Description

Hudson City Bancorp (HCBK) is one of the most over-valued large cap banks in the country. It trades at 26 times current earnings despite six quarters of no EPS growth and at 1.5 times tangible book value (which is declining because of buybacks) while only generating a 5-6% ROE that justifies something closer to 1.0 times. Not only is HCBK expensive, it is setting up for a major earnings disappointment within the next several quarters, as an analysis of their balance sheet (taken right from quarterly press release) indicates:

The other major red flag that pops out from the first table above is the sharp decline in core deposits, particularly the year over year decline in interest-bearing transaction accounts from $3.800B to $2.174B. Taken all together, core deposits (savings + interest-bearing transaction + money market + non-interest bearing transaction) fell from $5.4B to $4.3B, or down an impressive 20%. What makes this decline even more remarkable is that the numbers include the deposits from its July acquisition of Sound Federal, which added $250M in core deposits. Excluding this, core deposits would have declined 25%. (I can’t help but point out again that HCBK’s stock price is up 12% over the last year despite such terrible results.) And given that banks such as Commerce (CBH) continue to open branches in the tri-state area at a break-neck speed, it is highly unlikely the competitive environment will improve anytime soon. Tom Brown of www.bankstocks.com has a recent and insightful article looking at the craziness going on in the world of branch building. Tom’s study neglects to point out that much of the deposits have also shifted to less profitable cd’s. However, we still have some delusionally bullish analysts (i.e. Lehman Brothers) who are actually projecting 5-10% growth in core deposits despite recent evidence quite to the contrary.

What Is Hudson City Bancorp?

HCBK is covered by 20+ sell-side firms, so my description will try to highlight the bare bones nature of the franchise. Hudson City is an $8 billion market cap thrift/bank based in Paramus, New Jersey, not too far outside New York City. It has roughly 1250 employees and 111 branches, mostly in New Jersey, with a handful in New York and Connecticut. It has $35B in total assets, including $18B in traditional fixed rate or longer term hybrid residential mortgage loans and $15B in investment securities (i.e. bonds). On the other side of the balance sheet, it has $4.3B in core deposits, $9B in time deposits (cd’s), $16B in borrowings, and $5B in equity. To get a sense of how weak the Hudson City franchise is given its market cap, let’s look at a few peers:

When management or the sell-side boasts of its amazing “efficiency”, that is because the majority of the bank’s operations center around a handful of guys in a small room buying jumbo mortgages from third party brokers (from all across the entire Eastern United States) and funding them with Wall Street borrowings. Investors would be much better off thinking of Hudson City as an inefficient mortgage REIT that also lacks the beneficial tax structure. (For those unfamiliar with mortgage REITs, they are companies with around 10 professionals that raise capital (in a fashion similar to hedge funds) and then buy mortgage backed securities using roughly 20-to-1 leverage. Their interest rate spreads are currently around 30-50 basis points. The REIT, which is not taxed at the corporate level, is required to pay out all of its earnings as dividends. If you are a taxable investor, you will pay ordinary tax rates of 35%+ on these dividends, not the 15% rate associated with normal dividends. Many mortgage REITs trade near 1.0 times book.)

It is also key to understand that on June 7^th, 2005, HCBK completed its 2^nd step conversion from a mutual holding company (MHC) into a fully publicly traded bank 100% owned by shareholders. (The mutual nature of the previous structure meant that the deposit holders used to be the owners, just like at mutual life insurance companies where the policy holders are the owners.) These MHC conversions are esoteric and difficult to understand, even for people who specialize in financials, but the point is that HCBK is now a normal bank and there are no more “steps” to worry about. One of the effects of these conversions is that it raises a lot of equity for the company. After the 2^nd step, HCBK had 21% equity to assets vs. 6-8% for most normal banks and thrifts. So over the last year, in an effort to improve the ROE from a low 5%, HCBK has been buying back stock and using leverage to buy mortgages. Earning assets (which consists of mortgages plus bonds) rose from an average of $22.4B in Q2/05 to $33.9B for Q4/06. The increase was funded exclusively by borrowings and brokered time deposits. Tangible equity to assets was 13.5% at Q4/06; HCBK will probably try to bring this down to 9% over the next 1-2 years. It is interesting to note that despite the substantial increase in leverage over the past year, the ROE in Q4/06 was 5.6%, down slightly from 5.7% a year earlier. As a result of stock buybacks and an expensive acquisition, tangible book value per share has declined from $9.44 a year ago to $9.13 most recently, and that is despite retaining $0.22 of its $0.52 in trailing twelve month EPS (with $0.30 paid out in dividends).

Bernanke And The Fed

With the equity markets hitting records, unemployment at near all-time lows, strong jobs reports, an orderly downturn in housing, benign credit quality at most banks, a weak dollar, rate raising campaigns in much of the rest of the world, hawkish comments from vice chairman Donald Kohn, and most recently, the impressive 3.5% Q4 GDP growth, it is becoming increasingly unlikely the Fed will cut rates in 2007 or 2008. In fact, I think the odds have actually shifted in favor of one or two 25 basis point increases. Such an increase would likely send HCBK’s EPS another $0.02 lower per quarter. Yet HCBK is trading near an all-time high, as if 100 basis points of rate reduction are in the bag, and that quarterly EPS will soon approach $0.20. Of all the financial services companies I look at, there are very few whose operations would be more negatively affected by a rate increase.

Recent Results

Q4/06 results were terrible as HCBK reported EPS of $0.13, missing consensus by $0.01, their first real miss in years. Core deposits declined at a 20% annualized rate and the net interest margin slipped 12 bp (yet somehow the sell-side continues to be surprised) and is now down 51 basis points over the last year to 1.78%. Its already poor profitability continued to worsen, as ROE fell from 5.7% to 5.6% (despite a large increase in leverage) and its ROA fell from 1.10% to 0.80%. Tangible equity to assets was 13.5% vs. 18.5% a year ago and 14.5% in Q3/06. Looking forward, borrowings will continue to reprice upward, the tax rate will increase from 37% to 39% (unfavorable change in NJ tax code), and the competition continues to build branches which will cause HCBK to lose core deposits and force it to raise rates on the deposits it doesn’t lose. 

Valuation

As noted above, HCBK trades at 26 times current earnings despite six quarters of no EPS growth, and at 1.5 times tangible book value while only generating a 5-6% ROE that justifies something closer to 1.0 times.  It is also quite interesting to note that in the last six months, consensus EPS for 2007 has fallen 12% from $0.65 to $0.57, yet the stock has risen about 5% from its $13 trading range. With EPS and book value declining, I think HCBK can easily test $12 and possibly its post second-step low of just over $10. Ultimately, I am betting on the development of a much more negative 1990s-type psychology regarding banks and yield curve companies. HCBK’s recent results and poor outlook certainly justify it. And as one final note, any bank holding mutual company that undergoes a second step conversion is legally not allowed to sell for three years. We have at least another year and a half before HCBK can sell out.

If you’d like more background on this space, I have posted two other similar short recommendations on VIC—Astoria Financial (AF) posted this past summer and Brookline Bancorp (BRKL), posted two summers ago. Both have made money in a bull market and both are still over-valued.

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