Pennymac Financial Services, Inc. — Q3 2018 Form 10-Q
Business context and period. The filing covers the quarter and nine months ended September 30, 2018. Pennymac operates mortgage production, servicing and investment management businesses; PMT is a significant affiliate, customer and financing source. Unless noted otherwise, financial amounts below are in millions of dollars.
Key financial results
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Total net revenue | $250.9 | $250.6 | $733.4 | $656.8 |
| Income before taxes | $61.7 | $94.1 | $209.4 | $214.1 |
| Net income | $56.2 | $82.5 | $191.5 | $187.6 |
| Net income attributable to PFSI common stockholders | $14.5 | $17.1 | $48.9 | $38.4 |
| Diluted EPS | $0.57 | $0.71 | $1.94 | $1.62 |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $732.6 | $(646.3) |
- Revenue mix and trends: Q3 net servicing fees were $109.7 million, up from $78.1 million; gains on mortgage loans held for sale were $56.9 million, down from $108.1 million. Nine-month servicing fees rose to $340.2 million from $199.2 million, while loan-sale gains declined to $189.3 million from $293.2 million.
- Costs and profitability: Q3 expenses increased to $189.2 million from $156.5 million; nine-month expenses rose to $524.0 million from $442.7 million. The filing reports annualized return on average common stockholders’ equity of 10.8% for Q3 and 12.7% year to date, versus 17.4% and 13.7%, respectively, in 2017. A conventional operating margin is not clearly provided.
- Cash flow: Nine-month operating cash flow improved largely because mortgage-loan inventory cash flows shifted to a $543.1 million source from an $807.4 million use in 2017. Investing activities used $349.8 million; financing activities used $317.7 million. Cash and restricted cash ended the period at $103.3 million.
- Balance sheet and liquidity: At September 30, total assets were $6.99 billion, total liabilities $5.08 billion and total equity $1.92 billion. Cash plus short-term investments totaled $248.1 million; $81.6 million of cash was pledged. The company reported $3.25 billion of available repurchase-agreement borrowing capacity, subject to eligible collateral and margin requirements, and stated that liquidity was sufficient for current needs.
- Debt and obligations: Balance-sheet borrowings included $1.74 billion under repurchase agreements, $524.7 million under loan participation agreements, and $1.29 billion of notes payable; the company also had $223.3 million of excess-servicing-spread financing and $9.6 million of capital-lease obligations. Notes payable increased from $891.5 million at year-end 2017. Borrowing facilities carry covenants and margin-call provisions.
- Operating scale: The servicing portfolio reached $284.5 billion of unpaid principal balance, up from $245.8 billion at December 31, 2017. Mortgage servicing rights (MSRs) were valued at $2.79 billion, substantially above the prior year-end balance of $2.12 billion.
Material changes versus prior comparable periods
- Q3 net revenue was nearly flat, but pre-tax income fell 34% and net income fell 32% year over year. Management attributed the weaker production contribution primarily to lower mortgage origination market volume and tighter competition, which reduced loan-sale gains and origination fees.
- Servicing results improved as the portfolio expanded and rising rates generally supported MSR values. Net servicing fees increased by $31.6 million in Q3 and $141.0 million for the first nine months versus 2017.
- Net interest income was $22.2 million in Q3 versus $2.0 million, and $50.5 million year to date versus a $5.6 million loss. Management cited financing incentives and higher custodial-fund placement fees.
- In 2018, the company elected fair-value accounting for all existing MSR classes. This increased opening equity by $0.8 million and moved previously amortized MSRs onto the fair-value basis. The change increases exposure of reported earnings to valuation movements.
- The Registered and Master Investment Funds deregistered in July and, with the Private Fund, were dissolved in August. Investment Funds’ net assets were nil at September 30; PMT remained the principal advised entity.
Outlook, commentary and risks
- No specific earnings or revenue guidance was provided. Management noted reduced mortgage origination market size, rising-rate-driven competition and pressure on production margins; it expects to continue seeking financing to support growth but gave no assurance additional capacity will be available on acceptable terms.
- Financing incentives contributed $12.8 million to Q3 pre-tax income and $35.5 million year to date. The associated agreement has a rolling six-month term through August 21, 2019 and may be terminated earlier by the lender.
- PMT and other advised entities generated 25% of Q3 net revenue and 19% of nine-month net revenue. This includes related servicing, production, fulfillment, financing and management activity, making affiliate relationships a meaningful concentration.
- MSRs and other material assets and liabilities rely substantially on Level 3 fair-value inputs. Management notes that lower rates may encourage refinancing and reduce MSR values; adverse changes in discount spreads, prepayment speeds or servicing costs can also reduce valuations. Reported sensitivities are scenario analyses, not earnings forecasts.
- Mortgage purchase and funding commitments totaled $3.4 billion. The company had $21.0 million reserved for representation-and-warranty losses, with $139.3 billion of loan UPB subject to those representations; management cautioned that repurchase activity may increase as loans season.
- Management reported compliance with borrowing covenants and Agency capital and liquidity requirements. No legal matters were identified as reasonably likely to have a material adverse effect, and no material change to previously disclosed risk factors was reported.
- After quarter-end, a November 1 reorganization converted the ownership structure to a single publicly held common-stock class. The company also extended its $150 million revolving credit facility to October 31, 2019. In October, it entered a syndicated repurchase facility with up to $500 million of aggregate commitments and acquired Ginnie Mae MSR portfolios with approximately $3.2 billion of UPB.
- The effective tax rate was 8.6% for the first nine months, partly reflecting the federal tax-rate reduction and allocation of earnings to noncontrolling interests. Management expects the rate to rise after the reorganization eliminated noncontrolling interests.
Important facts for investors to verify
- Whether servicing growth and MSR-related gains can offset continued weakness in loan production and origination margins.
- The durability and terms of financing incentives, warehouse and repurchase facilities, and the company’s ability to meet margin calls and refinance short-term debt.
- How MSR fair-value assumptions and interest-rate movements affect earnings, equity and liquidity; review the disclosed sensitivity analyses and valuation inputs.
- The scale and economics of PMT-related revenue and financing, including the effect of the dissolved Investment Funds and the post-quarter MSR acquisitions.
- Potential repurchase and indemnification losses relative to the $21.0 million reserve and the large loan population subject to representations and warranties.
- The post-reorganization share count, tax-rate implications, and updated credit-facility terms; the filing reports 77,490,572 shares outstanding at November 1, 2018.