million for the second half of 2016 and $44 million annualized before any medicating actions such as cost reductions, or volume enhancement initiatives.
As we previously disclosed, Merrill Lynch is also intends to in-source the servicing of approximately 90,000 loans that are currently being sub-service by us for 18% of our total sub-servicing units.
We are allocating all excess originations operating capacity to clients other than Merrill Lynch and our portfolio retention efforts. Our key initiative to growth portfolio retention volume has produced outstanding results with registration as measured by dollar volume of approximately 146% on a sequential quarter basis and up 291% as compared to the second quarter of 2015.
As a result of the certain refinancing activity in late June and early July, we're operating in excess of our target case loads. At current interest rates, we believe that our portfolio retention initiatives outside the private label could generate over $2 billion in application volume for the full year and provide a positive pre-tax earnings offset of approximately $12 million for the second half of 2016.
In addition, we believe we are taking the appropriate action as necessary to realign the direct operating cost to match the reduction and origination in sub-servicing volume. We are also evaluating several actions to reengineer facilities and overhead cost.
Based on the work we have done to date and the strategic review and in consideration of all the factors affecting the PLS business, we believe that the model needs to materially change for it to be profitable and evolve to a simpler, more standardize lower cost and lower price model.
This would require a long-term transition to necessary to maintain adequate levels of profitability at substantially lower volume levels. In the near term, we remain focused on maximizing the profitability of the current PLS model. We've put plans in place to address the risk of further Merrill Lynch and refinancing related volume reductions that include reallocation of resources, cost reduction and potential facilities realignment.
Now please turn to Slide 9. We expect that third quarter results will be driven by the interest rate environment, the execution of our operating priorities and the impact of Merrill Lynch's in-sourcing of mortgage origination volume. Third quarter was off to a good start in our production segment due to the historic drop in interest rates during the first half of July. We experienced July registration rates in our PLS channels approximately 117% of their previous forecast.
If the low rate environment persists for the remainder of third quarter, we expect to experience a pick-up in loan registration volumes that should benefit for the production segment results in the third quarter and fourth quarter.
Also we believe that mortgage industry operating capacity will likely be constrained leading to higher origination margins. As a result, we expect to optimize margins and staffing levels commensurate with client volume. Offsetting these positive factors in our production segment is the impact of Merrill Lynch's in-sourcing of mortgage origination volume.
In our servicing segment, we're likely to experience elevated levels of prepayment fees and core amortization expense. At this time it's difficult to predict the net impact of the two counter-balancing factors resulting from the interest rate environment on our production and servicing segments.
In light of the persistently low interest rate environment, we believe that owned MSR to include our sub-servicing clients, maybe in client re-evaluate their MSR holdings from time to time. Any actions by our sub-servicing clients to dispose or reduce their MSR holdings could result in additional reductions to our sub-service loan portfolio. As a reminder, standard sub-servicing practices permit the transfer of loans after relatively short notice periods.
In order to optimize profitability, we will remain focused on driving growth through our most profitable channels including servicing portfolio retention and our PHH home loans joint venture while maintaining strict cost discipline. We intend to reallocate resources and response to any further client driven volume reductions and take cost reduction actions as necessary.
Now I'll turn it over to Rob to discuss our results for the quarter in more detail.
Our consolidated results are shown on Slide 10, and notable items are shown on Slide 11. For the second quarter of 2016, we reported a net loss attributable to PHH Corporation of $12 million, or $0.22 per basic share. This compares to a net loss of $30 million, or $0.56 per basic share, in the prior quarter. Included in this quarter’s results were pre-tax market-related MSR mark-to-market adjustments net of hedging gains of negative $12 million, as compared to negative $10 million in the first quarter of 2016.
Core loss pre-tax in the second quarter, which excludes the net MSR mark, totaled $11 million and included $15 million in pre-tax notable items comprised of $6 million in growth and re-engineering investments, $5 million in severance and $4 million in cost related to the strategic review. This compares to a pre-tax core loss of $39 million last quarter, which included $18 million in notable items.
The $28 million improvement in core loss as compared to the prior quarter was due to $39 million improvement in production segment earnings, as a result of significant increase in closings and wider loan margins. Partially offsetting this was a $10 million increase in the pre-tax core loss in our servicing segment, primarily due to increase prepayment activity on our owned MSR.
Moving to Slide 12 in the second quarter the mortgage production segment recorded a profit of 13 million as compared to $26 million segment loss in the first quarter. Production revenue increased $49 million while expenses rose 7 million and minority interest increased 3 million. Second quarter results for the production segment were positively impacted by a stronger origination environment driven by seasonal factors and higher loan margins. On a sequential quarter basis loan closings were up 30% to $10.4 billion, interest rate law commitments expected to close rose 13% and total loan margins widened 48 basis points to 343 basis points.
While total applications were up 3%, real estate applications were up 31%, private label applications were flat and correspondent lending was down significantly due to our announced exit from that channel. In addition the second quarter of 2016 was the first full quarter that reflected the repricing of all our private label contracts. Notable items in the segment totaled $7 million in the second quarter as compared to $6 million in the first quarter. Through the month of July total loan margins have widened further fluctuating in the 360 to 390 basis point range.
Now please turn to Slide 13 our mortgage servicing segment recorded a loss of $33 million in the second quarter of 2016 compared to a segment loss of $21 million in the prior quarter. These results include market related MSR mark-to-market adjustments net of hedging gains of negative $12 million in the second quarter and negative $10 million in the first quarter. During the second quarter primary mortgage rates decreased 23 basis points which led to a $70 million negative market-related fair value adjustment to the MSR partially offset by a $58 million gain in our hedge position.
Second quarter hedging results along with those of the first quarter reflected a higher hedge coverage ratio than the company's historical operating range. Consistent with our comments to explore ways to substantially reduce the MSR we hold on balance sheet. We intend to maintain higher MSR hedge coverage ratios for the foreseeable future in order to protect the value of the asset from adverse changes and interest rates. On a core basis second quarter 2016 mortgage servicing pretax core loss was $21 million compared to an $11 million pretax core loss in the first quarter.
Included in the second quarter's results were $5 million of notable items as compared to $11 million last quarter. The majority of the sequential quarter increase in pretax core loss was due to lower interest rates and increased MSR prepayment-related fair value adjustments totaling $35 million in the quarter versus $26 million in the prior quarter. Servicing segment total expenses were up $2 million versus the first quarter as repurchase and foreclosure-related charges increased $7 million while legal and regulatory expense fell $5 million.
Our total loan servicing portfolio of $231.7 billion in UPB at the end of the second quarter was down 1% from the prior quarter driven by the decline in our capitalized loan servicing portfolio. At the end of the second quarter we valued our MSR at 73 basis points of our capitalized loan servicing portfolio or $679 million representing a 2.6 times capitalized servicing multiple. Actual annualized prepayment speeds in the second quarter were 15% as compared to 11% in the first quarter.
Now please turn to Slide 14 through 16 our channel financial information for the second and first quarters of 2016. Positive operating leverage was evident in the production channels during the second quarter. In the financial institutions channel increases in closings and the full effect of our contract repricing drove $96 million of revenue in the quarter up from $67 million last quarter. While direct expenses only increased $2 million to $45 million. Real estate channel revenue totaled $66 million up from $46 million compared to the first quarter driven primarily by wider margins and higher locks and closings.
Direct expense rose from $40 million to $45 million on higher commissions. Shared service expenses and notable items were essentially flat quarter-over-quarter. Subservicing revenue was $21 million up $1 million as compared to last quarter due to growth in the subservicing portfolio. Direct expenses were flat at $13 million. Owned servicing revenues fell to $25 million from $34 million primarily due to faster prepayment speeds during the quarter. Direct expenses rose from $22 million to $29 million due to $7 million increase in rep and warrant expense. Owned servicing is the only channel where revenues are not in excess of direct expenses.
And moving to Slide 17 with regard to liquidity we closed the second quarter with $949 million in unrestricted cash excluding cash held in variable interest entities as compared to $867 million in the first quarter. The increase in cash is primarily due to increases in cash related to collateral postings and settlements on our MSR hedges, higher production-related earnings, partially offset by working capital needs.
Key cash requirements at the end of the second quarter totaled $540 million to $690million up $40 million and $90 million respectively from the prior quarter. The increase in key cash requirements was primarily driven by an increase in MSR cash hedging needs consistent with my comments earlier with regards to maintaining a higher hedge coverage ratio.
In addition contingent liquidity needs rose slightly due to changes in our rep and warrant reserve and reasonably possible estimate. Cash in excess of our key cash requirements equaled $259 million to $409 million at the end of the second quarter as compared to $267 million to $367 million last quarter. While we have eliminated our remaining $143 million earmark for inorganic growth investments. The remaining $42 million earmark for reengineering investment is under review pending the conclusion of the strategic review process.
Now please turn to slide 18 our tangible book value per basic share at the end of the second quarter was $23.31 based on $53.5 million basic shares outstanding as of June 30, 2016 as compared to $23.66 at the end of the first quarter.
And now I’ll turn it back over to Glen.
Thanks, Rob. Please turn to Slide 19 our priorities are completing the strategic review preserving the value of our balance sheet and resolving our key legacy regulatory matters. The strategic review process remains our top priority. Our team comprised of management, the board and advisors are deeply engaged and committed to maximizing value for our shareholders.
Second quarter financial results have improved significantly from the first quarter and are consistent with our expectations. We have exited the correspondent lending business and are evaluating options to substantially reduce our owned MSR portfolio as part of the strategic review process.
Origination volume and loan margins were off to a strong start in the third quarter and should possibly impact the production segment results offset by continued at elevated level of prepayment speeds in the servicing segment. We will take the necessary actions to minimize the impact of reduced PLS originations and subservicing volume levels including driving organic growth from our most profitable channels and taking appropriate cost reduction actions.
Finally we will provide material updates on the strategic review process when it's prudent for us to do so. I want to recognize and thank the PHH Board of Directors and my colleagues at PHH for their continued hard work and enduring commitment to creating value for our shareholders and customers.
In our prepared comments we have provided all the information regarding our strategic review process that we can at this time I understand that you may have additional questions but we won’t be taking questions on the review process the timetable or potential outcomes. We’re of course happy to take your questions on the business.
And with that we’re ready to take questions. Robbie.
[Operator Instructions] And we'll take our first question from Bose George with KBW. Please go ahead, sir.
Hi, guys. Good morning. Actually first just a question on the comment you made about the remaining $42 million of restructuring expenses, is that going to continue running through or is that just on hold while the strategic review continues?
We've temporarily put that on hold as regarding for the strategic review as opportunity present themselves opposed to the board managerial make a decision if it’s got the appropriate return now resulted in net improvement in the company's results and appears to be a prudent expenditure of capital. We will engage as in restructuring as appropriate especially in light of some of the PLS related volume reductions we spoke about on the call.
Okay, thanks. And then the - on the Merrill contract you noted the annual revenue cited 44 million, anyway to think about the - what could happen on the cost side, how much of that could be offset?
Yes, Bose right now I think it’s premature to speculate what we can do on the cost side. You know, as I said as part of our strategic review. We are evaluating cost reduction action and given the significance of the overall magnitude of volume in-source at Merrill Lynch thus far, we believe it’s prudent for us to put plans in place assuming the majority of that business were to be in-sourced.
So we’re considering that as part of our strategic review, I'm excited that overall when you look at the second quarter results even though Merrill Lynch’s volume year-over-year application volume is down by 30%, total fee based volume was basically flat down 1% during the second quarter on a comparable basis year-over-year.
And we had phenomenal growth in our portfolio retention channel up 291% year-over-year and that’s before consideration of the significant rate drop that really affected July more so than June. So as of right now we are tapped from an operating capacity perspective, we’re at full capacity.
Okay, thanks. Actually one just, the cash needs presentation that you had. With the hedge I guess staking $75 to $150 million, did you extend the MSR sold truly that frees up that capital that you can use for other things, is that a fair observation?
That is correct Bose, to the extent that we would be successful in selling the MSR. Any capital that has been allocated as continued liquidity for MSR hedging would be released.
Okay, great, thanks.
And we will take our next question from Mark Hammond - I'm sorry from Chris Gamaitoni with Autonomous Research. Please go ahead.
Good morning guys, thanks for taking my call. Can you give me some color into how PHH Home Loans is performing as the real estate closing volume is down 24%, and it sounds like the refinance platform recapture and very well, purchase down 19%. Obviously there is channel mix in there, so I’m trying to figure out how PHH Home Loans is doing and what the progress is on that?
Good morning, Chris. Look we are pleased with the results we have seen at the PHH Home Loans joint venture for the second quarter. As we went through the re-engineering phase last year, bear in mind that we made substantial changes to the infrastructure the joint venture for purposes of building a more stable consistent service delivery model to consumers on a prospective basis and also for the benefit of our real-estate partners.
And at the end of the second quarter we also significantly restructured the business that we did outside the joint venture, we terminated all of our MSAs, any type of arrangements of that nature and fundamentally substantially have exited retail originations outside of the joint venture.
As a result of that we turned over about 40% of the total loan officer staffing on a year-over-year basis of which half has been hired back and we are still hiring back the other half. So in consideration of the magnitude of the change, we like where we are with the joint ventures performing well. We are staying disciplined and focused on purchase market volume and we continue to be excited about the prospects of the channel.
We still think long term, call it end of 2017ish that a 20% capture rate is possible for the joint venture and for the second quarter capture rate has held steady at about 13%.
Okay. And then on - I just wanted to kind of dig into the comments made about sub-servicing partners potentially reevaluating their MSR investments. I’m kind of confused, I mean unless your partners are banks and why would they sell MSRs at the low rates when there is a typically hedge debt at the bank?
The way I’m looking at it Chris is, look MSRs have not generated modest returns for quite some time given the consistent occurrences and refinancing surges that we have had. I can’t believe we are the only people who are looking at the returns of MSR and whether or not it’s attractive enough and an attractive investment. I think given the most recent refinancing wave, I just think that people generally are going to be looking at the returns available on MSRs and saying is this an asset that I want to continue to hold.
Yes, but you don’t have cross-sell of other products that is part of a total consumer relationship with some of your customers, as the most of your customers?
That's fair, that’s something we don’t have and certainly something that will be part of the mix as people evaluate whether or not holding MSRs is just the right thing to do.
Okay, thank you.
And we’ll take our next question from Mark Hammond with Bank of America. Please go ahead.
Thank you. Good morning. On the Merrill Lynch news, is the 60% of volume at PHH in addition to the 20% that was announced in April, or is the 60% reduction inclusive of April and August notifications?
It’s cumulative, Mark.
Thanks. And what drove the $68 million increase in cash in the second quarter?
Rob, would you like to address that?
A couple of things. But the primary one was gains on our MSR hedge position as those hedges become more in the money. Our counterparties are required to post collateral to us. That was the primary driver.
Thank you. And my last question centers around the recent CFTB updated mortgage servicing rules. If you had a chance to go through them, I know it came out just a few days ago, and see there were any major impacts on PHH.
Mark, we have been tracking the CFTB developments as it relates to the mortgage servicing rules. I can’t say that we’ve completed the analysis of those rules yet. So I think it’s premature that - to talk about what we think the impact will be. Clearly, our objective is going to be to achieve full compliance with those standards, but it's bit premature to say what the long term impact of that would be.
Understood. Thank you.
[Operator Instructions] We'll take our next question from Fred Small with Compass Point. Please go ahead.
Hi. Thanks for taking my question. On the disclosure - the April disclosure for the Merrill Lynch impact that a 20% volume reduction would impact the pretax by $13 million. Did you update that for the 60% reduction that you now expect?
That has been updated. So the impact of the second half of the year we expect to be $13 million and $44 million on an annualized basis. The reason for not being a linear change is just giving the timing of that of when would expect that volume to be reduced.
Okay, got it. And then can you go into or can you provide any more detail on how you came up with that $44 million? Or can you frame at all sort of the top line and expense components?
Rob, do you want to address that?
I think the guidance, Fred, I can give you is it’s represented of a direct margin. So you can probably look at our - the best proxy that's out there would be to look at our channel information for the financial institutions channel. It won’t be perfect because it has got, obviously, a mix of clients and it has got port retention in there.
But the best proxy would be to look at the revenue and the direct expenses for the quarter that we presented that analysis, and you can probably estimate it from there.
Okay, got it. And then just on the regulatory stuff, the D.C. court of appeals that you said you thought you would hear back by the end of the third quarter. After you hear back depending on – and depending on which way the decision falls, what’s the next step there? Is that the anticipated end of it?
It's hard to speculate what exactly would happen. There are a range of possibilities depending upon the outcome of the decision. Either one of the parties, either ourselves or the CFPB can ask - for the case to be held by full panel of judges in the D.C. circuit.
It could get remanded back to a different court, it could go the Supreme Court. There is a number of different steps that could occur depending upon the nature of the decision and how the various parties are viewing the decision.
All right. Thanks a lot.
[Operator Instructions] And it appears we have no further question at this time. I’ll now turn the program back over to our presenters for any additional or closing remarks.
Great. Thank you Robbie, and thank you everyone for joining the call today. We look forward to speaking with you next quarter.
This concludes the PHH Corporation second quarter 2016 earnings conference call. Once again, ladies and gentlemen, the replay will be available beginning later today at the company's website at www.phh.com/invest or by dialing 888-203-1112 or 719-457-0820 and using conference ID 5132604. It will be archived until August 24, 2016. You may now disconnect.
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