Description
Hudson City Bancorp Inc. (HCBK)
Overview
Hudson City Bancorp Inc. (HCBK) is a NJ-based $26.5 billion thrift that recently completed a “second step” offering raising $3.8 billion. Since the company’s IPO in 1999, HCBK’s highly competent, owner-oriented management have done a fantastic job of growing its asset base and allocating its equity capital. Share repurchases (over 20% of shares outstanding since the IPO) has played a pivotal role in capital allocation. As a result, the stock increased from a split adjusted $2 per share to its recent $11.70 which, including dividends, has resulted in a 35%+ IRR since 1999.
With the additional capital recently raised (at $10/share), you get the opportunity to benefit from management doing it all over again. If management is able to deploy its capital in a reasonably similar fashion (not a long shot given their consistent operating history and strategy) the ROE should be able to grow to the 12% range in 4 years (it was 17% in 2004 prior to raising additional equity capital). This should result in a mid-$20s price target in 4 years (a 20%+ IRR including projected dividends) with little downside given their low current valuation (1.31x TBV).
Business
Hudson City is a classic thrift. They take in deposits and make residential first mortgage loans and consumer loans as well as purchase mortgage securities. They don’t do business loans or commercial multi-family mortgages. They retain the portfolio of loans that they originate and purchase.
Where the business excels is in how it goes to market and how it operates. Firstly, the company targets only higher and middle income areas in its core geography, principally New Jersey, which has the highest household income in the nation ($61.8k vs. $46.5k for the whole country).
Secondly, they are a low cost provider and they pass the savings on to customers in the form of more enticing deposit yields and lower mortgage rates. Sam Walton would be proud. Their efficiency ratio (bank operating expenses divided by fee and interest income) is among the best in the nation (~23%). Management generally chooses lesser branch locations in strip malls with strong anchor tenants, mostly without drive-through windows, staffed moderately with highly service oriented, long-term employees. The consistent service and higher deposit yields draw in the customers. With HCBK you won’t find the current trend of “bank a la Starbucks” that you are finding with many money center bank branches today (e.g. flat panel televisions, high end furniture and coffee bars). You know management is committed to expense control when their core Values Statement found in their annual report compares their tight expense control philosophy as the difference between “a crash diet and embracing a new way of life”. This is no crash diet.
Thirdly, they don’t vary from their core products. Again, back to the Values Statement: “Why spend money on the expensive lessons of diversification when we can pass those savings on to our customers?” Management sticks primarily to the jumbo loan market, which reflects the more affluent markets they serve. About 50% of the portfolio loans are purchased on a wholesale basis including areas other than NJ. They don’t write sub prime or commercial mortgages.
Fourthly, they preserve capital by avoiding credit risk. They require Loan to Value ratios south of 60%. Charge-offs was a net recovery for non-performing loans in the first nine months of 2005. Non-performing assets are .11% of total loans and OREO. These metrics put them near the top of the largest banks and thrifts.
Management has put forth an excellent strategy, they have executed it unswervingly and the market has rewarded them for it.
Operating Metrics
Year Assets Equity Loans Eff. Non-Perf
Ratio Assets ROA ROE BV/ Div Shr P/O
1999 $8,519 $1,479 $4,275 28% 0.17% 1.3% 9.00% $1.99 28%
2000 $9,380 $1,465 $4,841 31% 0.14% 1.3% 7.80% $2.04 35%
2001 $11,427 $1,289 $5,932 28% 0.14% 1.3% 9.80% $2.03 38%
2002 $14,145 $1,316 $6,932 24% 0.15% 1.5% 14.70% $2.14 34%
2003 $17,033 $1,329 $8,766 24% 0.12% 1.3% 15.70% $2.18 46%
2004 $20,146 $1,403 $11,328 24% 0.11% 1.3% 17.50% $2.35 53%
Q1-3'05 $26,552 $5,289 $13,787 23% 0.11% 1.1% 8.60% $8.85 54%
These operating metrics speak for themselves. The company has been run for the benefit of shareholders by returning capital via increasing dividends and buybacks while growing the asset base profitably. ROE pre-offering grew to 17.5% as a result.
The company has grown without being sloppy. Returns on assets have been maintained at 1.3% or better, non-performing assets have come down as a percentage of total assets to an exemplary 11 basis points. Their efficiency ratio has declined to an extremely competitive 23% in the third quarter as assets have grown while they kept their costs down. Though I don’t expect the numbers to be this attractive going forward due to a more challenging economy, a flatter yield curve and a bigger capital base, I think these numbers indicate what management is capable of achieving.
Management
Management has distinguished itself with their remarkable shareholder orientation. The dividend growth rate over the past five years has compounded 93.67% since the IPO in 1999. The payout ratio has grown to be in the mid 50%+ range and growing. Likewise, management has bought back shares consistently over that same time frame. Over 158 MM shares have been repurchased over five repurchase programs. This amounted to about 20% of shares outstanding.
The OTA, the governing body for banks and thrifts, limits buybacks after second steps for one year, but the bank petitioned to buy stock back before the one year anniversary and won. In their Q3’05 earnings release they announced their sixth buyback program for 29.9MM shares (5% of shares outstanding). Buybacks have been key to their philosophy since the IPO and will continue with this incremental capital. One quote that summarizes this share-holder friendly philosophy came at a recent Lehman banking conference. Regarding their past repurchase programs, CEO Ronald Hermance, Jr. said, “It’s why many of you don’t know us. We haven’t gone to a lot of conferences. In the First Step (IPO), it didn’t pay to attract your attention as it does today. In other words, buying back stock was so accretive, we didn’t need to have more competition for the same shares. That is what got us here today.” Now that they have a much bigger float and equity base they are making themselves more accessible.
Incidentally, management and directors bought 1.5MM shares in the second step offering and has created a 4% ESOP coinciding with their latest stock offering-—both of which I take to be further evidence of their alignment of interests with shareholders.
Growth Plan
As a value investor, any time you hear that the strategic plan is “more of the same” it is generally not an investment that would be cheap enough. Thanks to the second step capital infusion (as well as their excellent operating philosophy and current low price-to-book), I consider this to be a blessing.
The growth plan consists of growing market share, growing the foot print beyond NJ and growing the ARM business in response to current trends—all within the framework that has brought them their initial success (keep expenses down, hand it back to customers in the form of lower mortgage rates and higher deposit yields and keep the product offering simple). Additionally, this new capital does not have an obligation on the other side of the balance sheet (i.e. it isn’t debt) as it would be for competitors giving management the ability to pay more on deposits and offer lower rates on mortgages—a distinct advantage.
They have about 5% market share in NJ giving HCBK growing potential in their core market. In addition, the company recently opened branches in Eastern Long Island and Staten Island, NY in areas with similar demographics. Early results in the new area branches are encouraging. Management sees expansion potential in eastern parts of NJ, eastern Pennsylvania and the metro-New York city area excluding New York City itself (which they do not intend to enter given the associated cost and competition).
Valuation
Over the next several years, HCBK will go from its current position of being over capitalized (20% Common Equity to Assets) to being appropriately capitalized (12% CE/A) as it deploys the capital, dividends cash back to shareholders and repurchases its shares.
Management has consistently bought back around 3.5% of shares outstanding through a combination of operating earnings and debt. In addition, the dividend payout ratio should be around 52% in ’06 and growing. Given the capital base and management’s predisposition to return capital to shareholders as evidenced by their recently announced Q3’05 5% repurchase program, neither assumption is a stretch.
Management should be able to grow assets at 10-15% per year given their growth plan described above and the new capital. This seems reasonable compared to the 19% CAGR achieved over the last 5 years. These factors of reducing equity via dividends and buybacks while growing assets will likely achieve a ratio of common equity / assets of roughly 12% in 4 years. As a frame of reference, management shrank the equity to assets ratio to under 7% just before the second step from over 16% after their IPO (6 years).
Below is a reasonable four-year scenario where the company is able to grow assets by 13%, while repurchasing 4% of shares outstanding per year and growing the dividend payout ratio to 56% by 2009. This would result in a book value of $10.45 per share in four years and an ROE almost 12%. Using market multiples of 2x to 2.5x tangible book value, a reasonable multiple for higher ROE banks, creates a price target of between $20.90 and $26.13. You could argue that a larger multiple should be used on the high end of the range given the quality of management and the franchise (it has traded as high as 5.5x). North Fork Bancorp (NFB) is a decent comparable which currently trades at 4x TBV versus HCBK’s 1.3x. In addition, under this scenario you will collect $2.06 in dividends over the four years. Taking the midpoint price target versus HCBK’s recent price of 11.76 would achieve an IRR of 22% over 4 years. Obviously, the timing of these results is subject to execution, competition and the yield curve environment thus these results could be achieved faster or slower than predicted below affecting the predicted IRR.
Year Equity ROE Assets Eq/ EPS Div Div/ BV/
Asts P/O Shr S/O Shr
2006 $5,200 7.4% $29,813 17% $0.70 52% $0.37 547 $9.50
2007 $5,125 8.7% $33,539 15% $0.84 53% $0.45 525 $9.76
2008 $5,077 10.1% $37,731 13% $1.02 54% $0.55 504 $10.07
2009 $5,060 11.9% $42,448 12% $1.24 56% $0.69 484 $10.45
Risks
1. Yield curve changes, particularly flattening or inverting: the whole goal is to borrow on the short end and lend on the long end of the curve. It is a lot harder to make money at if we have an inverted yield curve or spreads tighten and the yield curve flattens. Management mentioned at the Lehman conference that they have been through all cycles at this point including an inverted yield curve in 1999 when they went public. Looking at net interest margins, I would expect they will come down with a flat yield curve but management has done a good job managing the balance sheet over the last 6 years as a public company maximizing margins as the yield curve changed.
2. Execution: this risk has three pieces to it. Firstly, $3.8b of capital is now burning a hole in their pocket. As mentioned, past behavior indicates to me that they will allocate capital intelligently, but it is still a risk. Secondly, they are increasing the number of branches opened per year from under five to closer to fifteen. Poor site selection could hamper results or harm their efficiency ratio. Thirdly, it is different managing a bank with $40B in assets where they will presumably be in a few years versus the $26B today.
3. Potential to do a poor acquisition: The company has grown organically to date. Management has commented that they may do acquisitions now. I take some comfort that at the current price they have stated using stock as acquisition currency is not an option. This limits acquisitions to cash right now thus limiting their targets to smaller-sized banks. But things could change in the heat of competition and they could do a poor job of it given they haven’t relied on acquisitions in the past.
4. Mortgage origination slow down: as rates creep up or the economy dips again housing starts as well as people moving from their existing homes could decline. Competition for a smaller origination pool could heat up harming HCBK’s business. Then again, they will most likely be better capitalized than a lot of the competition with their second step proceeds. In addition, they already possess a superior efficiency ratio that will keep them competitive.
5. New product risk (ARMs versus fixed rates): though the company is staying away from one year arms, it is clear that adjustable rate product is what more and more cash strapped consumers want. Obviously this introduces the potential for balance sheet mismatches, a risk in and of itself. Furthermore, the company was pretty much a fixed rate product shop and now has had to change to compete thus moving away from a core competency. The 10Q as of Q2 reported that the ratio of fixed to adjustable mortgages was 86.3% compared to 92.5% at the end of 2004, which demonstrates how the mix is changing already.
6. Real estate bubble: If home prices crater, than the bank’s average loan to value of ~60% will be affected. Given the bank’s conservatism, this is a smaller risk. Obviously the New Jersey concentration is a potential problem (insert your favorite NJ joke here). Close to 60% of all loans are secured with NJ property so it is tied to the state economy to a large degree. In addition, since their main product is the jumbo loan, there is additional risk given their values tend to decrease more in downturns.
7. Competition: NJ and the prospective northeastern states HCBK is targeting are highly competitive. De Novo branch building is an escalating arms race right now with more expensive locations and higher end fixtures and services as well as expensive teaser products to build deposits. Not only is this the market they want to grow in, but they are taking a different tact than most everyone else.
Conclusion
HCBK is an extremely well run company and its run for the benefit of shareholders. An ideal combination. With this additional capital and its current low price to book, the market is waiting to see how well management does putting the capital to work--particularly in a potentially difficult interest rate environment. I believe management and the business model provide ample comfort that history will repeat itself and the shareholders of HCBK will be rewarded once again benefit.
Catalyst
1. Execution of management’s plan
2. More analysts coverage as management actively communicates its story
3. Stock buy backs and increasing dividends per share