Description
Charter Financial (CHFN) was the largest mutual S&L in Georgia before it made its stock debut this week. It IPO'd at $10 and is currently trading at $14.45.
As thrifts go, Charter has one of the oddest 'financial shapes' that I have ever seen. It is totally out of proportion. I liken it to a 99-pound weakling with 25-inch biceps! I have never seen an S&L carrying as high a percentage of equity to retail deposits as Charter. It has a whopping $266M in equity to a paltry $152M in retail deposits. It gives new meaning to the term 'well-capitalized'!
This sleepy bank borders the states of Alabama and Georgia (has branches in both) and does most of its business in the low-growth 'Valley' that separates the two states. Historically, they've depended on textile workers for a good deal of their customer base and, unfortunately, that industry has been hurting, and it's reflected in their 'banking business'. 'The Valley' has lower economic growth rates than the states it resides in.
In a 'normal' 20% MHC offering, with half-million dollar purchase limits and heavy insider buying, I would have easily expected 'supermax' valuations...but with this one, I didn't think it would happen. Having such a disproportionate 'retail deposit to equity ratio' worked in favor of those depositiors taking part in the offering because it served to reduce the capitalization ratio.
The low amount of 'retail deposits' made it easier for depositor-shareholders to get better value at the open but it also takes away from the overall 'intrinsic value' of the bank because the 'liability side' of their balance sheet doesn't add much real value ($47M in core deposits just isn't anything to get excited about). Over the last few years, Charter's 'banking business' has produced really lousy GAAP returns because the equity base was just too large to get decent 'operational returns'. (Charter's historical GAAP ROE's and ROA's, along with its pro-forma GAAP P/E's, are among the worst I've ever seen for a mutual thrift offering.)
Charter's over-sized equity position has almost forced the bank to play the 'wholesale leverage game' of buying brokered deposits and borrowing large sums from FHLB and then investing those borrowed funds in 'mortgage backed securities'. With most of the balance sheet comprised of this wholesale and marginal investment strategy (with it's razor thin margins), it's not difficult to see why the returns have been so anemic. A 59 basis point spread on most of their assets does not make for good 'operational returns'. They do have 4 full service branches and 3 loan productions offices that have produced a good mix of residential, commercial and consumer loans...but only to the tune of $252M. They are good lenders with NPA's of only .26% and allowance reserves at more than twice that level. They certainly have the equity to greatly expand loan production but the 'Valley Area' is having a difficult time supporting any growth in their already leading market share. (They just built a new branch this month out of the valley in the more prosperous Auburn area.)
So as a bank, the GAAP operational and profitability ratios are certainly nothing to get excited about (in fact, they are awful) but fortunately, because of Charter's very large Freddie Mac stake, they are also almost meaningless. With this bank, almost everything hinges on Freddie!
A little history is in order on Charter's involvement with FRE. In the '80's, like many mutuals, Charter had more equity than could be profitably utilized in their business. They used this excess equity to amass about 6 million shares of FRE during this period, at an average cost of $1.40 per share. This one single move produced, in my estimation, one of the greatest performances for a 'financial' of the last decade. Everybody focuses on 'earnings' and 'growth of earnings' when assessing the value of a company...but the growth in 'book value' and 'intrinsic value' is a far better metric in determining its success. The poor historical GAAP numbers are meaningless because they don't take into account FRE's large contribution to Charter's bottom line. With GAAP, FRE's dividends to Charter are counted but not their earnings.
On the other hand, Charter's 'comprehensive ROE' and 'comprehensive ROA' are greatly affected by FRE's annual stock price appreciation. Factoring in those numbers produces an entirely different story, with a none-too shabby five year average 'comp ROE' of 19.1% and an off-the-chart 'comp ROA' of 5.5%...in comparison to GAAP's punk 3% and .6% respectively. And if you look at their 10-year and 15-year performance, only a handful of 'financials' have performed better during that period.
Great, they performed wonderfully when nobody owned them, but they've decided to go public NOW, after all the easy gains have been made with FRE! (They did try to do a standard conversion in '88 when their FRE stake was tiny in comparison to today's but the OTS denied them the right to convert because management wanted to exclude the market value of FRE in the appraisal process.)
So to understand the potential of this bank, we have to understand the future potential of FRE because management has given every indication that they have ABSOLUTELY NO INTENTION of selling these shares. The bank currently owns 5,055,000 shares of FRE. (Over the years, they've given thousands of appreciated FRE shares to their charitable foundation. This is a much more efficient way of 'giving' than funding a new foundation with low-priced Charter shares at the IPO. They still have carryovers for tax reporting purposes).
After the offering, 400,000 shares of FRE were upstreamed to the primary MHC holding company, 1,700,000 to Charter Financial, and the rest were placed in various subsidiaries that the intermediate holding company, Charter Financial will control. Public minority shareholders of Charter Financial will effectively own 931,000 shares of FRE or .2348 shares of FRE for every minority share of Charter Financial (about $15.75 of pre-tax FRE at today's FRE price).
The arbitrage situation of Charter to Freddie is obvious but it also creates a great deal of uncertainty for Charter buyers because FRE's stock has a great deal of bearing on Charter's value. FRE's after-tax proceeds comprise fully 80% of Charter's equity.
At CHFN's current price, it's selling at an adjusted price to book of 69%. This takes into account the 20% after-tax proceeds of FRE (at $67), 20% of the rest of the historical equity, and the net capital raised in the offering of $33,381,000. It's important to note that Charter's adjusted book value factors out the very large tax liability in FRE's stock price appreciation. These are carried on the books as a liability but in actuality (as a continuing hold), I consider them quasi-equity.
(Let me explain. Charter Financial's $116M deferred tax liability doesn't cost Charter a penny but produces REAL returns. Liablities are not all the same. The deposits are also considered by GAAP to be liabilities but in the real world they are considered assets to any potential acquirer. Buffett's insurance float is also considered a 'liabilty' because that money will EVENTUALLY be used to pay insurance claims but in actuality it is one of his most prized assets because he has use of that money in the interim. Charter's deferred tax liabilities can effectively juice up the REAL ROE because it produces without being counted!)
Management and directors bought 5% of the offering and will own over 20% after ESOP, MRP, and additional stock option plans kick in. (Interestingly, most of these shares are already factored in to the adjusted book value at the IPO's outset).
I like the way Buffett uses 'look-thru' earnings at Berkshire and I think this is a much better way of looking at Charter's 'real business' than using either the 'GAAP' or 'comp' numbers. If the Charter minority shares own 931,000 shares of FRE (they do), than why don't they own the earnings of those minority FRE shares? FRE will conservatively earn $4.50/share over the next year, which translates to $1.06/share on the newly issued minority shares just from FRE! Add in the interest from the money raised, and the return on the minority's historical equity...and we are looking at an adjusted P/E of less than 10 at today's price.
Well, is Charter a good deal or not? The flip answer is, 'it all depends'. For the long-termers, I think it's a no-brainer...but historically, both institutions and private investors never liked the lack of liquidity or control of the MHC structure. Also the size of this bank and the 20% minority share would 'normally' give them pause...but things are a'changin'!
OTS has made MHC's much more attractive vehicles. The bank can now choose to pay a very nice dividend to minority holders with very little impact to the bottom line or worry about dilution in a second-stage conversion because of the waived dividend. The 80% of Charter Financial owned by the MHC can waive it's dividend...thereby allowing most of the benefit to accrue to the public minority holders.
The bank could choose to second-stage in a few years...which would produce a windfall to minority holders. These deals are typically priced at 75% 100% of pro-forma book and would produce an easy double at current prices (higher if buybacks were instituted in the interim).
The grand slam of an exit strategy, though, would be a 'remutualization' (merging or getting bought out by a mutual or another MHC). All of Charter Financial's $266M in equity could be divided among it less than 4M minority shareholders. Most thrift M&A's take place at a multiple to book or at the very least a premium to book. Most recent 'remu's' have taken place at a slight discount to book value, making them very attractive to the acquirer. A buyout price of ~$70/minority share is certainly not out of the question in a few years because not only will the bank continue to grow but in all likelihood it will also institute a stock buyback plan, further shrinking it's already tiny float. Also, Charter Financial's FRE position is as fungible as it gets and opens up the bidding to any well-heeled MHC or mutual...not just a mutual neighbor. There's also an additional $17M of after-tax FRE tucked away in 'First Charter MHC' that hasn't been counted but could be used to sweeten the pot in any merger.
The risk, as with all thrifts, is the quality of management. The Johnson father and son team have it within their grasp to produce truly awesome shareholder returns...but will they? There is currently no better vehicle to own an oversized, appreciated FRE position than in an over-capitalized 20%-minority MHC. I have no doubt that Johnson & Johnson will grow the banking business by branching and updating technology...but at the same time I'm looking forward to dividends and buybacks. The eventual payout of a remutualization would be enormous in a few years...and there's not much risk while we wait.
Catalyst
(1)Freddie Mac just announced excellent Q3 results. They did so well, in fact, that they could 'afford' to take a one-time charge in reducing future high interest debt and replacing it with lower interest securities. Management also announced that future earnings growth will be in the mid-teens. Investors will eventually connect the dots that FRE makes up 80% of Charter's equity...and owning Charter is a cheaper and better way of ownning Freddie.
(2) More 'MHC remutualizations' will be announced in the next couple of years and the affects will not be lost on investors (article to follow).
(3) Very low minority percentage holdings in MHC subs (such as Charter's 20%) will eventually be seen for what they really are---potential goldmines...and they will be bid up, whether the 'remutualization' happens or not.