Hudson City Bancorp HCBK S
February 01, 2007 - 1:50pm EST by
skyhawk887
2007 2008
Price: 13.59 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 7,600 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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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:

 

 

 

Q4/06

 

 

 

Q3/06

 

 

 

Q4/05

 

 

Average

Interest

Yield/

 

Average

Interest

Yield/

 

Average

Interest

Yield/

Assets:

Balance $M

$M

Cost %

 

Balance $M

$M

Cost %

 

Balance $M

$M

Cost %

First mortgage loans

18,066.1

253.5

5.61

 

17,355.1

246.2

5.68

 

13,878.4

189.2

5.45

Consumer and other loans

418.8

6.9

6.57

 

341.9

5.4

6.35

 

220.2

3.2

5.86

Federal funds sold

224.9

3.0

5.27

 

166.4

2.2

5.30

 

219.8

2.2

3.96

Mortgage-backed securities

8,887.8

110.2

4.96

 

8,257.0

99.6

4.83

 

6,835.7

75.9

4.44

FHLB New York stock

423.5

6.2

5.81

 

388.9

4.6

4.77

 

194.7

2.4

4.85

Investment securities

5,915.7

69.3

5.68

 

5,675.5

63.9

4.50

 

5,541.9

59.4

4.29

Total interest-earning assets

33,936.8

449.0

5.29

 

32,184.8

422.0

5.25

 

26,890.7

332.3

4.94

Non-interest earning assets

579.2

 

 

 

458.1

 

 

 

314.6

 

 

Total assets

34,516.0

 

 

 

32,642.9

 

 

 

27,205.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and  equity:

 

 

 

 

 

 

 

 

 

 

 

Savings

811.3

2.0

0.99

 

809.3

2.0

0.98

 

823.2

2.1

0.99

Interest bearing checking

2,174.6

17.8

3.25

 

2,468.0

20.7

3.32

 

3,800.4

29.3

3.06

Money market accounts

878.0

7.6

3.45

 

805.1

6.6

3.25

 

363.2

1.1

1.19

Non-interest-bearing demand

484.1

0.0

0.00

 

466.9

0.0

0.00

 

442.6

0.0

0.00

Total core deposits

4,348.0

27.5

2.53

 

4,549.3

29.3

2.58

 

5,429.4

32.5

2.39

Time deposits

8,763.6

104.9

4.16

 

7,742.8

86.7

4.44

 

5,973.7

51.0

3.39

Repurchase agreements

8,589.8

86.2

3.98

 

8,250.5

79.9

3.84

 

7,413.0

67.1

3.59

FHLB New York borrowings

7,619.8

81.5

4.24

 

6,901.2

73.2

4.21

 

2,954.6

29.3

3.94

Total funding

29,321.3

300.1

4.09

 

27,443.9

268.9

3.92

 

21,770.7

179.8

3.30

Other non-interest liabilities

205.0

 

 

 

207.7

 

 

 

164.1

 

 

Stockholders’ equity

4,989.7

 

 

 

4,991.3

 

 

 

5,270.5

 

 

Total liabilities and equity

34,516.0

 

 

 

32,642.9

 

 

 

27,205.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest spread

 

 

1.16

 

 

 

1.33

 

 

 

1.59

Net interest/net int. margin

 

148.8

1.78

 

 

153.1

1.93

 

 

152.4

2.29

 

Net interest income makes up 99% of HCBK’s revenue, so pretty much nothing else is needed other than the above table to understand HCBK’s revenue outlook. What should first be obvious is that despite adding $7.3B in assets over the past year, HCBK’s net interest revenue has declined by $3.6M to $148.8M (see the bottom line in the table; and if you look at the income statement you’ll note that operating expenses have risen by $8M, a disturbing trend to say the least). The $4.3M drop from Q3/06 should be even more disconcerting. The most important information from the table regarding future revenue trends, however, is the rate HCBK is currently paying on its $16.2B of borrowings (representing over 50% of total funding), specifically the $7.6B in Federal Home Loan Bank (FHLB) borrowings at 4.24% and the $8.6B in repo borrowings at an incredible 3.98%. With Fed funds at 5.25% and the 5- and 10-yr. U.S. Treasury near 4.8%, the ability of HCBK to maintain these low rates is highly unlikely. In the table below (taken from page 41 of the Q3/06 10-Q), you will note that $10.5B of the total $15.6B in borrowings have maturities of five or more years, which would probably have everyone feeling pretty good because it means they have managed to lock in such low rates for such a long time. However, this is misleading because the table merely reflects the maturity of the borrowings. It does not reflect the callability of the borrowings, almost all of which come with one-, three-, or five-year non-call agreements. This means that, given how far below market the rates currently are, the effective maturities are much shorter than the 5+ years the table would imply. This intuitively makes sense: it is highly unlikely that HCBK, which has added much of its borrowings in the last year or two, managed to lock in long term funding at rates 50-100 basis points below what the Federal government pays. (HCBK does not disclose much information on the non-call agreements in its 10-Qs; management has suggested its 10-K will include more disclosure on this topic, not that I have read one sell-side report that is actually interested in this matter.) As these borrowings normalize over the next 1-3 years to something nearer 4.5%, HCBK’s net interest revenue will fall by $15M per quarter and EPS will fall by $0.02 per quarter, a major hit to the current quarterly EPS of $0.13.

 

Maturity Schedule at 9-30-06

Six months

Six months

One year to

Two yrs to

Three years

More than

 

 

or less

to one year

two years

three years

to five years

five years

     Total

Interest-earning assets:

 

 

 

 

 

 

 

First mortgage loans

1,285,919

1,301,621

2,262,342

2,071,470

3,011,162

7,936,470

17,868,984

Consumer and other loans

93,956

1,308

48,499

3,462

18,444

241,863

407,532

Federal funds sold

146275

146,275

Mortgage-backed securities

1,276,755

1,565,765

1,399,013

938,818

3,028,084

240,555

8,448,990

FHLB stock

412381

412,381

Investment securities

1,129,598

1,071,258

474,299

995,570

1,552,667

437,758

5,661,150

Total interest-earning assets

4,344,884

3,939,952

4,184,153

4,009,320

7,610,357

8,856,646

32,945,312

 

 

 

 

 

 

 

 

Interest-bearing liabilities:

 

 

 

 

 

 

 

Savings accounts

47,988

41,815

41,222

41,222

82,444

577,110

831,801

Interest-bearing demand  accts

216,490

216,491

334,826

334,826

563,426

619,938

2,285,997

Money market accounts

21,264

21,264

85,055

85,055

170,111

467,804

850,553

Time deposits

5,691,607

1,745,303

584,360

189,211

141,287

8,351,768

Borrowed funds

3,232,000

1,275,000

16,000

600,000

10,525,000

15,648,000

Total interest-bearing liabilities

9,209,349

3,299,873

1,061,463

650,314

1,557,268

12,189,852

27,968,119

 

 

 

 

 

 

 

 

Interest rate sensitivity gap

-4,864,465

640,079

3,122,690

3,359,006

6,053,089

-3,333,206

4,977,193

Cumulative interest rate gap

-4,864,465

-4,224,386

-1,101,696

2,257,310

8,310,399

4,977,193

 

 

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:

 

 

Market

# of

Mkt Cap/

# of

Mkt Cap/

Core Deposits

Mkt Cap/

Bank

Cap ($M)

Branches

Branch

Employees

Employee

($M)

Core Deposits

Sovereign Bancorp

11,700

800

14.6

12,000

1.0

36,321

0.32

BankNorth

7,400

600

12.3

7,500

1.0

19,230

0.38

Astoria Financial

2,900

86

33.7

1626

1.8

4,442

0.65

Webster Financial

2,800

177

15.8

3200

0.9

7,154

0.39

Valley National

2,900

168

17.3

2433

1.2

5,558

0.52

Commerce Bancorp

6,300

428

14.7

11500

0.5

40,077

0.16

Median

4,600

303

15.3

5,350

1.0

13,192

0.39

Hudson City

7,600

111

68.5

1250

6.1

4,384

1.73

 
If someone were to acquire HCBK, it would pay an average of $69M per branch, or roughly 4.5 times as much as peers, $6.1M per employee (6 times as much) and $1.73 for ever $1 dollar of core deposits (over 4 times as much). Investors and would-be acquirors need to ask themselves what they are really getting. For its price, HCBK clearly has the worst operating franchise of any large-cap bank in the country, by a long shot.

 

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 7th, 2005, HCBK completed its 2nd 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 2nd 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.

 

Catalyst

Just reported first earnings miss on margin compression; Continued repricing of borrowings; Hawkish comments from the Fed; Possible Fed rate increase given strong GDP report; Falling EPS estimates
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