Description

TFS Financial (“TFS”) is a misunderstood and under-followed company that has yielded a dramatic undervaluation and with it, a tremendous investment opportunity. At its current price of $11 per share, the Company is trading at approximately 60% of its economic book value of $18 per share.  I believe the fair value of the stock could be as much as 100% higher than the current price, and interestingly, the downside risk is incredibly limited since the company is holding its entire market capitalization in excess capital.  This investment opportunity has arisen as investors have seemingly yet to dig into the details to adequately ascertain an important item:  how many shares are outstanding?  Let me explain.

Background

TFS is a Cleveland-based thrift that was founded in 1938.  The Company has expanded its operations over the years to include 40 branches in both Ohio and Florida and it currently has over $9 billion in assets and almost $8 billion in deposits.  The company was legally structured as a mutual holding company (MHC), and as a result, the business was historically not particularly profit-minded, as all of its shares were held by the MHC (which is effectively a trust with its own separate board of directors).

In April 2007, TFS was IPO’d through a “first step conversion” after issuing some of the MHC shares to the public.  After the offering, approximately 105 million shares are now outstanding (including 11 million in an employee stock ownership plan) and an additional 227 million shares continue to be held by the MHC.  For GAAP purposes, the total share count is deemed to be 332 million (the 105 million public shares plus the 227 million mutual holding company shares), and therefore, a casual observer would be lead to believe that this is a $3.6 billion market capitalization company trading at a reasonable thrift valuation of 2x book value based on tangible equity outstanding of around $1.8 billion (pro forma for the offering).  However, a little digging would reveal that the shares held by the MHC are virtually identical to treasury shares from an economic standpoint, and therefore, investors should not consider them outstanding for the purpose of determining TFS’s fair value.  For example, if and when those additional shares are issued to the public, the company (not the MHC) would receive the proceeds and that value would accrue to existing shareholders.  Additionally, if TFS pays a dividend, the MHC waives its right to the dividend on its shares, thereby funneling the entire distributed value to the public shareholders. 

Additionally, management has not yet done any real investor marketing and their option package has not yet been set.

The Value Proposition

Essentially, when TFS went public, it gave the existing business away to the shareholders for free: the company raised around $1 billion in new cash proceeds and new shareholders received a thrift with $800 million of pre-offering tangible book (in addition to the net cash from the offering of $1 billion).  The result is a company with tangible book value per share of around $18 compared to the current price of $11 (of which $10 is newly raised cash!).  The reason that this interesting phenomenon occurs is that before the IPO, the company effectively did not have any shareholders that owned the thrift.

The Company currently is significantly overcapitalized with 20% equity to assets vs. a more normal operating level of 6-8%.  The way I think about the fair value of the business is as follows:

1)  Shareholders own a thrift with around $9 billion in assets that should have around $600 million of required equity.  After the company transforms to a public institution, it should earn a normal ROE that should justify around 1.5x to 1.7x book value (a multiple conservatively below the thrift average) on that capital.  This would yield fair value of $1 billion or approximately $10 per share on the operating business.

2)  Additionally, shareholders own the excess capital position, which is the remaining tangible equity.  This amounts to $1.2 billion or approximately $12 per share on the excess the capital.

The total fair value for TFS is around $22 per share, double the current price.   

Current Price                                        $11 / share

Public Shares                                       105 million

Market Capitalization                       $1,155 million

Tangible Book Value                        $1,840 million

Tangible Book Value Per Share              $18 / share

Thrift Value

Total Assets                                           $9 billion

Required Equity / Assets                           7%

Required Thrift Equity                           $630 million

Price / Book Multiple                            1.6x       

Estimated Thrift Value                        $1,008 million

Estimated Thrift Value / Share            $10 / share

Excess Capital

Tangible Book Value                         $1,840 million

Less:  Required Thrift Equity                $630 million

Excess Capital                                  $1,210 million

Excess Capital / Share                          $12 / share

Downside Protection

Adding to the fascinating nature of this situation is the incredibly low downside risk that is provided by the significant excess capital position.  For example, TFS could theoretically dividend to public shareholders the entire market capitalization and still be an adequately capitalized thrift.  While some of you may be wondering about the credit risks posed by a thrift in Ohio and Florida, the company is in a very conservative position as it almost exclusively holds quality prime whole loans (ie, none of the much-publicized levered CMOs or CDOs that have so much embedded risk and minimal exposure to non-prime), and even if these historically low-risk loans fall victim to a widening credit deterioration, the impact on the company and its value is very limited given the significant overcapitalization.  For example, a 3% loss on its $8 billion loan portfolio (vs. only a 1% current delinquency rate) would be incredibly high by any historical standard for these types of loans, but yet it would only impact value per share by approximately $1.50 per share, after-tax.

Additional Upside and Value Creation Through Share Repurchases

An MHC can begin repurchasing its shares beginning one year after the IPO.  Prior MHCs have taken significant advantage of any market undervaluation to create value for shareholders, and I would suspect TFS will be no different.  The combination of dramatic undervaluation and significant overcapitalization yield a potent formula for additional value creation as the company can significantly increase book value per share and fair value per share.  For example, if TFS used 25% of its excess capital to repurchase shares at $12, tangible equity would fall to around $1.5 billion and the share count would fall to 80 million, resulting in a book value per share of over $19.  This would also have the impact of increasing my fair value from approximately $22 per share to $24 per share.

Even More Dramatic Long-Term Upside Possible…

Additionally, there is the potential for even more significant upside over the longer-term.  The following situation I will discuss has occurred many times with other MHCs and is not a purely theoretical exercise.  I will mention a few specific historical case studies later, but I will start by painting a very possible (if not likely) future scenario for TFS.

After several years of deploying its excess capital into branch growth and share repurchases, the company will likely transform itself into an average thrift with an average capital position and ROE.  At that point, the company will likely be trading above book value like its peers and will be in a position to raise additional capital by selling shares out of the MHC to the public.  This will be a windfall for existing shareholders since the new capital raise can be significant and highly accretive to book value. 

For example, if the company has repurchased shares using 25% of excess capital (as in the example above), the company would be left with $1.5 billion of book value.  If the company earns an average 7% ROE over the next five years (with the ROE gradually increasing throughout that period), the book value would compound to around $2.1 billion in 2012.  If the company then decided to conduct a “second step conversion” (ie, a full conversion from an MHC to a public company), it would sell the 227 MHC shares to the public.  Let’s assume a reasonable post-conversion valuation of 1.2x book value (which is lower than several recent similarly sized second-step valuations and a reasonable valuation for a heavily overcapitalized thrift).  That would imply a share price of around $33 as the new equity raised would be around $6.5 billion (net of offering expenses and ESOP) and the resulting pro forma book value would be $8.2 billion or $27 per share.  Discounting the future 2012 stock price at 8% (a reasonable rate in my opinion given the company holds so much cash), you are left with fair value today of $22 per share, which is the same as my fair value estimate above. Arguably, you could discount this outcome at lower rate given the low risk nature of the situation (given the large cash balance) and this would clearly result in a higher current valuation.

Second Step Illustration:

2012 Tangible Book Value               $2,100 million

Net Proceeds Raised                        $6,500 million

Pro Forma Tangible Book Value       $8,600 million

2012 Shares Outstanding                        80 million

New MHC Shares Issued                     227 million

Pro Forma Shares                                307 million

Book Value Per Share                          $28 / share

Second-Step Valuation                         1.2x  price/book

Second-Step Offering Price                   $33 / share ($29 net of offering and ESOP expenses)

The calculation of the offering price is clearly circular, but as a check, you will note that (1) the offering price of $33 per share is 1.2x pro forma book value based on issuing the remaining 227 MHC shares and (2) the $29 net offer price (net of 12% offering and ESOP expenses) x the 227 million shares is equal to the $6.5 billion in net proceeds.

Some Prior Mutual Holding Company Examples

This is not the first (and likely, not the last) thrift demutualization to be misunderstood and mis-valued by the market.  A look back at a couple examples yields an insight into the explosive potential of the undervaluation of this situation.  People’s Bank of Connecticut (now called People’s United Financial) and Hudson City Bancorp are examples of large, liquid thrifts that went public through a first step conversion and ultimate sold all the mutual holding company shares to the public through a second step conversion at prices meaningfully above book value.  Both companies have delivered average shareholder returns of over 30% annually during the past six years (inclusive of dividends).   In my estimation, the undervaluation of TFS will likely not last for long as investors realize the outsized return potential from this situation.

Historically, the tremendous success of these investments has been driven by a set of common factors (all of which apply to TFS):

1)  Undervalution.  The misleading GAAP accounting confuses certain investors into counting the mutual holding company shares in the total share count for valuing these businesses.  In the case of TFS, this allows current shareholders to buy into the company at 60% of book value.

2)  Tremendous Potential For Buybacks.  The overcapitalization of all of these MHCs (People’s and Hudson City included) has allowed the companies to repurchase significant amounts of stock at very accretive values.

3)  Heavy Management Ownership.  The conversions of MHCs to public companies have historically been accompanied by the creation of ESOPs that significantly align the interests of senior management with the public shareholders.  In the case of TFS, the ESOP currently holds $125 million worth of stock.  Management will own additional shares through a stock benefit plan and they have even made recent purchases of stock in the offering and public market.  Also, a second step conversion is usually accompanied by the contribution of even more shares to the ESOP (typically around 5% of the company – which could be an additional couple of hundred million dollars).  Therefore, shareholders in TFS can rest assured that management is heavily incentivized to create shareholder value through the numerous levers they have to pull – just like several MHCs before them, including People’s and Hudson City.

It is important to point out that there are some other publicly traded MHCs (that have not completed the second step conversion yet) and several of them do trade below their economic book value, albeit none as low as TFS.  These companies include ISBC, CFFN, KRNY, NWSB, WAUW and UBNK among others.  While they are also undervalued in my opinion, it is critical to point out that many of these “comps” are very small and illiquid compared to TFS and I don’t think provide a basis for terribly meaningful comparison.  The only decent size comps are ISBC, CFFN, and NWSB which trade at 75%, 89% and 115% of book value, respectively.

Risks / Concerns

There are three primary risks or concerns that I see to realizing full value out of purchasing TFS stock today.  I don’t believe any of them will result in major capital impairment, but rather will likely impede the achievement of fair value.

1)  Mortgage Credit Risk.  As a thrift, the company holds a considerable amount of mortgage loans on its balance sheet.  As I discussed above, I don’t believe this to be a meaningful risk to the company given the type of loans they hold and their significant excess capital position.

2)  Continued Market Undervaluation.  It is possible that the company will continue to be misunderstood and under-valued by the market due to the misleading GAAP figures.  However, management can always work towards correcting this through share repurchases (unless my third risk below comes to fruition).

3)  Irrational Management Behavior.  While management has a tremendous financial incentive to create value over time through significant share repurchases and an eventual second step conversion, there can be no guarantee that they utilize those levers to create value.

Catalyst