Description

Astoria Financial will increase EPS by more than 50% over LTM levels. It is a misunderstood and uniquely counter-cyclical mortgage thrift with a superior market share, golden credit quality, strong management team, and a host of near-term catalysts. Although the thrift index at large has performed well this year, there’s still much to be told in the AF story…

Company overview:
Astoria Financial is the holding company for Astoria Federal Savings and Loan, one of the largest thrifts in the US. The savings and loan has 83 branches in and around the New York City area dominating the coveted Long Island market (#1 deposit share of all thrifts, #3 behind Chase and Citi). The Company is a portfolio lender, meaning it earns on Net Interest Margin, not production volume or gain on sale, rather than a mortgage banker. It “originates” mortgages through multiple delivery channels including retail, commissioned representatives, and third party originators (from whom they purchase loans).

AF has a geographically diverse mortgage portfolio with less than 50% in the state of New York and the rest in about a dozen eastern states, plus Illinois and Florida. Most mortgages are 3/1 and 5/1 Adjustable Rate Mortgages (ARMs) that reduce interest rate risk. On the liability side of the balance sheet, AF attracts deposits by offering CDs, checking, savings, money market, and NOW accounts. These funds are used to write loans and purchase mortgage-backed securities.

Key Stats:
83 Branches on New York’s Long Island including Brooklyn and Queens
Assets
$9.0 B 1-4 Family mortgages (yielding 5.26%)
$2.6 B Multi-family/Commercial (yielding 7.55%)
$9.0 B MBS (yielding 4.01%)
Liabilities
$5.7 B Core deposits (costs 0.50%)
$5.4 B CDs (costs 3.73%) --$2.7 B refinancing from 2.55% to 1.6%
$9.6 B in Borrowings (costs 4.77%) --$5.0 B refinancing from 4.53% to 3.20%
1.79% NIM (Last 9 mos. annualized)
$2.59 LTM EPS
2.40% Adjusted FY04E NIM
$3.57 Adjusted FY04E EPS
$16.57 Tangible BV/Share

AF is effectively a counter-cyclical mortgage play. Typically during times of declining interest rates mortgage thrifts benefit as loan production rises and interest spreads widen. This is not the case for AF, primarily an originator of 1-4 family ARMs that are prime grade, have very low prepayment penalties, and are very susceptible to refi/prepayment. Throughout FY 2002 and the 9 months ending 9/30/03, the Company cumulatively originated $9.1 B of 1-4 family mortgage loans. None of this production was retained due to customer refi and the net loan portfolio actually decreased by an additional $1.3 B over the same period. Interest-yielding assets are only slightly higher today than they were 5 years ago despite record production, highlighting the unprecedented level of refinancing/prepayment AF has experienced. There is little reciprocal benefit from such immense refi volume as less than 2% of total revenue is derived from refi activity. Furthermore, because AF owns both loans and MBS securities that were predominantly purchased at premiums during a declining rate environment, as these assets are prepaid the Company incurs accelerated premium amortization expense and is forced to reinvest these cash flows in lower-yielding assets. This, especially the premium amortization, has squashed Net Interest Margin (NIM) from 245 bps in 1999 to a paltry 152 bps last quarter.

Net Interest Margin, EPS, and Multiple Expansion
Although AF shares have run 33% year-to-date (in lockstep with the NASDAQ bank index), we believe there is still significant upside to this name. The Company is in a very dynamic transition phase with lots of moving parts. In our opinion, applying conservative assumptions to each of the various scenarios both establishes a margin of safety and leaves a good deal of upside beyond the “base-case”. There are several important catalysts in queue:
I.) FY04 effects of a massive $7.7 B refinancing ($5.0 B of borrowings and $2.7 B of CDs)
II.) Benefits of stable interest rate environment: lower premium amortization expense, resumption of double-digit loan portfolio growth.
III.) Remaining 3.6 MM share repurchase.
IV.) Continued thrift consolidation and demand for quality acquisition targets in the Northeast market.
V.) Very strong relative performance to comps given AF’s unique counter-cyclical position -- as rates stabilize/increase AF will benefit, most peers will do worse.

I.) The Company’s two largest sources of funding are borrowings (loans/reverse repos) from the Federal Home Loan Bank (FHLB) and CDs from retail customers. On the CD side, the $2.7 B to be refinanced carries a weighted average coupon rate of 2.55%. 85% of the $2.7B matures before the second half of ’04. During Q3’03 AF rolled over 94% of a $780 MM CD tranche reducing the rate from 2.01% to 1.60% AND extending the maturity from 12 mos. to 15 mos. Currently, the 18 mos. CD rate is at 1.29%. We assume a 1.6% refinance rate to adjust for extended maturities/steepening yield curve and that 75% of the maturing CDs are rolled over at the new rate (management has indicated both of these assumptions are conservative).
IMPACT: FY’04 EPS will increase by $.11 and NIM by 6 bps.

The FHLB borrowings refinancing is even more advantageous to AF in ’04. The entire $5.0 B at 4.53% will mature in various tranches by the second quarter of 2004. In Q3’03 $900 MM of maturing FHLB loans were refinanced from 5.29% to 2.63%, a 266 bps reduction. The current 5-yr. FHLB rate is 2.82%. We assume a very conservative 3.20% refinance rate.
IMPACT: FY’04 EPS will increase by $.40 and NIM by 22 bps.

II.) AF’s large compression in NIM is primarily attributable to premium amortization expense caused by rapid prepayment in both the loan and MBS portfolio. As rates stabilize/increase this hole in the NIM will largely be plugged. Management says that “normal” premium amortization expense is approximately $16-17 MM annually and that there is an additional $48 MM in the MBS portfolio that will amortize over the next three quarters. We assume $70 MM of total ’04 premium amortization expense, down from a $125 MM annualized LTM amount.
IMPACT: FY’04 EPS will increase by $.45 and NIM by 26 bps.

Stable/increasing rates will also lead to the resumption of loan portfolio growth as decreased prepayment will keep more loans on the books. Management stated on the Q3 conference call that they expected 10% growth in FY04 and recently indicated in conversation they think they may be north of this number. Loan portfolio growth will resume as the wave of refi/prepayment activity recedes. In September, refinance loans as a percentage of total loan originations fell to 50% and management believes this number has trended further downward. Given the continued decline in refi activity expected throughout Q4’04, we believe a small portion of loan production is already being retained and would not be surprised if the Company reports some portfolio growth in Q4. We back into a loan portfolio growth rate of 10.5% for FY04 by assuming originations will fall 41% but that 60% of the remaining production is retained (i.e. a higher portion of the remnant loan production is purchase vs. refi loans). In conversations, management indicated this deconstruction of loan portfolio growth is reasonable. Compounding this growth quarterly with a CAGR of 2.5% equals 10.5% annually.
IMPACT: Adds another $.32 to FY04 EPS, subtracts 7 bps from NIM.

III.) AF’s management has demonstrated a commitment to returning capital to investors having declared over $1.1 B in dividends over the past 5 years and repurchased $3.2 B worth of stock. The Company has another 3.6 MM shares left under the present repurchase program and management has indicated that these shares will be repurchased in FY04 and that another repurchase program is likely to follow. We assume the current repurchase is completed in the second half of FY04.
IMPACT: Adds $.08 to FY04 EPS.

A summary of my adjusted earnings per share and NIM construction:

FY04E EPS / NIM
$2.21 / 1.93% – Unadjusted*
+$0.40 / +0.22% – FHLB refinancing
+$0.11 / +0.06% – CD refinancing
+$0.45 / +0.26% – Reduced premium amortization
+$0.32 / -0.07% – Portfolio growth
+$0.08 – Share repurchase
$3.57 FY04E EPS / 2.40% NIM – Adjusted

*The unadjusted FY04E NIM (1.93%) is higher than that of Q3 (1.52%) for two reasons. First, in calculating unadjusted FY04E NIM, the premium amortization expense for the 9 mos. ending 9/30 ($93.6 MM) is annualized rather than the amount for Q3 only ($58.2 MM). Annualizing the Q3 number would result in too distorted of a FY04 premium amortization expense. Secondly, Q3 NIM is calculated on the quarter’s average balance sheet figures whereas going forward NIM is based on the ending account balances at 9/30.

IV.) We believe AF is also an attractive takeover candidate given its strong market presence and the scarcity of available targets in the region. Recently there has been an increase in M&A activity throughout the Northeast thrift market and heightened interest in the lucrative New York metro area as evidenced by the greater occurrence of de-novo branching by larger out-of state banks. Two recent transactions occurred at the following valuations:

Roslyn Bancorp acquired by New York Community Bancorp 6/27/03
2.9x Tangible BV
38% Core deposit premium
11.0x EPS

Staten Island Bancorp acquired by Independence Community Bank Corp. 11/25/03
2.5x Tangible BV
34% Core deposit premium
21.3x EPS
(Deal stats from Moors & Cabot research report 12/2/03.)
(Core deposits include now/demand (checking) accounts, savings accounts, and money market accounts.)

Given these precedent transactions and AF’s premium market position, AF could be taken out in a deal at 14x-15x forward earnings, 2.8x Tangible BV and 37-38% core deposit premium. Incorporating the effects of the refinancing, lower refi/prepayment activity, and remaining share repurchase, AF could see a purchase price of $44-$54.

V.) AF is effectively a counter-cyclical play because it is a mortgage portfolio lender rather than a mortgage banker. This means that the Company’s earnings are driven by the spread between interest-yielding assets and the associated interest-bearing liabilities rather than loan production volume and gain-on-sale revenue. During a period of declining interest rates AF suffered the ills of prepayment cash flows compounded by high-cost borrowings while many of its peers benefited tremendously by selling loans at higher prices and generating revenue from loan production fees. Going forward, AF should have little expense risk as rates increase and mortgage momentum subsides because it does not depend gain-on-sale revenue and has no “production machine to feed”.

Balance Sheet
AF is favorably repositioning its balance sheet by increasing deposits (lower-cost) and reducing borrowings (higher-cost). From year-end ’99 to LTM, AF reduced borrowings by $2.4B to $9.1B, and increased deposits by $1.6B to $11.2B. The Company has also increased its composition of core deposits to 51% over the same time period. Core deposits are preferable as they are less expensive (AF spends approx. 34 bps compared to 3.62% for CDs), provide a natural interest rate hedge and generate income from cross-selling. Checking accounts have grown at a 16% CAGR since 2000. Attesting to AF’s strong market share and high level of customer satisfaction (82% of customers are “highly satisfied” with branch service based on management survey), AF has been able to sustain this core deposit growth without matching the unprofitable rates offered by competitors looking to drive customer traffic/cross-sell. For example, WAMU offers 75 bps savings accounts vs. AF’s 40 bps.

Credit Quality
AF has a superior credit risk profile with a conservative underwriting culture, no sub-prime lending, low Loan to Values (LTV), a ‘AAA’ MBS portfolio, and high reserves for Non-Performing Assets (NPAs). AF portfolio loans have an average LTV of 63.2%. AF has a 250% NPA reserve with only .15% of loans non-performing compared to a thrift average of .41%.

Management
AF has a strong and shareholder aligned management team that has run the Company to maximize value. George Engelke (CEO), Monte Redman (CFO), Alan Eggleston (EVP) and Arnold Greenberg (EVP) have all been with the Company since it went public in 1993 providing consistency of strategic direction. Insider and ESOP ownership is 13.5% of the common shares.

Valuation
AF has a market capitalization of $2.9 B, and trades at 1.9x book value and 2.2x tangible book value. Of 25 comparable thrifts, AF trades at a 24% discount to the median LTM PE, a 26% discount to forward PE, and a 5% discount to price/book. AF also has an efficiency ratio of 47.2% compared to the peer median of 58.6%. With street estimates at $3.11, the ’04 forward PE multiple is 12x. Applying this multiple to $3.57 of 2004E EPS, the implied price is $43 (17% return). Based on the peer group forward PE multiple of 16x, the implied price is $57 (56% return). Taking a midpoint of this valuation and incorporating recent transaction multiples, I believe AF is more appropriately valued in the high 40’s to low 50’s.

Risks
-In an economic recovery, thrift stocks may fall out of favor with the market.
-If origination of purchase mortgages slows dramatically, portfolio growth may not be fully realized.
-If the yield curve flattens for an extended period the Company’s NIM will continues to suffer from refi cash flows and associated premium amortization expense.
-If interest rates back up earlier and more dramatically than expected, the benefits of the liability refinancings will be diminished (however, rate increases have already been built into our assumptions)
-A continued stock market rally could stimulate more personal investing and pressure AF’s core deposits.

Catalyst

- Net Interest Margin expansion
- $7.7B liability refinancing saving $0.51 per share
- Reduced premium amortization expense saving $0.45 per share
- Guidance to double digit loan portfolio growth adding $0.32 per share
- 3.6m share repurchase adding $0.08 per share
- Potential acquisition target
- Valuation multiple expansion as AF outperforms peers in rising rate environment.