Description

Importantly, Oritani raised ~$400mm in equity from a 2nd step thrift mutual conversion in late June (converting shares held by depositors into publicly traded shares), thereby increasing tangible book value from ~$250mm to $650mm. This was a transformational deal which triples the float of the company and provides a tremendous amount of capital for Oritani to aggressively pursue expansion opportunities.

Thrift Conversion Overview
Very simply speaking, a thrift conversion is a capital markets transaction whereby ownership transfers from depositors to new public shareholders. One can think of a thrift conversion as similar to an initial public offering, however unlike an IPO, new shareholders in thrift conversions have a claim on both the primary capital they contribute into the company, as well as the existing capital of the institution.

Several well-respected value investors have discussed thrift conversions as attractive investment opportunities: In his book, "Margin of Safety", Seth Klarman describes thrift conversions with the following "In a real sense, investors in a thrift conversion are buying their own money and getting the preexisting capital in the thrift for free." Peter Lynch, in his book "Beating the Street" describes thift conversions with the following "Imagine buying a house and then discovering that the former owners have cashed your check for the down payment and left the money in an envelope in a kitchen drawer, along with a note that reads: "Keep this, it belonged to you in the first place." You've got the house and it hasn't cost you a thing. Say your local thrift has $10 million in book value before it went public. Then it sold $10 million worth of stock in the offering - 1 million shares at $10 apiece. When this $10 million from the stock sale returns to the vault, the book value of this company has just doubled. A company with a $20 book value is now selling for $10 a share

Applying Lynch's logic to Oritani Financial is slightly more complicated, because Oritani completed its conversion in two steps, however the same basic framework still exists. In the case of ORIT, the thrift had $254mm of existing book value before the recently completed offering, which belonged to public holders from the first step (completed in Jan 2007). These first step holders had a claim on 26% of the pro forma equity. In the second step (completed June 24, 2010), an independent appraiser valued the remaining 74% of the company at $414mm, which was raised ~2/3 from existing depositors as well as ~1/3 through a syndicated offering to institutional investors. The valuation implied that the total company is worth $559mm, and the first step holders 26% equity stake is worth $145mm... however, the total book value of the company is $648mm ($254mm of existing book + $414mm raised less applicable deal fees and other expenses). Therefore, the second step holders investors were able to purchase the existing book value at a discount (They get a claim on $254mm of value for a $145mm price tag) For every $10 invested in the second step offering, investors received $11.60 of tangible book value... not quite as good as Peter Lynch's hypothetical example of $20 of value for $10 (which very well may have been reality back prior to the 1983 publishing of his book), but I will try to explain why, with the stock now trading below the $10 deal price for the second step, I believe Oritani is a very good value in today's market.

Investment Thesis
Oritani is a profitable banking institution, which as discussed, is trading below pro forma book value. The company has been growing book value and recently has been aggressively adding assets at attractive spreads. Unlike most banks, ORIT has maintained positive net income and EPS each quarter throughout the crisis. In the March quarter, Oritani achieved a 1% ROA, inclusive of an elevated level of provision expense, which was used to bolster reserves. Management has guided toward the provision declining in the near term as credit trends have stabilized. Also, unlike most banks, which are shrinking their balance sheets and shifting the composition of their balance sheet from loans into more liquid securities, Oritani has been rapidly growing its loan portfolio at the trough of the cycle. Loans outstanding are up 11% in last nine months. Historically, business written following a credit crisis tends to be highly attractive on a risk-adjusted basis over the long term. This makes intuitive sense too... as a bank you want to lend when others are not lending (less competition from banks and better terms from debtors). The margin has been expanding at a rapid pace. Oritani's net interest margin ("NIM"), or the spread between interest earning assets (loans and securities) and funding, has increased from 269bps at 3/31/09 to 329bps at 3/31/10 (excluding one-time items). This was due primarily to replacing lower yielding securities with higher yielding loans. The bank has benefitted from a less competitive lending environment amongst banks, and has been able to utilize their excess capital to put on assets at attractive spreads

Oritani has a significant amount of excess capital and has the ability to deploy capital efficiently and opportunistically. Oritani's tangible common equity to tangible assets (TCE/TA) was 12.4% as of 3/31 pre offering and with the recent offering, TCE/TA has increased to ~26%. Utilizing a conservative leverage ratio of 8% (in line with peer banks and well above regulatory thresholds for "well capitalized"), I estimate that Oritani has excess capital of ~$450mm. The company will be able to effectively deploy their capital either through organic loan originations, or potential FDIC-assisted transactions. FDIC acquisition opportunities are extremely attractive opportunities for acquiring banks, as acquirors generally buy banks in receivership from the FDIC, with the FDIC covering the large majority of future losses from the targets loan portfolio. These deals have been materially accretive for virtually every publicly-traded bank that has participated in one over the past 18-24 months. FDIC deals in ORIT's market may be limited, given the better relative financial strength of banks in their geographic region (versus more failed/failing banks in the troubled regions of FL, CA, NV, etc), however, some opportunities do exist in their market, with 7 banks singled out by research firm KBW as potential targets. Alternatively, ORIT could pursue an FDIC deposit acquisition opportunity outside of their footprint. One example of this is New York Community Bank's acquisition of the deposits of Ohio based AmTrust Bank in late 2009, which was viewed very favorably by the market. One of the great things about an FDIC deal for ORIT would be that given their size, even a small deal in the scope of the industry could have an immediate and significant positive impact for Oritani. However, even absent an FDIC-assisted deal, significant opportunities exist to deploy capital in high yielding Commercial Real Estate/Multi Family loans. Oritani historically targets loans with $9-15mm average sizes, however this conversion gives them flexibility to write larger business. Additionally, they benefit from a large and fast-growing geographic footprint (North NJ/NY) in which to write business. It is important to note that deploying large amounts of capital is not a new endeavor for Oritani. It was successful in deploying the proceeds from its 1st step offering without sacrificing asset quality, and has originated over $500mm of loans since 1/1/09 and has over $200mm of loans in pipeline ($376mm in 2009, $172mm in 2010 YTD through May, and $228mm pipeline) The addition of loans to the balance sheet has the potential to be meaningfully accretive to earnings, and is the building block for normalized earnings which are well above run rate earnings. I will outline this in more detail in the "Valuation" section below.

Oritani's underwriting has been proven conservative, as the bank has escaped the recent credit crisis relatively unscathed and credit metrics have steadily improved over the past nine months. In terms of credit quality, Oritani has one of the best Texas ratios of all US banks, at 15% at 3/31, pre-offering... falling to single digits post offering. I believe that the Texas ratio is the most important indicator of the level of financial strength of a bank. This measure looks at capital levels relative to potential embedded losses, and is defined as non-performing assets / (tangible equity capital + loan loss reserves). Generally speaking, a Texas ratio of <40% is viewed favorably by banking regulators, and some say is the key criteria for banks to be allowed to bid on lucrative FDIC-assisted transactions. In addition to having robust loss absorption capacity, recent historical credit trends have been highly encouraging. Non-performing assets ("NPAs"), one of the broadest measures of troubled assets at a bank, to total assets have declined from 2.7% at 6/30/09 to 2.0% at 3/31/10. Oritani is well reserved for loan losses embedded in their NPAs, with reserves at 1.7% of loans at 3/31, and it would not be inconceivable for reserves to be released on a go forward basis, as credit trends continue to improve. This would serve to further bolster capital levels and create additional capital to be deployed into higher yielding assets, thus further boosting earnings. The "loan portfolio detail" section within the Appendix of this report outlines each of the largest categories within the loan portfolio, and discusses the relevant underwriting factors which I believe are contributing to ORITs better than average credit quality.

Importantly, not only is the credit quality of Oritani's book better than peers, the absolute level of exposure of legacy assets are minimal relative to equity capital, which will provide a margin of safety if economic conditions worsen from here. Due to the large amount of capital raised in the 2nd step offering, loans to equity for Oritani is <3x, versus more than 10x for the average bank. This metric provides a similar insight as the Texas ratio, in that it shows that Oritani can withstand significant deterioration in their loan portfolio without a large magnifying effect on equity, relative to other banks. Also, it is important to note that this ratio does not include originations in 2009/2010, which are much safer vintages, as industry-wide underwriting criteria had been significantly tightened, and few banks were lending during that time. Because ORIT was growing loans aggressively during this period, 09/10 vintages represent a much larger % of loans than peer banks.

There is significant hidden asset value on Oritani's balance sheet in the form of long-standing real estate joint ventures, valued on the books at cost. The company has 18 real estate joint venture investments, primarily in multi-family. In these transactions, Oritani invests in the equity of the project 50/50 w/ longstanding lending partners. As part of the 2nd step conversion, Oritani hired an independent valuation firm to appraise its JVs and Real Estate Investments, which are held at cost. The market value in excess of book value is $50mm pre tax, or $0.50 per share of incremental book value.

Management interests are aligned w/ shareholders and management has a history of accretive share repurchases and creating value for shareholders. Since the demutualization in January of 2007, the company has bought back 4mm shares of stock out of 14mm total common shares, representing 29% of total shares in 3.5 years. Additionally, shares have been a steady performer, and have returned +40% since the 1st step conversion, versus a 24% decline in S&P 500 and a 47% decline in the bank index. Insiders of Oritani own $25mm, or over 4% of the company, and have the majority of their net worth invested in the company.

Unfavorable trading dynamics following the second step conversion as well as general skittishness on the part of investors with respect to financial institutions are presenting an attractive entry point for the stock. In the second step offering, institutional investors were limited to $8mm each maximum purchase limitation (this is common in thrift conversion deals). The deal was priced at $10.00 on June 24th, and since has broken deal price, trading at $9.70. It is my belief that because of the purchase limitations, the deal was highly fragmented, with a small amount of shares placed in the hands of a large amount of institutions. Given recent risk aversion/de-risking that has occurred recently in the market, many investors are hesitant to initiate new positions or add meaningfully to exposure, and investors looking to reduce exposure generally target non-core positions, and ORIT likely fits the bill for many investors (ie, a $2b hedge fund that bought the deal likley wouldn't think twice about selling the $8mm they received). I believe we are in the midst of a natural shareholder turnover process which is presenting an attractive entry point. Additionally, concerns about a double dip recession in housing and the economy, as well as uncertainty over financial regulatory reform have put pressure on financial stocks in general recently. I believe Oritani has been unfairly lumped into the broad category of a "Financial Stock", despite the low level of legacy loan exposure to equity and significant levels of excess capital to opportunistically deploy, which clearly delineates it from broader banking peers.

Valuation
Near term valuation is compelling with 35% upside in the next twelve months. ORIT has TBVPS of $11.60 (pf for offering and real estate JV value) and management has indicated that they will implement a dividend of $0.30 annually starting in June quarter. Recently completed second step conversions are trading at 110%-115% of pro forma tangible book. I believe the most appropriate thrift conversion comp for Oritani is Northwest Bancshares, Inc ("NWBI"). NWBI completed their 2nd step conversion in Q3 of 2009, and is trading at north of 115% of pro forma book value. From a fundamental perspective, ORIT and NWBI are very similar. Both have similar credit metrics and capital levels. NWBI has slightly better prospects for FDIC acquisitions (Pennsylvania market slightly more stressed than NJ), but ORIT operates in more attractive, higher growth geographies . NWBI is a larger bank than ORIT, with a $1.3b market cap. I believe there is a liquidity discount associated with ORIT that compresses over time, as the company executes on its business plan to deploy assets and institutional awareness grows for the name. The price target of $13.00 represents $11.60 of tangible book value x 1.1x + $0.30 NTM dividend, represents 35% upside from current levels.

Significant longer term value exists, as ORIT possesses an attractive standalone business in desirable geographic markets, with comps highly valued by market. ORIT's business model is similar to that of New York Community Bank ("NYB"), which has $6.60 of TBV and trades at 2.3x of tangible book value and 11x NTM earnings. NYB is multi-family and CRE lender in NY/NJ area, funded primarily with time deposits. Investors are attracted to dividend yield of 6.5%, and relative stability in credit costs over cycle. ORIT should be able to increase dividend yield toward that level over time as assets/ROE/Net income grows, and dividend payout ratio remains constant. The management team has proven to be very committed to return value to shareholders. Additionally, the market should begin to appreciate how well Oritani has managed through the credit cycle, and as credit metrics continue to stabilize/improve over the coming quarters, Oritani should see the multiple differential versus a bank like NYB contract.

Earnings power will reach $1.50 per share as excess capital deployed. ORIT raised a net $394mm in their 2nd step offering. In the short term (next 12 to 18 months), that capital can be deployed and levered with a 15% equity ratio, implying $2.625b of assets to be deployed.
**Yield On Assets: Conservatively, the yield on these assets should be in the range of 6%, as capital is deployed into lending on stabilized commercial real estate assets. As an example, in their most recent conference call, Boston Properties discussed secured refinancing of some of their office assets in "the high 5% range". Obviously, asset quality of the BXP portfolio (which owns such assets as the GM Building in Manhattan and the Prudential Center in Boston) sets this rate as a floor. With smaller loan size, and likely slightly lesser quality assets (but still good credits), I believe ORIT can negotiate higher rates and better terms with its debtors.
**Cost of Funds: The incremental cost of funds should be ~2.00%. Per Oritani's website, the average rates on a savings account, 1 year CD and 3 year CD are 0.75%, 1.00% and 2.25%, respectively. ORIT can raise locked in 3 year money at 2.25%, versus CRE loans that are generally originated in the industry as floating rate, thus gaining exposure to margin expansion if short term rates rise from here.
**Provisions: Management, on a recent conference call, provided guidance for provision expense. Their view is that provisions for new loan growth will be 1.25%, and they believe that provisions for existing loans are over (ie confirming that the existing book is adequately reserved)
**Opex: Operating expense should be 50bps on assets. Loan origination is a scale business with high incremental margins. This 50bps on assets translates into an incremental $13mm in operating expenses, which is 44% of the existing expense base of ORIT. The company has a strong history of controlling expenses, and I believe this assumption could be conservative.
**ROA: Summing all of this together, I believe the incremental after tax ROA on the capital to be deployed is ~1.35%. This is higher than the 1% ROA ORIT achieved in Q1, however Q1 included an elevated provision on their existing loan portfolio. Additionally, the new assets will benefit from the scale and existing infrastructure, which naturally means the returns should be higher.
The preceding analysis has been based on the deployment of capital over the next 12-18 months. In the longer term, ORIT should be able to decrease their leverage ratio to 8% equity to assets (more in line with peers). Using the same 1.35% ROA, this results in incremental EPS of $1.19, which added to existing run rate EPS of $0.30, arrives at a normalized EPS of ~$1.50. Applying an 11x multiple (same multiple as NYB), one arrives at a target price of $16.50. Discount this target back 2.5 years at a 10% rate, the present value target is $13.00. While in general I am wary of investing based on out year pro forma cash flows, I believe in this case, this analysis is helpful to sanity check the target price derived from the book value analysis shown above. Also, as an additional sanity check, the $1.50 in earnings equates to only a 12-13% ROE. The analysis above assumes that all of the capital raised is deployed into new loans. The more likely case is that a portion will be used for share repurchases as well. Recall the company has bought back 29% of the publicly traded shares post the first step offering. If we assume the company over time uses 30% of the net proceeds for share repurchases, at current prices this would be over 50c accretive to tangible book value per share, neutral to the normalized EPS analysis described above, and would reduce the burden of putting the capital to work in loans, allowing ORIT to be more selective with debtors, likely resulting in positive selection with respect to asset quality over time.

ORIT is a longer term takeover candidate. ORIT is a likely takeover candidate after 3 year moratorium for second step conversions; historically, investors begin to start to discount takeover potential into stocks two years into the three year moratorium. Kevin Lynch, CEO is 63 years old... historically, he is nearing the age when bank stock CEOs become much more likely to sell. While I dont have his analysis handy, Jason Goldberg, large cap bank analyst at Barclays Capital, has done some interesting work on this topic. According to KBW, median price-to-tbv multiple for conversions sold between 1996 and 2010 was 1.44x, peak multiple of 2.0x in 2006. Additionally, earlier this month, financier Wilbur Ross announced he was buying a stake in Sun Bancorp (Nasdaq: SNBC), a bank headquartered in Vineland, NJ with $3.5b in assets. Ross will use this bank as a platform to roll up banks in the New Jersey market. This transaction not only creates a logical intermediate term acquiror for Oritani, but also reinforces the validity the opportunity set in the NJ market for Oritani.

Downside protection: unlike most financials, a significant margin of safety exists with ORIT. Because loans prior to 2009/equity is so low, and TCE levels are so high (as described in the underwriting section above), company can withstand significant stress in loan portfolio with minimal impact to equity. At the current price, the market cap discount to tangible book value (excluding reserves) is over $100mm... to put this in perspective, the company has $41mm non-performing loans ("NPLs") at 3/31... this means that for this stock to be trading at 1.0x book value, NPLs would need to increase by a factor of 5, turn into defaults at a 100% frequency, and suffer a 50% severity. As described above, credit trends are going the opposite way, with metrics improving steadily over each of the past three quarters. I dislike using the word "draconian" to describe cases in financial models, but I do believe that word is apt in this case. Further, pro forma for capital raise, excess capital (using a conservative 8% TCE/TA) is $450mm... this means that for this stock to begin flirting with regulatory capital levels, NPLs would need to increase by a factor of 20, turn into defaults at a 100% frequency, and suffer a 50% severity. I don't even want to imagine what the world would look like under that scenario, as one could probably count on their left hand the number of solvent banks in the US at that point. Additionally, after a regulator-imposed 1 year moratorium on share repurchases post 2nd step, accretive share repurchases should provide margin of safety if stock remains at or below book value. Therefore, in terms of a realistic downside case, I firmly believe that it is difficult for this stock to trade meaningfully below book value ($11.60 currently, and growing) for an extended period of time, given the above. I believe that with a return potential of 35%, and limited downside, the risk-reward in this name is extremely attractive.

Catalysts
Several catalysts have arisen from recently announced 2nd step mutual conversion. Since the offering, Oritani has traded 3.5mm shrs average daily volume ("ADV") v 40k ADV in the last twelve months prior to the offering. The dramatic increase in ADV from the near tripling of the float will result in a larger institutional interest going forward. Additionally, in the 2nd step offering, 27.4mm shares were sold to existing depositors of the bank (67% of the total offering), which will help define a sticky shareholder base over the intermediate term. Also, Oritani currently has limited sellside coverage (only KBW and Sterne Agee), and there is potential for sellside coverage expansion/increased awareness on the name

Favorable near term trading dynamics: Institutional holders were limited to $8mm each in the deal, and it is highly likely that the weakness in stock price since the deal is due in part to ORIT being a non-core position (just too small) for many institutions, and in turn this has been a good name for them to turn to in order to reduce exposure in a period of general risk aversion/de-risking that has occured recently in the market. Also, index rebalancing is a potential significant positive. Oritani is a member of the Russell 2000 index, and the index will need to buy shares as a result of the second step offering. The shares will be to buy at end of July. Preliminary estimates are that north of 1mm shares will be needed to be bought. Additionally, the company purchasing ESOP shares will provide support to the stock. Oritani set aside $17mm for an Employee Stock Ownership Plan. These funds will be used to buy stock in the open market, which will be used for management incentive awards. $17mm will buy 1.7mm shares at $10.00. This represents 3% of the company, and could be significant in terms of % of average daily volume. This capital reserve is excluded from the tangible book value calculation above

M&A could provide explosive catalysts, albeit a sale option is longer term, and an FDIC deal is not core to the thesis, but rather an inexpensive call option. This is a rare case where either an acquisition (in an FDIC deal) or a sale would act as a positive catalyst for the stock.

In my opinion the biggest catalyst for the stock is simply the execution of their business plan. Deploying excess capital at attractive spreads begins to crystalize to the market the embedded earnings power of the company. Aggressive share repurchases in the open market serves to accrete tangible book value and limit stock price volatility. Further dividend increases (as a similar proportion of expanding earnings) make the stock more attractive to a wider range of investors.

APPENDIX
Loan Portfolio Detail
CRE, 49% of loans: It is important to note that these loans are primarily permanent loans (ie loans made on properties that have stable cash flows in place to service the interest expense on the loans), unlike many banks that lend mini-perm loans (lend on properties in lease up that rely on signing new leasing tenants). I believe this is a large contributing factor to the better than average credit quality for ORIT.

Multi Family, 23%: Again, these are primarily permanent loans, secured by cash flowing apartment buildings. Multi family lending in NY/NJ has historically had very low credit loss levels, primarily given the land-constrained geography. This asset class presents a great opportunity to grow originations, as significant competition existed in conduit market at peak in 2006-2008 (large banks originating loans and securitizing them in the capital markets through CMBS issuance) As CMBS issuance has dried up but refinancing needs still exist, ORIT is in a position of strength to grow profitable originations at the right time in the cycle.

1-4 Family Mortgage, 17%: These loans are generally underwritten to FRE guidelines, which makes this portfolio less susceptible to losses than most other banks. This is another area of differentiation in credit quality in ORIT's portfolio versus peers.

Construction Lending, 7%: Oritani has a smaller level of exposure than many banks to this troubled asset class. The bank has shown discipline in not over-extending themselves in this product, which offered the highest yields during the boom years. They have also benefitted through the good fortune from operating in a relatively strong, land-constrained geography.

Deposit Detail
ORIT has experienced significant growth in core deposits the recent past, with core deposits growing 15% in the past nine months. One company-specific key to this success has been the bank recently beginning incentivizing its bankers for selling core deposit products. Additionally, across the industry, the dynamic exists of deposits shifting from weaker to stronger players, and commercial deposits generally follow commercial loans for a given borrower, which should benefit Oritani as they continue to deploy capital. Additionally, the cost of deposits for ORIT has declined from 3.6% at 6/30/07 to 1.5% currently. This provides the company the ability to lever up their excess capital and earn an attractive spread on new assets.

Catalyst