Description

First Financial Northwest (FFNW) $5.25

Mkt Cap               $98MM

P/B                         0.46x

Recommendation

We believe FFNW is a highly attractive "orphan equity" that is grossly undervalued for a variety of identifiable reasons.  The company is a capital rich bank trading below 50% of tangible book value.  On first glance the company appears to be another bank loaded with NPLs, but on further inspection FFNW has more than sufficient capital to absorb the expected losses on these NPLs even under scorched earth assumptions.  With the stock trading at ~50% of tangible book, the market has already discounted expected losses from these NPLs and is essentially pricing the company as if it going to fail. In reality, the housing market in Seattle is bottoming (prices are leveling and volumes are picking up significantly) which should allow the company to make significant progress on reducing NPL levels over the next 6-12 months.  In addition, the company is a conservative underwriter and therefore ultimate loss severities on non-performing loans are likely to be much lower than market expectations. We anticipate a worst case tangible book around $8/share vs. current tangible book of $10.88/share. We expect the stock to trade towards tangible book as the company's NPL levels decline over the course of the year.  In addition, the Company was forced to curtail its dividend (more below) which we believe will be reinstated next quarter along with a special dividend for the recently curtailed dividend.  Since demutualizing in 2007, the company has a history of shareholder friendly behavior such as large share repurchases.  We would expect to see management step up share repurchases once the OTS recognizes the strength of their balance sheet.  We're not the only ones who think the bank is cheap as management and the board have been purchasing shares recently on the open market at higher than current prices.

Overview of the Company

FFNW is a single branch community bank based in Renton, WA. First Savings Bank Northwest was founded in 1923 in Renton, WA as a Washington state chartered savings and loan. FFNW converted to a federal mutual savings and loan in 1935 and to a Washington state charted mutual savings bank in 1992. In October 2007, the company did an IPO in conjunction with its conversion from a mutual holding company to a stock holding company at a price of $10/share with KBW as the lead underwriter. FFNW is the 19^th largest bank in the state of Washington with 0.83% deposit market share. In King County, WA (Seattle) FFNW is the 8^th largest bank with 1.81% deposit market share.

The Balance Sheet

FFNW's bank capital ratios are very strong with Tier 1 leverage of 11.33%, Tier 1 risk-based at 16.43% and Total risk-based capital at 17.73%. In addition, FFNW's holding company has $49.1MM of additional capital. FFNW did not take any TARP capital.

The $109MM investment book is almost entirely invested in government guaranteed loans.

The loan book is heavily weighted towards residential real estate. The commercial real estate book is predominately warehouses and office buildings with minimal retail and no strip malls.

Non Performing Assets

FFNW has seen a doubling in its non-performing assets over the past year with the increase almost entirely due to residential construction land/development loans. Note: $37.1MM of the $48.0MM non performing one-to-four family loans are non-owner occupied units held by the bank's construction/land development customers.  FFNW did not finance any high-rise developments. According to management, ~95% of non-performing loans relate to 15 borrowers.

FFNW's NPLs are unlikely to grow materially going forward if for no other reason than 68.8% of the company's construction land/development loans are already non performing and 17.1% of the non owner occupied residential loans are non-performing. FFNW significantly curtailed its construction/land development lending in Q4 2007 and the company is not currently writing any new construction/land development loans. As a result the construction land/development book has fallen by 34% YoY. Note: $43.1MM of non-performing loans in Q1 2010 relate to 2 merchant builders who are actually current on their loans.

FFNW has historically been a conservative underwriter - before Q4 2009 the bank hadn't had any REO in over 20 years. The average LTV at origination for the company's owner occupied residential loans is 60%. Construction loans were underwritten with maximum loan to values of 75% of the appraised value. Non-owner occupied residential loans have maximum LTVs of 80%.

FFNW has been building loss reserves over the last 4 quarters.  According to management, realized loan loss severity has ranged from 0-25%. Realized losses on OREO sales were 11.1% in Q1 2010.

The Seattle Housing Market is Recovering

Residential real estate sales activity in the Seattle area increased significantly in Q1 2010 with King County (Seattle, 41.8% of FFNW's book) seeing sales volumes up 54% YoY and Pierce County (Tacoma, 16.7% of FFNW's book) seeing sales volumes up 24% YoY.

Meanwhile, home price declines in the Seattle metro area appear to be moderating.

Since FFNW's problem loans are almost entirely tied to residential housing in Seattle the increased sales volumes and moderating price declines should allow the bank to achieve its goal of cutting NPAs by over $60MM by the end of 2010.

Valuation is cheap

FFNW trades at 49% of tangible book value.

As a stress test, we assume the bank encounters a 50% loss severity on its REO, a 40% loss severity on its non performing construction/land development loans, 25% loss severity on its other non performing loans and an additional 3% loss on all of its current performing loans. In total the bank would have $87.4MM of charge offs. This compares to its current $36.4MM allowance implying a worst case need for $51MM in additional provisions. This would cut tangible book to $153MM or $8.17/share. In other words at the current share price, the stock is trading at 65% this worst case tangible book value.  Even with $51MM in additional provisions the company would still have tangible common equity north of 11.6% and therefore the company would not need any additional capital.

Shareholder Friendly Management and Board

The company decided against taking TARP capital because it did not want to accept the restrictions on its ability to pay a full dividend and to buy back its shares. The company proceeded to increase its dividend to 8.5 cents/quarter from 8 cents/quarter in October 2008 and the company continued to buyback its stock.

CEO bought 5,000 shares on May 7^th at $5.03/share and CFO bought 4,000 shares on May 7^th at $5.03/share. Director Gary Faull bought 1,000 shares on May 12^th at $5.34/share. CEO bought 4,302 shares on March 9^th at $7.54. Director Gary Kohlwes bought 2,400 shares at $7.25 on March 9^th. Insiders have only bought stock since the company de-mutualized in 2007.

Company has had a voracious appetite for its own stock. Since going public, the company has bought back 4.9MM shares at an average price of $8.23/share using just over $40.6MM on repurchases. In Q4 2009, the company bought back 1.2MM shares at an average price of $6.50.

Income Statement

FFNW has consistently generated ~ $3MM in pre tax pre provision earnings per quarter with PTPP earnings declining over 2009 to reflect the forgone interest from non performing loans.  As the bank stabilizes its balance sheet, management believes it can raise pre-tax pre provision earnings back to $5MM/quarter implying earnings power approaching $0.75/share.

Catalysts

While FFNW suspended its dividend in conjunction with its Q1 2010 earnings release, management believes it will be able to reinstate a dividend possibly by the end of Q2 or in Q3 2010. The OTS indicated it was willing to allow the company to pay a $0.01/share dividend this quarter but management and the board are confident the OTS will allow them to pay the full $0.085/share dividend next quarter. When the OTS approves the company's ability to issue dividends, management and the board are looking at possibly doing a special dividend to reflect past dividends that weren't paid.

Significant reductions in non-performing assets. Management expects to be able to cut its non-performing loans in half by the end of the year. If it is successful in doing so, then the bank will look to gain regulator approval to resume share repurchase activity.

Risks

FFNW poked its nose at its regulators in Q4 2009 by buying back 1.2MM shares when the regulators had asked banks in the Seattle area to conserve capital. In response, FFNW has been subject to a more stringent examination resulting in more of its current loans being forced into the non performing category.  In April, FFNW entered into an informal supervisory agreement with the OTS which requires the company to obtain OTS approval prior to declaring a dividend or buying back stock. The company is also required by the FDIC to obtain written non-objection before growing assets more than 5%, changing funding mix or declaring or paying dividends. The company expects to enter a formal written enforcement order with the FDIC to develop and implement plans to reduce construction/land development loans, improve credit quality and improve profitability within a specified time frame.

It bodes repeating that we think management is very high quality, especially for a company of this size.  We recommend interested investor reach out to CEO Victor Karpiak and head of Strategic Development Scott Gaspard, both of whom are happy to walk through the story.

Victor Karpiak: 425.255.4400

Scott Gaspard: 425.254.2002

Catalyst