TFSL: $12.19, $3.7B mkt cap

Summary

TFS Financial Group (TFSL: $12.38) is available at what should turn out to be a very attractive price due to lingering overhang from a deserved, if somewhat delayed, 2011 smack-down from the regulators in the form of MOUs from both  the OTA/OCC (since lifted) and the Fed (lifting expected soon).  Also the company is an MHC, complicating reported financials and further limiting its investor appeal. Given the family history, the excess capital and the acquisition disinterest (management discipline?) TFSL is unlikely to pursue a second step (and subsequent sale) anytime soon.

To cut to the chase, we think the Fed MOU will be lifted this year and that TFSL is on the verge of significantly accelerating shareholder friendly capital actions. TFSL could realistically buyback 25% of the public float and still be well capitalized. The core business is fine; somewhat of a boring niche, but relatively low risk and massively over capitalized (+16% TCE/TA) for the size/risk of the business.  Book value, adjusted for the MHC structure is $23. Minority interest earnings are currently around 90-95c, prior to the flow through of improved credit and any further buybacks.   Round #s 307M shares, but 74% held by MHC, so under $1B in float.

While we have the standard 2^nd step model, we also think it unlikely anytime soon, so our best guess is that aggressive repurchases and the resulting minority earnings and book value accretion suggest a stock in the mid-to high teens over a reasonable time frame.

Note: We expect an emphasis on buybacks versus dividends as new regs appear to require annual deposit holder (mutual member) approvals for dividend payments to minority holders (public shares).

Other than a relatively brief, but quite ill-timed, foray into second lien mortgage lending management seems generally conservative in keeping with the legacy of a family company founded by the current CEOs parents in 1938. This foray, the so called Home Today loan program, should have been called Home Today, Loss (MOU) Tomorrow as the losses were large and quick.  The good news is that the program was stopped relatively quickly, has been aggressively reserved and now account for less than 2% of the loan book.

Also, please note that dman976 posted an excellent write-up of TFSL in Dec 2012 (@ $8.44, congrats so far dman).  I will not attempt to outdo that write-up but perhaps to update the current situation and highlight recent developments and a likely catalyst.  I will refer to the MHC structure and use MHC adjusted numbers given the various MHCs that have been posted on VIC over the years, but am happy to elaborate in Q&A if anyone so inclined.

Caveats:

Asset Sensitivity: Given the historical emphasis on fixed rate loans, TFSL is not yet leveraged to higher rates.  This sensitivity is changing rapidly given the ARM production focus but an immediate shift would leave TFSL looking up at others with bigger ARM or C&I books.

Management:  Mgmt has significant equity incentives (see Options, RSU section below) but also pays itself reasonably well, by Cleveland standards.  Mgmt is quite optimistic about the company’s earnings and capital return potential.  When was the last time you saw this in an earnings release?  “As I’ve said before, we’re experiencing sunshine and blue skies”.  I guess the CEO was in the FL offices that January day and not Clevelend.

Thesis

 The lifting of the MOU will allow a very aggressive share buyback.  Management is quite open with their intentions in this regard.  Investors may simply have grown tired of waiting as the timing is completely up to the Fed and previous timeframes have proven to be premature.  The MOU appears to be focused on “refinement and enhancement of our enterprise risk management process” and not on capital adequacy.   Yes, Citi probably said the same thing about CCAR, but I think TFSL is a simpler business and an even more over capitalized balance sheet.

So, why this year?  One, the OCC did lift the Subsidiary MOU in December 2012.  Two, management did receive approval (ok, technically it was a “non-objection”) from the Fed for a 2.2M share buyback late last year.  This buyback (2.7% of the float) was completed in less than 2 months, at an average price of $12.09; not bad given the trading volume.  Three, In February, TFSL also received approval from the Fed to dividend $85M up to the holding company. Four, despite receiving the upstream approval, instead of applying for another modest buyback, management elected to wait for the next Fed review and bet on a lift of the MOU and the resulting governor on size of buyback.   Based on management’s commentary, we read this a bet that they think they are close enough to the MOU lift that they are better of waiting and having open season on buybacks rather than reapplying for incremental buybacks.

The company was reinstated as an approved seller to FNMA in November 2012

Note: TFSL did previously used 3 separate buybacks to repurchase over 20% of the float at around $12 over the 2008-2009 period. 

At 12/31/13 307.1M shares, 73.9% held by MHC (not traded or included in minority calculations)

We estimate about $225M of holding company cash at 12/31/13.   Note TFSL is on a Sept fiscal.

Business Summary

HQ in Cleveland.  Founded in 1938 by current CEO’s father. 1st Step offering in 2007.

Retail branches in Ohio (21) and Florida (17).

To oversimplify, Ohio lending concentrated in Columbus and Cincinnati. Also does national residential lending via targeted marketing for larger balance, but low LTV, high FICO customers.  Had a large HELOC business but have been swapping into ARMs w 60-70% LTVs.  Do use CD funding to enhance core OH/FL retail deposits.  Ohio $5.7B deposits, Florida $2.7B.

Historically a long term fixed rate lender, but now 74% of production is ARMS (41%) and 10-year fixed(33%) with remainder (26%) fixed w/ term >10 years.

First Mortgage Loan Portfolio: ARMs: 38%, ST Fixed:12%, LT Fixed: 50%, but declining rapidly.

HELOCs, one of the other causes of the regulatory issues are now down to $1.8B or 18% of total loans of $10.3B.

New business focus: 25% of current loan production now outside OH/FL footprint.  11 states (CA, CO, CT, IL, NC, NJ, OR, PA, TN VA and WA).  Use non-commissioned employees for application and underwriting process in all states.

Conservative approach should control growth and limit risk:  Q1 first mortgages averaged 777 FICO and 63% LTV.  Lend to people who don’t really need the money? 

Yesterday I received a direct mail piece for TFSL’s Smart Rate Mortgage:

For loans over $417K

3/1 ARM: 2.29%/3.09% APR, $295 closing costs

5/1 ARM: 2.95%/3.15% APR, $295 closing costs

Includes a “relock anytime” feature.

Finally, lock in by 4/18 and get a $100 Home Depot giftcard….such a deal!

Solid, if relatively boring core business.  Market to competitive rates to jumbo, high FICO, low LTV borrowers and keep costs down to earn a decent, but defendable margin. 

Note:  The low cost structure is in part due to the simplicity of the product offering:  Mortgages, no credit cards, limited commercial lending, no auto loans.

NIM 2.47% in latest quarter.

A bit of noise in FQ1 charge-offs as management cleaned up credit tail by charging off everything in foreclosure over 1500 days, despite history of modest recoveries.  Previously, these loans were held at estimated net realizable value. Recoveries will now be recognized as received.  Core credit trends very solid.

Management Incentives:

As of 12/31/14 in addition to about 500K shares held directly, there were 6.9M options with average exercise of $11.14, of which 3.9M are vested.  In addition, there are 1.5M RSUs of which 1.1M have yet to vest.  The combination of options and RSUs suggest a decent incentive for management to stay focused on driving shareholder value.  Also, the MHC structure adds the usual  (generous?) ESOP incentives, especially in the unlikely event of a second step.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.