Flagstar Bancorp, Inc. provides a range of banking services to consumers and small businesses. As of December 2004, Flagstar operated over 100 bank branches in Michigan and Indiana, 131 home loan centers located in 26 states, and correspondent lending offices located across the country. The Bank offers a line of consumer and business financial products and services to individuals, and small and middle market businesses. It also offers its customers 24-hour telephone and Internet banking services. It offers various consumer and business deposit products, as well as various value-added, fee-based banking services Flagstar conducts the wholesale portion of its home lending operation through a network of correspondent lenders consisting of banks, thrifts, mortgage companies, and mortgage brokers. Flagstar was founded in 1993 and is headquartered in Troy, Michigan.
Inveestment Thesis and Valuation
Although the company has averaged well in excess of 30% ROE over the last several years, this thrift trades at a significant discount to its peers, based on several concerns, which I think are overstated.
The company has built up its business as a mortgage originator. The company’s earnings peaked at $3.99 EPS as a result of the big refinancing boom in 2003. Of this $3.99, roughly $2.99 of the earnings was generated from the mortgage banking side while only $1.00 was generated from the retail banking side. Seeing the end of the mortgage refinance boom, the company began cutting its mortgage banking staff significantly in 2003 (well ahead of other banks such as Washington Mutual) and focused on growing the retail banking side.
As a result, the company should generate about $1.40 of its earnings from the retail banking side in 2004, and close to $1.55-$1.60 in 2005, driven by new branch growth. In fact, management indicated that these earnings numbers for retail banking are depressed due to the fact that 1/3 of all branches are unprofitable because they are new. If they stopped growing new branches, normalized earnings from retail would be over $2.00 per share on the existing branches. In addition, the company should generates roughly $1.00 per share from the mortgage bank in both 2004 and 2005. Overall, the company believes it will generate ROE in excess of 20% going forward.
When you buy Flagstar Corp, you are buying the retail bank for fairly reasonable multiple (16x 2004 and 14x 2005) and you are getting the mortgage bank for free. Giving the retail bank a 14x forward multiple, and the mortgage bank a 6x forward multiple, I arrive at an intrinsic value of about $29.00 vs. the current price of $22.70.
Looking at it another way, let’s give no recurring value to the mortgage business, but simply mark up the servicing assets to market value, while giving the retail bank a 14x multiple
Retail Bank: $1.60EPS*14=$22.40
Servicing Assets (Difference between market and book) $1.00
Total value: $22.40+$1.00=$23.40
Current Price: $22.70
Therefore, even if we give no recurring value to the mortgage business, the company is trading at slightly below intrinsic value.
The company currently has an expected 2004 tangible book value per share of about $12.25. Adjusting the book value per share up by $1.00 to mark to market the servicing assets, the adjusted book value of almost $13.25 reflects a fairly cheap price to book of 1.7x. Additionally, the company is growing its book value at over 10% per year ($2.50 of earnings less $1.00 of dividend)
To the extent that interest rates increase and the mortgage business is adversely affected, you have paid a reasonably fair price for the retail banking. To the extent that interest rates stabilize or actually fall, you get a huge benefit from the mortgage business that generates earnings well above what the company is currently forecasting (Note that the $0.85-$1.25 of earnings from the mortgage business assumes a 10 year treasury of 4.5%-5.25%, while the current 10 year treasury is at 4.22%). When you buy Flagstar, you are getting a retail banking company with a mortgage multiple.
While waiting for this transition to occur, you get paid a $1.00 dividend (4.41% dividend yield). Additionally, although management thinks that a buyout in the near term is unlikely, there is always the possibility that they get acquired at some point at a substantial premium to the current stock price (comparable multiples would lead to a buy out price of between $25-$46,)
The Hammond family owns 35% of the stock, including 20% owned by Chairman Thomas Hammond as well as 8% owned by son and CEO Mark Hammond. Throughout 2003, the Chairman and CEO had been selling stock when the stock price had approached $30 and have since stopped selling and instead monetized his holdings by initiating a very healthy dividend. The Chairman had indicated that he would not sell any stock below $23.
Management hinted that they might consider selling the company in the $30’s, but will unlikely sell until the retail bank has matured, as a good portion of the deposits are wholesale and therefore are not considered to have any franchise value. Management hinted that the company might get sold when it has enough retail branches to develop a deposit franchise.
Most importantly, management is focused on ROE rather than on growth for growth’s sake. In many of the conference calls, the Chairman indicated that he will not originate loans that cannot be sold for a decent profit and will not sell MSR’s unless he gets the right price. He also indicated that for the right price he would sell as much MSR’s as possible for a good profit now even if it would hurt future earnings later. The focus is on maximizing economic return rather than generating smooth quarterly earnings or revenue growth
The Bear Case
What is the bearish case?
First, bearish investors consider this company to be primarily a mortgage originator. As indicated in my valuation analysis, this does not appear to be the case. Second, bearish investors believe that the company has been propping up earnings by selling MSR’s for big gains, which will adversely affect future earnings. As mentioned before, the choice to retain or sell MSR’s is based on maximizing return rather than maximizing future earnings. In fact, the company made out very well by selling MSR’s at 4.5x the annual servicing income.
Also, there is some legitimate concern that the flattening yield curve will drive down retail banking spreads, while the company struggles with heavy competition driving down the mortgage banking business, despite relatively low interest rates.
Finally, the company has benefited from low loan losses. If we are currently in a housing bubble, a sharp decline in housing values would negatively impact them.
Continued transition to retail bank
Get paid 4-5% dividend as we wait