PennyMac Financial Services, Inc. (PFSI) Earnings Call Transcript & Summary

Hello. Good morning and thank you for joining us. I am Barclays’ consumer finance analyst, Mark DeVries. And I'm pleased to be joined by PennyMac Financial Services CEO, David Spector; and the CFO, Andy Chang. They have some prepared comments to deliver, which will be followed, time permitting, by some polling of the audience and Q&A for management. If you'd like to ask a question, you should have an option to enter it on the upper left hand side of your screen or you can try to e-mail it directly to me, and we will do our best to address your question in the time we have today. Before we start off with the prepared remarks, I'd like to lead off with a question for the audience. To participate, please click through to the polls on the left side of your screen. After you respond, you should be able to toggle back to the video of the discussion. Turning to that first question, what do you view as the biggest catalyst for PFSI over the next year? Better-than-expected origination volume, gain on sale margins holding at elevated levels, incremental earnings from the Ginnie EBO opportunity, improved servicing margins or other? Now with that out of the way, I'm going to hand it off to David for his comments. David, the floor is yours.

Thank you, Mark. Well, good morning, everyone. Thank you for joining us here today and for your interest in PennyMac Financial Services. I'd like to spend some time reviewing the company and talking about our success over the years, the drivers of that success and the unique and highly scalable, technology-driven platform that we built here at the company. Let's start with Slide 3. PennyMac Financial's in its 13th year of operations. We are a leader in the U.S. mortgage industry with large businesses in loan production and loan servicing. In addition to traditional mortgage banking, we also have an Investment Management business, which oversees the investment activities of PennyMac Mortgage Investment Trust, or PMT. This combination is unique among nonbank mortgage companies and provides us with a unique strategic advantage. Underlying our strong operational expertise and efficient platform is a well-developed and sophisticated risk management infrastructure that provides significant governance and oversight of our business activities. This combination of strong operational execution and focus on risk management has been the foundation for our growth as an industry leader in both mortgage production and mortgage servicing. Over the last 12 months, we were the third largest mortgage producer in the United States with total production of over $150 billion in UPB. And over the same time period, we were the largest government-insured producer and largest correspondent aggregator. We are also a top 10 residential mortgage servicer in the United States, with a servicing portfolio approaching $400 billion in unpaid principal balance. In our Investment Management business, we manage a publicly traded REIT in PMT. Through PFSI's extensive mortgage expertise and operational capabilities, PMT is able to invest in unique residential mortgage-related assets sourced from its correspondent production activities. Our synergistic relationship with PMT allows us to address significant opportunities in the United States residential mortgage market. And since 2013, we have nearly doubled net assets under management through a combination of strong investment performance and successful capital raising activities. Now let's turn to Slide 4 for a look at PennyMac Financial as an attractive investment opportunity. We have been profitable every year since the company's founding in 2008, and the chart on the top right illustrates PennyMac's strong earnings per share since its IPO in 2013. I'm very proud of the record financial results we delivered in 2019 and the record results we are delivering in 2020. But these earnings have been driven by the continued investments we've made in our operating platform over the years. With our corporate reorganization in 2018, in addition to BlackRock's recent sale of their final strategic ownership position, we have seen increased liquidity and public flow. Finally, last year, we introduced a quarterly cash dividend of $0.12 per share, which our Board of Directors has since increased to $0.15 per share. We believe this regular dividend represents an important component in the structure of providing long-term sustainable stockholder returns. Now let's turn to Slide 5 and take a few moments to discuss PennyMac Financial's success, which is built upon our unique business model and expertise in risk management. Our success is a direct result of the unique business model we organically built, our unwavering focus on risk management and a track record of successful capital management. PennyMac Financial is recognized as an established leader in the mortgage industry with scale in both loan production and servicing, which continues to drive profitability across different market environments. 42% of our production in the first half of the year was purchased money loans, significantly higher than the industry average. [indiscernible] turn the slide. Our expertise in managing risks since the company's founding in 2008 has enabled PennyMac Financial to remain a consistent and constructive source of new capital for consumers seeking to purchase a home or refinance their existing home. This commitment is demonstrated by our strong balance sheet with low levels of leverage versus competitors and the well-developed and sophisticated enterprise risk management systems and infrastructure that we have built. Further, PennyMac Financial continues to be recognized as a leader in capital markets operations and interest rate risk management, which includes our successful history of hedging mortgage servicing rights. These foundational disciplines have been critical to our success, including during the COVID-19 crisis and in the current market environment. Finally, this management team has a track record of successful capital management, with retained earnings driving book value growth. Since our initial public offering more than 7 years ago, we've grown book value at a compounded annual growth rate of 25%. Additionally, we've repurchased over 8 million common shares since 2017. Now let's turn to Slide 6 and more closely review PennyMac Financial's earnings growth. The fastest growth of our Consumer and Broker Direct lending channels is a significant contributor to the recent growth in PFSI's earnings. As you can see in the upper left chart on this page, the growth in production pretax income has been driven by the profitable growth of the direct lending channels. Notably, Production segment pretax income for the first half of 2020 was $778.2 million, up significantly from $527.8 million for the full year 2019. As you can see on the chart on the upper right, operating earnings for the Servicing segment provide a core earnings contribution driven by the growth of our servicing portfolio and increased scale. Core results from our servicing business in 2020 are substantially up from last year's level, with pretax income, excluding valuation-related changes of $129.2 million for the first half of 2020 compared to $146.8 million for the full year 2019. And Investment Management pretax income has grown in recent years with the growth in PMT's equity. Now I'd like to turn to Slide 7 to discuss our development and utilization of technology. Our technology investments, which include proprietary systems development as well as the integration of leading vendors, are a critical element of PFSI's competitive advantage. Last month, we introduced and announced the completion of the development of P3, a new portal facing our correspondent sellers that leverages PennyMac's proprietary technology and Ellie Mae's next generation Encompass Digital Lending Platform. This system seamlessly integrates with PennyMac's proprietary loan bidding system that instantly prices loans for unique characteristics and required returns. We expect this system to improve the overall experience for our customers while also increasing the speed at which we can deploy updates or system enhancements in a rapidly changing mortgage market environment. Through the end of August, all of our correspondent clients have been migrated on to P3, and over $26 billion in lock volume has been processed. We are also continuing to make investments to upgrade and deploy updates to MAC, our consumer direct portal, and POWER, our broker direct portal. P3, MAC and POWER are all directly supported by our industry-leading, low-cost and efficient centralized loan fulfillment process. We expect the investments we've made in production technology and process efficiencies will continue across all channels as we further scale our business, with plans to eventually consolidate all of our channels onto a single cloud-based system. In servicing technology, last year, we announced the completion of SSE, our proprietary workflow-driven servicing system. SSE has been instrumental to our performance during this COVID-19 crisis, providing automated solutions for forbearance management and enabling our servicing associates to provide solutions to up customers with COVID-related hardships. These investments have enabled us to consistently grow our business throughout different market environments. So let's turn to Slide 8 and review market share trends across PennyMac Financial's businesses. In the correspondent channel, PennyMac represents 10.5% of total production volume in -- represented 10.5% of total production volume in 2017 and has grown share to become the market leader, representing approximately 17% of total channel volume in the first half of 2020. We estimate that PennyMac's market share in Consumer Direct was approximately half of a percent in 2017 and has since doubled as we represent approximately 1% of the total volume in the channel. We believe there is significant opportunity to grow share by the strategic advantage of our servicing portfolio, which is approaching $400 billion in UPB and 1.9 million customers, in addition to initiatives in place to grow volume from outside our portfolio. PennyMac entered the broker channel early in 2018, and we've made strong gains currently at approximately 1.8% market share for the first 6 months of the year. This channel represents a significant opportunity for PennyMac, and we've seen strong growth in volumes since the COVID crisis began from brokers that appreciate the stability and strength of the PennyMac platform. The broker channel provides PennyMac with access to a large and growing part of the origination market and additional opportunities to grow purchase money originations. Now let's turn to Slide 9 and discuss PennyMac's opportunity in the mortgage origination market. Economic forecast for total originations in 2020 have increased to $3.1 trillion, the highest level since 2003, and forecast for total originations in 2021 have recently increased to nearly $2.4 trillion, higher than the strong market we saw in 2019. These forecasts are supported by mortgage rates that continue to reach all-time lows, driving robust refinance and purchase mortgage demand. Forecast for purchase money originations have also increased recently driven by higher demand for single family homes. Production margins have remained elevated in the direct lending channels driven by capacity constraints, while correspondent government margins have decreased from record levels seen early in the second quarter as other market participants have returned. PennyMac Financial has been able to capitalize on the current opportunity as a result of its capital structure, risk management disciplines and significant technology and infrastructure investments made in recent years. Now let's turn to Slide 10 and discuss the faster growth of our direct lending channels and its impact on production earnings. We have hired over 1,000 [ PennyMacers ] in the second quarter and continued to grow capacity, while investments we've made to our end-to-end fulfillment process continued to provide scale benefits in our direct lending channels. In the second quarter, we funded more than 2.5x the volume we funded a year ago in our Consumer Direct channel and more than 3x the volume we funded in our Broker Direct channel. And while the direct lending channels, both Consumer and Broker Direct, represented 21% of PennyMac's production volume in the second quarter, they accounted for approximately 60% of pretax income from PennyMac's Production segment. PennyMac Financial has substantial potential to grow market share in the Consumer Direct channel, which is currently 1% of the market, and the Broker Direct channel, which is currently at 2%, versus the correspondent channel where PennyMac is already the market leader, with 17% share of the market. Now let's turn to Slide 11 to discuss our servicing portfolio trends and the potential for Ginnie Mae early buyouts, otherwise known as EBOs. Our servicing portfolio, UPB, has increased 5% since December 31, 2019, and is approaching $400 billion despite elevated prepayment speeds and some disruption in the correspondent production market in the first half of 2020. At June 30, 2020, $20.4 billion in UPB of the loans in PennyMac's predominantly government mortgage servicing rights portfolio were 90 days or more delinquent and not in foreclosure as a result of COVID-related forbearance plans, thus providing the potential for significant EBO activity in the second half of 2020 and in 2021. Revenues related to the reperformance and subsequent redelivery of previously delinquent Ginnie Mae loans bought out in prior periods are expected to meaningfully exceed associated expenses and the cost of managing a large and growing predominantly Ginnie Mae servicing portfolio. We are expanding our financing facilities and expect to deploy a portion of excess liquidity to fund future EBO activity. Now let's turn to Slide 12 and talk about trends for PennyMac Financial in the third quarter. We expect production volumes to remain at elevated levels in the third quarter. Quarter-to-date, through August 31, correspondent acquisitions totaled $27.8 billion in UPB and locks totaled $35.2 billion. Consumer Direct originations totaled $4.1 billion in UPB and locks totaled $7.1 billion. The committed pipeline at August 31 was $5.6 billion. And Broker Direct originations totaled $2.1 billion in UPB, while locks totaled $3.4 billion. The committed pipeline at August 31 was $2.4 billion. The total UPB of our servicing portfolio was $396 billion at August 31. In total, we expect PennyMac Financial's earnings per share for the third quarter to exceed the record EPS we reported in the second quarter. And finally, while prospects for the U.S. economy remain uncertain, given the present market environment, we expect PennyMac Financial's exceptional financial performance to persist into 2021. This concludes my prepared remarks. Thank you for your time, and now we'll open it up for questions.

Thank you, David. Before we get to Q&A, I'd like to slip in another question for the audience. Next question for the audience, what is the biggest risk to shares that you see here? Weaker-than-expected gain on sale margins, weaker-than-forecast purchase volumes, weaker-than-forecast refinance volumes or increased regulatory scrutiny? With that out of the way, I'd like to move to the Q&A. Could you discuss trends you were seeing across the varying originations channels so far in 3Q, kind of outside of the volume color that you just provided?

So starting with Consumer Direct, we continue to see robust demand for refinance activity. And as a result, we're continuing the strong healthy pace of originations that we saw in Q2 as well as the numbers that I just laid out for you. And I think that we believe that we'll continue to see that demand through the remainder of the year. Also, I'm hopeful that we can continue to see the share growth that we've seen this year. And I think that, that share growth continues to come at robust margins, and it's our desire to maintain margins kind of at the levels that we've seen in July and August. And we're hopeful that, that margin compression that many expect to take place will take place over a longer period of time than we've seen historically. In the Broker Direct channel, I think that we've seen a really nice growth in our Broker Direct business. That channel, I think, coming out of COVID, I think, has seen a little bit of a sea change as the 2 market leaders who are over 50% seem to be taking down their share for different reasons. And I think that we can take our share numbers up pretty decently to fulfill the needs of the brokers who seem to be waking up to the fact that having more than 2 broker lenders is in their interest. And I'm hopeful that we can continue to be -- that we can continue to see strong broker acquisitions in that space as well as the growth in production activities. The margins in Broker Direct continue to remain at their healthy levels that they were in Q2, and I would hope and expect that margin compression to follow kind of a path similar to what I expect in Consumer Direct. And then both those paths, I would say, are going to be less steep down than we've seen historically. In the correspondent channel, there, I think we -- in the COVID crisis, we saw many step back in correspondent. We continued, I'm proudly to say, to operate, and I'm equally proudly to say, to operate at wider margins. Since that time, we've seen the margins in the correspondent space come back very quickly to levels that in the -- on the conventional side, the levels there are where they were pre-COVID. On the government side, they're a bit elevated from where they were pre-COVID. But I think that we are -- we continue to maintain our share as the #1 correspondent aggregator. And I think that given the company's liquidity position, my hope is that we can continue to grow correspondent and to invest in very valuable, low-rate mortgage servicing rights. So I think on that front, that leads to the fourth area of mortgage servicing where I would expect the servicing portfolio to continue to grow and to grow with really valuable low note rate new issue servicing. And I think that, that's something that we want to see the servicing portfolio continue to grow and to do so in an organic way. Having said that, if there's an opportunity to buy a bulk package of sorts, that's not something that we've shied away from in the past. But I think that at this point, we're not seeing the bulk servicing market really showing any packages. And I think we can continue to grow the servicing portfolio on an organic basis. And so I'm -- I think that, as I said, for the foreseeable future, we are forecasting a healthy, robust origination market with very nice margins associated with it.

Okay. That's very helpful. On the correspondent business where you've obviously been taking share here, it sounds like that share gain kind of later -- maybe in 2Q, started to accelerate as some of those large players you mentioned step back. Do you have a sense for kind of what your run rate is today in terms of market share compared to the -- what you disclosed for just the first half of the year?

I think -- Andy, do you want to...

Yes. I was going to say it's pretty close, right? So I think we certainly saw opportunities, as you pointed out, in the second quarter with the dislocations. As David pointed out, you've seen people return. And so we estimate that our market share is around that 17% in correspondent and is still there in today's market.

What I like about our share growth in correspondent is that the correspondent market is split between bulk bidding and best efforts. And best efforts is where you have smaller originators who are locking loans when their customers are locking a loan. And if that loan funds, it then gets sold to us as an aggregator. That best efforts channel is one that is typically smaller originators, is typically at higher margins. And that's more than typical. That's what we're seeing today. And our growth in best efforts has been really, I would say, meaningful this year. And I think a lot of it's coming out of the COVID crisis where these -- some of these originators were doing their own hedging, and they decided to move to the best efforts business in correspondent and away from bulk. So I think that, that business is one where -- or that part of correspondent is one that I'm really hopeful that we can continue to see the growth at the typically higher margins than we see in bulk.

Okay. I'm sorry, I misspoke. I meant to ask about the Broker Direct channel where the run rate there, with some of the bigger players stepping away obviously and the opposite phenomenon in correspondent, with players stepping back in. But any sense for kind of what your run rate is on Broker?

Yes. I think right now, we're funding over $1 billion a month in Broker. My comment to the team here is just more, more, more. And I think that we're going to do so in the prudent fashion that we've always operated. I think that this is the same management team in place that developed and grew correspondent. And we know how that's -- how that growth story has played out over the years. And I'm highly hopeful that we see something similar in Broker. I think right now, given the low share, it's just a function of adding the capacity on the -- just continuing to add capacity and do so in a way where we can continue to make meaningful share in roads. But I think at this point, we're too low a base to start putting ourselves out there to say where we want to be. I know that in the long run, being a 10%, to me, is not overly aspirational. And it's -- but as I said, over the long run.

Okay. That's helpful. Could you talk a little bit more about kind of some of the tangible benefits you've seen from the rollout of P3? I mean is it something where it's kind of a necessary defensive move to hold on to share that you got there in correspondent? Or do you think it really gives you an advantage that could enable you to take even more share than you already have?

Yes. Look, so I think the story on P3 is a really interesting one from the point of view that we found ourselves in a position where our correspondent system was owned and maintained primarily by Black Knight. And with the rollout of SSE on the servicing side and with the well-publicized issues that we've had with Black Knight, we decided that we had to move away from Black Knight. And in doing so, we had a really golden opportunity to create a state-of-the-art cloud-based system that is workflow-based for us on the processing side here, but this also provides real benefits to our clients being that it's a brand-new system. And I think that it's -- it should not be lost on anybody that we've rolled out a brand-new system in the midst of the largest market since 2003. We're the largest aggregator, and we've continued to grow our production volumes and do so in a way that have not had any interruptions or any problems. And I think that speaks to the technology, human capital that we have here in the company. And I think if you ask our customers, they're equally enthusiastic about the program. And I think it's one of those, I would say, technology builds that's unique in my career and the fact that we had a 14-month period to get it done. From the outset, it was pretty much a big bang effort to get a brand-new system in place, and it got completed. So I think that it's all systems go. And the teams are now working on continued enhancements to that technology as well as to MAC and POWER.