Description
HFBL trades at 10.03 per share. It could dividend out $16 and still be considered a well capitalized bank. In other words, you are paying $14.2mm to control $30mm in tangible equity. Also, management has recently shown intent to return capital to shareholders. It is one the cheapest publicly traded Mutual Holding Company (MHC) in America.
The quick numbers for people who scan:
Price: $10.03 Minority share percentage: 40%
Fully diluted price to tangible book: 73% (using 88% net 2nd step proceeds)
Excess tangible capital as a % of minority market cap: 160% (using 8% required capital)
Total Assets: $113mm
Deposits: $72mm
Cash: $12mm
Tangible book as a % of assets: 27%
Non-performing assets: None
Projected tangible book value after second step (assuming net proceeds): $49mm
Market cap of minority shares at 90% of fully converted tang. Book: $20.6mm
Market cap of minority shares at 100% of fully converted tang. Book: $25.6mm
Current market cap: $14.2mm
In order to understand what you are purchasing when buying HFBL, you need to understand what an MHC is and what it means to shareholders. Let me start by saying that Bloomberg or Yahoo will be little help looking at MHCs. I suggest using a broker that specifically deals in MHC stocks and even then, they don’t all understand the implications of the structure.
MHCs are a particular type of thrift and the MHC structure has become a preferred method of converting from a mutual thrift to a publicly owned thrift. The basics of an MHC is that a holding company is formed that acquires the mutual thrift (in this case the holding company is Home Federal Bankcorp, Inc. of Louisiana and the thrift is Home Federal Savings and Loan Association). Then, a majority of the holding company stock is transferred to a Mutual Holding Company (in this case Home Federal Mutual Holding Company of Louisiana). The remaining shares of stock in the holding company are sold to the public. The MHC does not pay for its shares, only the public shareholders commit money. This is all called the first step or stage conversion.
After the first step conversion, the minority shareholders effectively have 100% of the economic interest in the thrift but only a minority voting interest. By this I mean that until the MHC pays for its shares in the thrift, it typically will not share in any dividends or take-out payments. This has profound implications for the holders of what I call the minority stock (the initial public shareholders).
After the first step, the thrift must wait at least three years to second step or sell itself. Selling MHCs is a tricky business because the Office of Thrift Services (OTS) doesn’t like the fact that a fair takeover premium can result in a 200-400% premium to the stock price. My understanding is that they believe (probably rightly so) that the benefit of a take over should be shared by all owners of the thrift which includes the MHC shareholders (who prior to a second step are the depositors).
The second step. The second step is when the MHC shares are paid for. This is done in a fairly convoluted way with share splits or ratios so that the offering price will equal $10, but the basics are that there is a secondary offering of shares, after which the MHC dissolves and the thrift is a standard one. During the process the right to purchase the MHC shares lies with the depositors first, then other investors may take part if there are shares left over. The important thing about the second step is that it is typically priced at a particular price to tangible book. By looking at what price second step transactions have occurred at, we can compare the current price assuming a second step. This will give us the potential appreciation (or lack thereof) of the current minority shares.
What are typical second step prices? According to Thrift Investor, the median pro forma second stage conversion price from 1995-2004 was 87.5%. This didn’t include a post-IPO pop of 7.5% which implies that the actual conversion price when trading commenced was in the low-90% range. The lowest year was 1999 when the median price was 74.4% before the IPO pop. The stock of standard thrifts that have been public for a long time can reasonably trade significantly above these figures. Conversions do not because the moment they convert they receive a huge infusion of cash that isn’t worth any more that the value it is.
What would happen to HFBL if it second stepped right now? While they can’t for another couple of years, this helps provide additional valuation information. I will use proceeds rather than conversion ratios as I find them confusing. The common way to put numbers on a second step is to discount the expected proceeds to account for offering costs and the dilutive effects of management stock packages and options. A typical figure is that these costs represent 12% of the offering proceeds.
Using 88% in net proceeds, HFBL would raise an additional $19mm. With the $30mm in current tangible equity, this would result in $49mm in tangible equity (of which $31mm would be in cash: $12mm current, $19mm proceeds). This is arguably worth close to tangible book as it’s just cash, let’s say 90%.
$49mm tangible equity
$44mm (at 90%)
$17.6mm (the minority share’s 40% stake)
$14.6mm current market cap
This gets a 24% upside from today’s price probably occurring 3-4 years from now.
At tangible book there is about a 37% upside from today’s price.
24% price appreciation in 4 years is 5.5% per year, plus 6.5% earnings yield gets you to 12% annualized return. I think this represents a floor for the valuation as it does not include any return of capital to the shareholders and would leave the thrift ridiculously capitalized with $130mm in assets and $51mm in equity.
The law firm of Luse Gorman cites four reasons why MHCs are attractive to mutual banks: “Control – MHCs preserve the mutual ownership and control of a savings bank.
Better Capital Management – MHCs raise less than half the capital of a standard conversion. This reduces the pressure to reinvest new capital quickly and produces a better return on equity.
Dividends – MHCs can pay attractive and sustained dividends to stockholders, and federal MHCs are permitted to waive their receipt of dividends.
Stock Benefits – MHCs offer the same stock benefits of fully converted stock holding companies without risking a loss of control.” (http://www.luselaw.com/get/?id=23, Page 1)
I would like to go over these points from the point of view of the investor. As for Control, management is wholly entrenched in an MHC.
The MHC shares have voting rights and management controls their right to vote. Since an MHC must hold more than 50% of the outstanding shares of a company, management by definition has the majority vote. I think that the main result of this entrenchment is that it ruins the investment potential of many MHCs that are attractively valued, but who’s management cannot be counted on to effectively deploy capital or return it to shareholders. It is imperative that management demonstrate some shareholder friendly traits in order for MHC investments to work or shine.
Better capital management: I agree with this. Even with a partial conversion MHCs can end up with 20-30% tangible capital to assets. Any amount over 8% or so (assuming adequate reserves) is excessive and does little but dilute the RoE. The best thing an MHC can to when it converts is pay dividends, buy back stock, or invest in the business. I prefer when they do the first two. HFBL has declared its intent to purchase 10% of the minority shares outstanding. It has also declared and subsequently raised its dividend. I can only hope for more of the same.
Dividends: This is a VERY interesting point. Because the MHC shares contributed no capital for their shares, they typically don’t receive dividend proceeds. What this means is that MHCs can sustain distributions of more than all of their fully diluted earnings per share. This is because while the earnings in this case use 3.6mm shares, they only have to pay dividends on 1.4mm shares. (Soon to be 1.25mm shares.)
HFBL has $30mm in tangible equity. It could distribute out $22mm of that equity and still maintain over an 8% tangible equity to asset ratio. Since HFBL does not need to pay dividends to the MHC shares, this would equate to $16 per minority share in dividends. While it CAN do this, the question remains whether they WILL do this. I hope they will and I believe they have shown an inclination to act in a way that beneficial to the minority shareholders. They have shown this by declaring and then raising their dividend (granted the amount is still small at $.06 per quarter). More importantly they have also committed to purchase up to 1.4mm shares of stock. At the current market prices this is $1.42mm and represents a meaningful step toward reducing some of the excess capital.
Stock benefits: see control.
Other bank issues:
Earnings: I think the way to look at an MHC’s income is to divide the income by only the minority shares outstanding because those are the only shares that receive dividends. This gives you about $.66 in trailing earnings or about a 15x multiple. Nothing spectacular, but also not terrible.
Reserves and non-performing assets (NPA): HFBL is in northern Louisiana and so it looks like they missed the severe effects of hurricane Katrina. As of 9/30/05 they had 0.0% NPAs and no charge offs. Their reserves are 1% of loans outstanding. This is higher than some other thrifts but seems reasonable given the economically depressed are HFBL operates in.
RoA and RoE: RoE stinks and it will continue to stink as long as there is so much excess capital. RoA was decent back before the first step at 1% in 2003 and .86% in 2004. However, the bank doesn’t need to be great or even good in order for this investment to do well.
Management: I have spoken with management and beyond their publicly stated intention to buyback stock I have no additional read or insight into what they will do. However they have purchased meaningful amounts of stock personally and I hope they work hard to get themselves rich as this would enrich shareholders as well.
Conclusion:
HFBL represents a $22mm pile of cash and a bank worth about $8mm (tangible equity, 8.5x trailing earnings unadjusted for change in capital) that can be purchased for $14.5mm. Management’s plan to buyback stock and the increase in dividend implies that they are trying to get the pile of cash into shareholders hands
Catalyst
Current buyback of 10% of minority shares.