Description

TFSL is a deep value situation with a catalyst clearly in view. TFSL is an undervalued bank and every day that passes the company gets closer to an event that should send the shares up significantly from current levels. I am plagiarizing from another VIC write up (thank you in advance dr123) in describing the bank with some adjustments and then will go on to discuss the current state of play along with some additional analysis:

Background:

TFS Financial (TFSL) is an Ohio-based (Cleveland) thrift which went partially public in 2007 in a “first step conversion”. Like many sleepy MHCs, TFSL didn’t loan aggressively in the halcyon years of stupid lending and, as a result, didn’t implode subsequently. In fact, management bought back shares aggressively during this period ($186 million in 2008 and $103 million in 2009). Loan loss provisions peaked in fiscal 2009 (September) at $115 million against $9.2 billion in loans. Loan loss Reserves are $100 million and shareholder equity is $1.8 billion (16% of total assets). Overall asset quality has been improving steadily, while pre-tax pre-provision earnings have been on the order of $100 million annually.

TFSL trades at ~$8.40, while its current book value is $21.50 (SE / shares issued). The current minority shares market cap is far below the excess capital of the bank, creating the opportunity to substantially increase shareholder value simply by buying back stock. Fully converted (this is a Mutual Holding Company - MHC), I estimate book value per share at ~$12.50. Management has stated that they have no intention of doing a second step conversion any time soon, which I don’t view as a bad thing. If they instead look to manage the bank as it currently stands and aggressively repurchase stock and pay out earnings as dividends (which looks increasingly likely given recent dividend waivers achieved by other MHC’s) future cash flows to minority shareholders could be substantial. By the complicated but interesting math of MHCs, management is incentivized to buy back as much existing / issued stock as possible. They started doing so after going public. Then the regulators stepped in.

In June 2010, the OTS issued an MOU citing, among several items, that the level of home equity line of credit loans was too high. Later, in February 2011 a replacement MOU was put in place that cited TFSL address issues focused on interest rate risk modeling and enterprise risk management (such things as succession planning, management comp, etc.). Management has clearly addressed the home equity loan issue and is currently permitted by the regulators to originate and hold new HELOC’s. The enterprise risk management piece appears to be buttoned up. The only issue outstanding appears to be the interest rate risk modeling. I believe the market is far too concerned with this issue. While management has indicated the regulators would like to see better profitability, TFSL has been profitable in every year where data is available including from '08-'11 unlike most thrifts/banks. TFSL was (and is still) prohibited from buying back stock and/or paying dividends until (A) the MOU’s conditions are met and (B) the OCC (OTS was merged into the OCC) actually lifts the MOU. TFSL management asserts that (A) above has occurred; now it is a waiting game for regulatory approvals (B).

Today there are 308.9 million total shares outstanding, of which 81.8 million trade publicly as what I call “minority shares”. The remaining 227.1 million shares stand in reserve as yet to be issued to depositors upon a second step conversion. Market cap based on minority shares is around $690 million. These shares would not be issued for free, however. Depending on the conversion valuation (historically ranging from 60% to 100% of fully converted book value), a second step conversion would yield $1.3 to $4.4 billion in new proceeds. This is where financial data warehouses get BV/share wrong (stated by FactSet, for example, at $5.74 per share) because the additional capital received for issuance of shares in reserve is not calculated, though the full share count is calculated.

Update (dman again)

The stock has recently been smacked after its recent earnings call based on what I believe to be a lack of understanding from investors regarding the regulatory process as it relates to the lifting of MOU’s by banking regulators.

The Company has been written up on VIC on two other occasions and is significantly lower than those levels due to the ongoing overhang of regulatory issues. The stock is 15% below the levels at which dr123 wrote up the stock in April 2012. I thought that dr123’s write-up was well done and should be referenced in advance of reading this piece. This write up will be much more detailed so I hope you have some time on your hands . . .

I will address a number of issues in this report that I view as relevant. They include the following:

1.) Presentation/discussions to/with board/management on structure/ability to create value through buybacks/dividends

2.) Board composition and management comments as it relates to willingness to create shareholder value via financial engineering available to MHCs

3.) Recent developments on MHC asymmetric dividends

4.) Regulatory order and current state of play

5.) Management comments and lack of understanding of regulatory process by market participants

6.) MOU lift precedents

7.) Loan credit quality and earnings outlook

8.) Current trading

9.) Suggestion to hedge

10.) Conclusion

1. Presentation/discussions regarding ability to create value through buybacks/dividends

We recently met with management and later had time to present our ideas on creating value through financial engineering with some folks on the board. While the math was of course familiar to them (considering the prior massive buyback program), I think our conclusion was something they had not considered and we hope will be discussed as a real potential outcome at the board level. Our belief is the board should implement a major tender offer (as large as the regulators will allow) post-regulatory order lift at $12.50-$13 per share. We believe this will be a one-time opportunity for the bank to buy back a large amount of stock in one shot considering the very large overhang of investors buying for the catalyst of the regulatory order being lifted.

This was in part done to put something on the table that they had not thought about but also to ensure that they are aware that unhappy shareholders are anxious to see some liquidity at a premium after the poor share price performance over the last several years. The concept of a large buyback has been discussed on earnings calls by numerous analysts/investors and I would guess it will be pushed for aggressively and publicly by large shareholders after the MOU is lifted.

While the math in the below analysis will be familiar to those of you with experience in MHC’s, I hope it helps those who may not be familiar with the structure. For those of you who know MHC’s, I am aware that the mutual shares should be considered, but based on management’s statements about the lack of a second step conversion in the near future and a willingness to pay dividends (and recent industry developments in that regard), I present the numbers on a “pre-second step” basis. Investors who do not understand the structure should be aware that the math becomes much more complicated upon a second-step conversion. Additionally, I would point as dr123 did, that

-Total Capital to Risk Weighted Assets is 22%, implying over $850 million in excess of the required 10%;

-Core Capital to Adjusted Tangible Assets is 13.5%, implying over $900 million in excess of the required 5%;

-Tier 1 Capital to Risk-Weighted Assets is 21%, implying over $1 billion in excess of the required 6%.

As you can see, excess capital is well in excess of minority market cap of $690 mm. So the buyback analysis below that we have shared with the board/management is not necessarily pie in the sky (although the first scenario is extremely unlikely). Below are the contents of the presentation/analysis:

Page 1:

TFSL Capital AllocationOpportunity

• MHC structure provides TFSL a unique opportunity to take very simples steps to create significant value for shareholders
• Due to the regulatory order and resulting depressed stock price over several years, the bank has a unique, one-time opportunity to repurchase substantial amounts of stock via a tender offer as a result of the share overhang from investors purchasing stock below $10 over the last several years
• Our expectation is the stock will trade into the mid $10 per share range post regulatory order lift
• Average tender offer premiums paid suggest 20% premium paid above trading price
• This suggests a tender offer range of $12.50-$13
• At these ranges of buyback prices, pre-second step book value can be increased substantially via a large tender offer with the bank remaining very well-capitalized

Page 2:

Post-Regulatory Action Share Volume Analysis

Page 3:

Potential Overhang Analysis

Page 4:

Time to Repurchase – Historic Approach

Page 5:

Historic Non-Control Tender Offer Premium Analysis

Page 6:

Tender Offer Pricing Analysis

Page 7:

Substantial Book Value AccretionOpportunity

• Pre-Second Step Assumptions:
  • Current Shares Outstanding: 81.8 Million
  • Current Price $8.4
  • Current Market Cap $690 Million
  • Current Tangible Book Value $1,805 Million
  • Current Price/Tangible Book Value 0.38x
  • Current Book Value/Share $22.06
  • Normalized Net Income $60.0 Million*
  • Normalized EPS $0.73
  • Modeled using 3 scenarios:
    • $800 Million Repurchase @ Prices Ranging from $12.50-$13
    • $550 Million Repurchase @ Prices Ranging from $12.50-$13
    • $300 Million Repurchase @ Prices Ranging from $12.50-$13

* Assumes loan loss provision reverts to normalized levels of $20 million per year. Scenarios adjust for loss of interest income from use of cash and investments.

Page 8:

Tender Offer Scenario: $800 Million Repurchase

Page 9:

Tender Offer Scenario: $550 Million Repurchase

Tender Offer Scenario: $300 Million Repurchase

A lot of numbers/support for our position but the basic conclusion/assertion is this:

- A huge amount of stock (3x the market cap) has traded since the regulatory order was put in place

- Even under scenarios where only a fraction of the shares are waiting for the regulatory catalyst as a time to exit the stock, many hundreds of millions of dollars worth of stock will be available for repurchase

- However, in order to repurchase that stock in a meaningful fashion quickly the bank will need to pay a premium in the order of 20% of the then current market cap based on precedent transactions. This would imply a $12.50-$13 price based on our belief that the shares would trade over $10 post regulatory lift (move back toward historic pricing from ’07-’10 but be weighed down by shareholders exiting the regulatory arb); it will take 45 days for TFSL to have the ability to buyback shares post MOU lift due to a need to apply with regulators

- If the bank waits and tries to repurchase the shares in the market it will take them years to purchase what they could in a single shot. If they try to buy $550 million worth of stock at 10% of the volume every day (they are restricted to 25% by law and 10% is fairly aggressive) it would take seven years to buy that amount. This is supported by the fact that it took them over two years to buyback $280 million worth of shares in ’07-’08.

- The more aggressive the bank is with buybacks the more value is created. If the bank were to buy back $800 million worth of stock at $12.50 for example, pre-second step book value would go to $56 per share. Again, obviously unlikely but it shows how compelling the math is.

- Even if the bank does an enormous buyback of $800 million (80% of minority shares) they will remain well above “well capitalized” levels.

The conversation was effectively a one-way street as we asked the players we spoke with not to relay any meaningful thoughts other than what was publicly available. We were asked, “what would you do if you were in our position”; I flipped right to the $800 million tender offer page and said “I would try to buy this much stock and then I would keep buying in the market if that was humanly possible. The point is I would buy as much as I could.” Obviously this is virtually impossible given this many shares will not be available to tender (many won’t part with shares at that price given the accretion) and regulators would have a hard time allowing this large of a buyback for optic reasons but I think the point was made. Later I said I would buy back every share with the exception of one share that I owned and pay myself $100 million if shares didn’t go up from $12.50. Clearly I was being facetious.

The bank’s balance sheet is liquid with almost $900 million in cash and investments. I would also point out that prior to going public the bank was operating with about a 10% equity/assets ratio (versus over 16% today). So historically they have been comfortable managing the bank with far less of a cushion.

Shareholders are currently clearly frustrated and will be pushing hard (probably publicly) for something like this tender offer to occur. Hopefully the board/management will listen to reason. I think that is possible given the next point.

2.) Board composition and management comments as it relates to willingness to create shareholder value via financial engineering available to MHCs

I believe some form of a buyback will be put in place it is just a matter of in what form and how large. The board of this bank is not filled with local yokels who are unsophisticated. While the local real estate players are included (as they should be), the Board has three serious players with substantial financial experience. I would be shocked if they don’t “get it”. Here are the bios of these three individuals:

Robert B. Heisler, Jr. retired as the Dean of Kent State University’sBusinessSchool in October of 2011, a position he held since 2008. Prior to that appointment, he served as a Special Advisor to the University President. Mr. Heisler retired as Chairman of KeyBank, N.A. in 2007 after 37 years in the banking industry. Prior to his role as Chairman, Mr. Heisler served as Senior Managing Director of Key Capital Partners and held various positions throughout the organization, overseeing investment banking, brokerage, asset management, private banking and investment research. Mr. Heisler is a director of FirstEnergy Corp. and Myers Industries and holds leadership positions in manyNortheast Ohio community organizations. Mr. Heisler’s extensive business and banking experience enhance the risk management and oversight functions of the Board and are important to his service on the Board and the Enterprise Risk Management Committee.

Terrence R. Ozan serves on the board of directors of Capgemini, Cohesant Inc. and a privately held chemical manufacturer and supplier. Mr. Ozan served as Chief Executive Officer of North American operations and was an executive member of the Capgemini Global Management Committee prior to his retirement in 2003. Prior to the formation of Capgemini in 2000, Mr. Ozan was the Chief Executive Officer of worldwide consulting services for Ernst & Young and served on various boards and governance committees. In his nearly 30 year career at Ernst & Young, Mr. Ozan also directed many different domestic business units of the organization. Mr. Ozan’s extensive business and banking experience enhance the risk management and oversight functions of the Board and are important to his service on the Board and the Enterprise Risk Management Committee.

William C. Mulligan has served as a managing director of Primus Capital Funds, a private equity firm, since 1987. Mr. Mulligan joined Primus Capital Funds in 1985 from McKinsey & Company, Inc., an international management consulting firm. Mr. Mulligan serves as a director of several private companies and one public company, Universal Electronics, Inc. Mr. Mulligan’s exposure to a wide range of companies and strategic acquisitions provides extensive business, financial and risk management skills that are important to his service on the Board and the Audit and Compensation Committees.

So we have a former major player at one of the largest banks in the Midwest and a top 10 sized bank in the U.S. who is also a board member at a pair of Northeast Ohio Fortune 1000 companies, the former CEO of Capgemini NA and E&Y Consulting and the Senior MD at a private equity firm with a 30-year track record managing over $1 billion and seven funds with top quartile returns. Clearly these guys are no shrinking violets and are incentivized to maintain their high profile and historic level of success inNortheast Ohio. A poorly performing bank with a muddling stock price is not something they want to see. I would expect these players would be pushing hard for a buyback.

In addition, the CEO has a good reputation inNortheast Ohioand is a very competitive individual. I do not believe he is one of those CEO’s who doesn’t care at all about the stock price and I believe he wants to see the stock price higher. Employees are weighed down by a poor performing stock price; a big tender offer and $13 stock price could rejuvenate the troops. I realize that helping employee morale is a weak argument but it doesn’t hurt.

Finally, the Company has on numerous occasions referred to the fact that after the regulatory order is lifted they will return to repurchasing stock/paying a dividend. This is in virtually all presentations they have put out over the last couple of years. Here is language from the COO on an earnings call as an example:

“So, on page 12 we're still on the sort of a waiting game on cash dividends and stock repurchases. We understand that's very critical to shareholders and it's very critical to us. I think we are all part owners of the company as well. It's very critical to what we are doing as a company. But I think that the key is we have to get the regulators happy with what we have done in response to some of their concerns, so we will wait for that to happen.”

You can find examples like this all over the place in various presentations. So it is very well telegraphed that they want to buy back stock the only question is how much and how fast.

3. Recent Developments with Regards to MHC Asymmetric Dividends

Recently, the FED has put out guidance that MHC’s will have to get approval from 50%+ of the mutual company shareholders in order to pay out asymmetric dividends (dividend to just the minority shares). Many thought this would be a huge barrier toward paying dividends and would result in MHC’s turning off payouts. But recently a couple of MHC’s have gone out and received approval to make these payouts despite the obstacles:

From NECB (Northeast Community Bancorp) 10-Q (out 11/20/12):

The MHC received the approval of its members to waive its right to receive annual dividends aggregating up to $0.12 per share declared by the Company in the 12 months subsequent to the members' approval at a meeting of the MHC's members held on November 9, 2012. The Company is waiting for the Federal Reserve Bank ofPhiladelphia's approval of the waiver.

Recent PR from Kentucky First Federal:

First Federal MHC Makes Definitive Announcement on Kentucky First Federal Bancorp Dividend Waiver

HAZARD, Ky. and FRANKFORT, Ky., Sept. 27, 2012 (GLOBE NEWSWIRE) -- Kentucky First Federal Bancorp (Nasdaq:KFFB), the holding company for First Federal Savings and Loan Association of Hazard, Kentucky and First Federal Savings Bank of Frankfort, Kentucky, announced that its majority shareholder, First Federal MHC, has received notice from the Federal Reserve that there would be no objection to a waiver of dividends paid by Kentucky First Federal in the next twelve months. On August 23, 2012, the Company's Board of Directors declared a cash dividend of $0.10 per share payable on September 28, 2012, to shareholders of record on September 10, 2012. Earlier that day, the members of First Federal MHC had approved the dividend waiver by casting 64.3% of the eligible votes in favor of the waiver. The results of the vote along with other pertinent materials and declarations were submitted to the Federal Reserve immediately for their final review.

Tony D. Whitaker, Chairman of Kentucky First Federal Bancorp, stated that to his knowledge this was the first solicitation of a member vote for a dividend waiver and will be the first waiver to which there was no regulatory objection since the publication of interim and final rule Reg MM in November of 2011. He expressed his great appreciation to the members of First Federal MHC for their participation in the vote and to the Federal Reserve for their prompt attention which will allow the dividend on September 28, 2012 to be paid to the public shareholders but withheld from the MHC.

First Federal MHC owns 61.2% of the outstanding stock of Kentucky First Federal. On August 23, 2012, Kentucky First Federal announced that the Board intends to resume the quarterly dividend schedule the Company has used since its inception with the next dividend record date being on or about October 31, 2012, with payment on or about November 19, 2012. However, future dividends are not guaranteed and are declared at the discretion of the Board.

Chairman Whitaker also announced that if there were no further rule changes or guidance from the Federal Reserve, First Federal MHC expects that it would once again seek approval of the dividend waiver by its members in 2013.

The upshot is that the idea of turning on dividends for MHC’s is clearly not as impractical as many thought. This is a positive development and sets a precedent that TFSL can turn back on its dividend in the future and raise the payout per share substantially by doing a large stock buyback while paying out the same dollar amount out of earnings annually.

4. Regulatory Order and Current State of Play

The current regulatory order is still in play and has weighed on the stock price for well over two years. The current MOU is focused on improving “enterprise risk planning” and “interest rate modeling”. Unlike many banks that needed to dramatically improve capital ratios (a much larger hurdle to jump over), TFSL’s issues were more system and management oriented. In the recent call management mentioned that the regulators would like to see better profitability as well. Management has said on numerous occasions that they feel they have complied with everything the OCC has asked and they are simply waiting their turn. I think they believe they are “in the queue” and waiting for regulators to finally focus on the bank.

5. Management comments and lack of understanding of regulatory process by market participants

Throughout the regulatory process management has made statements that they believed the issues raised in the MOU were easy to address and that they were complying substantially with what regulators had requested and earlier this year felt that they were getting close to being lifted. Here are a couple of statements from earnings calls:

May ‘12:

Paul J. Huml - Chief Operating & Accounting Officer, TFS Financial Corp.
“No, I think that's clearly the regulators have said we don't – not supposed to comment on the status of their exams but it's really just our best guess that fourth quarter (quarter ended 9/12) we might hear something”

Marc A. Stefanski - Chairman, President & Chief Executive Officer, TFS Financial Corp.

“The only other thing I could add to that is that in our discussions with the regulators, they're very anxious to continue to move these kinds of things forward especially with the organizations like ours that prevent or actually don't really have – are a threat to the FDIC insurance.”

February ’12

Paul Huml – Chief Operating & Accounting Officer, TFS Financial

“From a regulatory standpoint, just an update on where we are because we've had a few changes in a regulatory standpoint; we had a Memorandum of Understanding that was in place from February of 2011. We believe that we have met all those objectives. We responded to all the issues that they raised. However, at this point, we are waiting for the OCC and the Fed to review and validate all of the progress that we have made. “

However the language on the conference calls changed on the June quarterly call:

July ’12:

Paul Huml – Chief Operating & Accounting Officer, TFS Financial Corp.

“Next page is probably the most difficult to write about because we've walked that fine balance between the regulators who don't want us to discuss anything to do with what they're doing from an exempt standpoint and as we try to balance and making sure that we're keeping the shareholders informed in what they need to know. So, we're trying to keep a good balance, we are trying to keep everyone informed as we've gone through the regulatory process from when the MOU was first put in place, it's always – it's certainly up to them as to when the MOU is removed and we continue to get regulatory review of us; there is nothing final that we've received from our regulators. We have had indication that a number of the issues that are out there are getting cleaned up. I think that the issues going forward revolve around the interest rate risk and our modeling that analysis. And being a savings and loan where we have a lot of long-term loans and shorter-term deposits, interest rate risk is always going to be an issue that we deal with. So, we're always watching it as we came through the new regulators, the OTS got rid of the model that they used to use to model interest rate risk and analyze their various companies and we have a new model in place that is going to need time to be back-tested and validated and all of the various buzz words that we need to do from a regulatory standpoint.”

October ’12:

Marc Stefanski – Chief Executive Officer, TFS Financial Corp.

“Well, it's kind of early as far as the interest rate risk modeling. We've bought a system at the beginning of last year and we just began to scratch the surface on its capability in the hiring process of getting people on board to – who completely understand and can work with this system. And so from our review this year, I mean, it's too early to give a significant, let's say, significant – improving significantly from where we were in terms of modeling. Now, some folks will say, well, it was adequate what we had and that's fine, but with the new model, we again have to prove that we know what we're doing with it and that we collect enough data that we have the people in place and the processes in place to continue to monitor that and to make it an effective tool for predicting what – well, trying to predict where interest rates are going to go and how our modeling capability will ensure the safety of the organization.”

So it is fairly clear that in the first half of the year management expected to have the MOU lifted in the July-September timeframe but the regulators gave them guidance between May and July of this year that the bank’s interest rate modeling was insufficient and needs to be improved. However, they also received indications that they had cleaned up most other issues hanging around (there are always minor things in these banks) and the enterprise risk management and home equity issues (they are now able to originate HELOC’s again) are clean. So that leaves one issue for the bank to resolve – modeling and managing interest rate risk. The question is how does this proceed and what do the regulators need to see?

My argument is that the market is vastly overblowing the risk that this interest rate modeling issue will draw out the MOU for years on end. While the CEO’s language from October was a bit stark in terms of them “just getting started” analyzing the data that does not mean the regulators will hold them up until they have multiple years of data.

The issue comes down to this (which the COO noted in the July conference call): they have historically modeled interest rate risk exposure in a fairly sophisticated fashion but the regulators wanted a more robust system that utilized more variables. Because the interest rate modeling software is a forecasting tool and the bank bought the more sophisticated software in early 2012, they do not have a long history of testing the effectiveness/accuracy of their projections and it is difficult to back-test given the new variables required by the system. As a result, to get multiple years of projection testing would be problematic.

However, the bank has made a great deal of progress in addressing this issue. According to the recent 10-K, over the last couple of years the bank has brought in expert consultants to aid in properly modeling the risk, purchased new software, tested the software and is now using it to make projections. I believe that rather than needing to see multiple years of projections and results detail, the OCC wants to see TFSL continuing to test and fully integrate the system while putting in place bodies to look at it on a regular basis. This belief is based to a certain extent on experience. I know well people who have been on the board of banks with MOU’s in place that have subsequently been lifted. These institutions were in far worse shape than TFSL. The process is to some extent iterative with the regulators initially raising the issues, followed by responses and adjustments to policy by the Company. The regulators then eventually respond and come into board meetings to give updates to the board of directors. And so on. The final step is a board meeting in which the regulators let the board know they have signed off on lifting the MOU but here is a (typically laundry) list of issues that remain outstanding and that you must continue to address. The point is that it is not expected that every item will be perfect but rather that the bank must be making reasonable progress in good faith towards the ultimate goal and that issue will be monitored closely by the regulators on a go forward basis; if the bank does not do a good job of complying after the MOU is lifted there is a risk they will go back under a new MOU. Interest rate risk management in a bank is obviously integral to its health and as a result the OCC is being tough on TFSL on this topic. For TFSL is working with expert consultants, purchasing a new system, beginning to use it, testing it, showing the regulators projections, hiring people to man the system and generally being very responsive to the regulators demands enough to say they are making sufficient progress towards having a much better handle on interest rate risk (resulting in a lift to the order in the relatively near future)? I would venture to say yes.

A final risk mitigant on this topic and something that should help assuage OCC concerns is that the bank is primarily sourcing and holding 5-year ARM’s rather than long term fixed rate mortgages (much of the book is still long-term but it is shifting). As a result the duration of the portfolio is slowly coming down resulting in less portfolio risk.

We have discussed the TFSL situation with other bankers and management of banks that have been under MOU and subsequently had them lifted. The feedback has been as follows:

- These issues are easy enough to solve and the regulators pragmatic enough (considering the excess capital and lack of threat to FDIC insurance) that the elapsed time seems longer than it needs to be;

- Surprised they are still under MOU

- Regulators are often on their own time frame and things can slip a few months

Additionally I do believe the CEO’s point that the regulators have told them that they are trying to move forward MOU lifts for banks such as TFSL that don’t form a risk to the FDIC. This should give TFSL a little bit more latitude given the interest rate risk isn’t as much of a threat to a bank with this much capital versus others. It could be that management is correct when saying they feel like they are simply “in the queue”.

The bank has also referred to the regulators wanting TFSL to improve its profitability prior to coming out of the MOU. I believe this will not be a huge hurdle. For one thing they have been profitable over the last few years while taking very large provisions. Additionally, for the reasons I lay out in Section 7 I expect earnings to improve this year. Finally, I have seen banks that had been losing money and had just flipped profitable come out of MOU’s. A very modest improvement should be enough.

The market seems to believe that the bank is in a permanent penalty box. I can’t imagine that to be the case given how uncomplicated the issues are.

6. MOU Lift Precedents

I have not seen a complete analysis by others looking into how long it takes the typical bank to get out from under an MOU. Obviously it will depend on the individual circumstances/regulator but I felt it could be helpful from a directional standpoint. I have identified a group of recent regulatory order lifts but would imagine this is not complete; if anyone has others to point to that could be helpful:

As you can see from the above analysis the average time to lift for the banks I looked at was around 2.2 years. This would put TFSL into the late Q1-early Q2 time frame for the order to be lifted. However, many of the above banks have far inferior capital positions; they took huge losses in 2010 and 2011 and exhibited higher risk characteristics than TFSL although recent earnings have improved as they write back into earnings the over-reserves they took in the big bath years. Some of these banks had far more complex issues to deal with.

Given the lack of complexity of the issues with TFSL, the precedents and the feedback received from others who have been under MOU, I think I am being conservative in saying the lift should occur in the next twelve months.

7. Loan Credit Quality and Earnings Outlook

It is not necessary that the bank put up amazing earnings numbers for this idea to be successful but it would be helpful for the bank to improve its profitability. TFSL has been profitable every year for which the Company has provided data (including the years in its IPO prospectus), unlike many financial institutions. They have been marginally profitable for the past few years due to large loan loss provisions and increased costs from dealing with foreclosures.

The bank’s most recent quarter resulted in very little in the way of profitability and has contributed to the sell-off. However, the Company’s recent delinquency rates have been improving markedly while the bank has continued to take sizable loan loss provisions. The bank took nearly $100 million in loan loss provisions in 2012 as it did in ’09-’11. The numbers in 2012 would have looked better than prior years if not for a series of changes the regulators made which forced the bank to take larger write-offs than projected ($10 million+ beyond what they typically would have taken). Prior to ’08 they never had a year in excess of $10 million in loan loss provisions. The CEO recently made bullish statements on provisioning for next year on the most recent conference call:

“I think we've certainly felt that – I think if we went back a year ago, I didn't think we felt that we would have $102 million in our provision for this year and we felt we'd be a lot lower. If you go back in history, our provision 2006 prior was generally under $10 million for the year, so we've tried to focus on high credit quality when we originate loans. So having any loan losses is not something that we've grown accustomed to. We certainly hope and expect that number to be lower next year, but trying to put a number on it at this point I think we – a lot of it is so dependent on the economy and where it goes. I mean, certainly our delinquencies are trending in the right direction, but there's still a lot of unknown as to what's happening with the economy and where that's going to go.”

His point that delinquencies are going in the right direction is a good one. Here are the most recent results:

The following tables from the recent 10-K show the ongoing reduction in delinquencies since the crisis:

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The bank is currently sourcing mortgages with FICO scores on average of 780+ and LTV’s of 60-65%. It appears that the loan book is beginning to solidify.

The bank also has the ability to dramatically increase its net interest margin. The bank has very high cost funds relative to others in the industry; one of the primary reasons for this is being addressed by management. They have committed to using more wholesale funds (they have been primarily retail and have been aggressive on pricing) and billions of high cost funds are rolling over in the next couple of years (3%+ long term CD’s). If they are able to add 20 bps to net interest margin you could see an additional $10-$15 million in earnings. This is less of an issue versus loan loss provisioning however.

Finally, it appears the bank is willing to reconsider its position that it will hold onto all of its loan production and may begin to again source mortgages for sale to Fannie Mae which might increase fee income. From the most recent call:

“Q. Right. Well, I remember going back a couple of years you decided not to originate for sale to Fannie Mae. I'm wondering if you're rethinking that strategy at all. I mean, if you've got people coming to you who want fixed rate product why not act as a mortgage banker, sell it and then turnaround to sell it to Fannie or Freddie or one of the agencies?

Marc A. Stefanski - Chairman, President & Chief Executive Officer, TFS Financial Corp.

Sure. Everything is on the table. We're looking at everything that would help improve the profitability of the organization without risking anything like our culture and things that might be very precious to us and especially in our footprint.”

This point is also discussed in the recent 10-K.

A decline in provisioning to 50% of previous levels (in-line with the decline in delinquencies) and a modest increase in net interest margin could take earnings up from $10-$15 million to $50-$60 million, which is still below levels from the mid-2000’s. While not incredibly attractive, when combined with a large stock buyback program the stock will be well on its way into the teens.

8. Current Trading

While I am not one for technical analysis I do occasionally take a look and see the trading history in a stock to help understand the sentiment in a position relative to history. Currently TFSL is near a 52-week low which is virtually equivalent to an all-time low (went public in early 2007). The stock has made fairly sharp bottoms around $8 in 2010 and 2011. The stock has about 7-9 days volume of short interest (based on 250K shares/day traded) so a little bit of short covering is possible. Additionally, tax loss selling may be taking a bit of a toll as the stock sits near its lows toward the end of the year.

9. Suggestion to Hedge

While this is a very interesting investment from a standalone perspective, risk certainly exists as it relates to the housing market and overall financial system. Considering the macro risks, I would suggest hedging the position with puts on a broad financials index. I would not suggest a paired short position as it is possible that TFSL is dead money for a while but the XLF or some other bank index lights fire. The puts would give you protection in a runaway downside scenario while limiting losses in the dead money scenario.

10. Conclusion

TFSL is a simple story (that I have made overly complex probably) that should result in outsized returns. The catalyst is simple and in range (12 months or less) and the bank has a clear incentive, interest and has telegraphed a willingness to run the stock up into the low double digits through highly accretive stock buybacks. Long-term shareholders are frustrated and will be pushing for a positive outcome after the regulatory order is lifted and management appears to care to some extent what they have to say. The bank’s balance sheet is solid, loan quality is improving and earnings should improve next year while valuation is quite cheap, providing for some level of downside protection. From these levels this very simple and reasonable outcome would result in 40%+ returns. To the extent one is concerned about macro events driving the stock lower, a simple hedge should be considered.

Disclosure: Please do your own due diligence. We maintain a position in the issuer and may buy or sell shares at any time without disclosure on this website.

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