I am recommending a long position in Waterstone Financial.

 

• Milwaukee MHC continuing to recover from significant credit problems.
• Currently operating under an MOU, capital ratios already well above required levels.
• Improving credit and upcoming second step should ultimately drive valuation to book value, implying 35%+ upside.  Will take time as ROE will remain weak largely due to overcapitalization.  Stock should appreciate with growing book value and increasing P/B multiple, which will benefit from aggressive stock repurchases. 
• Recent earnings have been entirely driven by mortgage banking.  Will undoubtedly weaken as originations slow but remain profitable.
• Proceeds from the second step will help accelerate the lifting of the MOU, ultimately leading to aggressive capital management.
• Currently trading at the max exchange ratio, implying 73% of book value post second step.  Providing valuation support.

Waterstone is a thrift with a wholly owned mortgage banking subsidiary.  The community bank has been around since 1921 and has eight branches in the Milwaukee area.  The loan book and deposit mix are what you would expect from a thrift - predominately single family and multi-family residential and CDs, respectively.  Waterstone Mortgage originated $1.7 bn in loans generating $11.5 mm in net income in 2012 through its 68 offices located in Wisconsin, Minnesota, Pennsylvania, Florida, Arizona, Indiana, Ohio, Idaho, Iowa, Illinois and Maryland.

 

Loans & Credit
Total loans receivable were $1,125 mm as of 3/31.  Breakdown as follows:

 

1-4 family       $445 (39.6%)

Multifamily      $515 (45.8%)

Home equity    $36 (3.2%)

Construction    $33 (2.9%)

CRE                  $77 (6.8%)

Other               $19 (1.7%)

 

Loans are concentrated in the Milwaukee metropolitan area (~7% outside Wisconsin) with roughly 85% secured by residential real estate.  Total loans are down ~1/3 from 2008.  Yield on loans was 4.94% during the first quarter, slightly down from the low 5%s experienced in 2012.  The roughly $300 mm securities portfolio yielded 1.30%.  Average total interest earning assets of $1,548 mm yielded a blended 4.24% in the first quarter.  

 

Recent performance and various metrics provide comfort that we have reached a credit bottom and Waterstone is at least adequately reserved.  As of 3/31 NPAs were 5.94%, down from 6.66% as of year end 2012; currently at their lowest level in the last five years.   Allowance is 40%+ of NPLs, up from 23% in 2008 - the absolute number isn't terribly helpful but the delta suggests the provisioning has built more of a cushion.  The 60+ and 90+ delinquent buckets appear to have stabilized ~$60 mm and recent REO sales have been around carrying value.  With credit stabilizing and an adequate allowance level, provisions should trend lower helping profitability.  Provisions were in the mid $20 mm range in 2009 - 2011.  Last year they declined to $8.3 mm and in the first quarter of 2013 they were $1.8 mm.

 

The Texas ratio (NPAs / (tangible equity + reserves)) was 40.9% at 3/31, down from 47.3% at the end of 2012.  The decrease was largely the result of a decline in NPAs.  Assuming the second step occurs at the max valuation exchange ratio and all else being equal, the ratio declines further to 21.9%.  Even without the second step, Waterstone's Texas ratio is acceptable and improving.  Just another piece of the puzzle suggesting that Waterstone is more than adequately capitalized and reserved.

 

I expect Waterstone will continue to opportunistically sell REO and possibly execute a larger bulk sale of NPLs.  I have no direct knowledge but in speaking with smaller banks in the area, it appears there are buyers of troubled loan portfolios.

 

Waterstone had $915 mm in deposits as of 3/31.  As mentioned, CDs make up the bulk of the balance:

 

Demand                   $87 (9.5%)

MM and savings      $116 (12.7%)

CDs                         $712 (77.8%)

 

Deposits are in decline as CDs have been maturing; little need to add as loans have also been in decline.  There is a small shift in the make-up of deposits as Demand and MM/savings slightly increased in the first quarter.  Cost of deposits in the first quarter was 67 bps, down from 127 bps in 2012. 

 

Total borrowings are $479 mm, split between $45 mm in short-term repos, $84 mm in repos maturing in 2017 and $350 mm in FHLB advances maturing in various amounts in 2016, 2017 and 2018.  Cost of borrowings was 3.82% in the first quarter, slightly lower than that experienced in 2012.

 

The NIM was 2.66% in the first quarter, up slightly from 2.62% in 2012 and the five year average in the 2.60% range.  I forecast the net interest margin will remain ~2.6% - 2.7% for the foreseeable future.  The recent steepening of the yield curve could help but time will tell whether it is sustainable and, if so, how long it takes to flow through the financials.

 

Non-interest expenses
The blended efficiency ratio (bank and mortgage banking) has been in the low to mid 70%s since 2008, but has been trending up over the last few years for a few reasons:

 

1) Non-interest expense at the bank has remained in the $33 mm range while interest income has declined, causing an increase in the efficiency ratio

 

2) Mortgage banking has a much higher efficiency ratio and has been a larger percentage of the overall performance given its growth and the decline in the banking business

 

Waterstone should get the benfit of declining REO expenses over time and should also resize its cost structure given the new/lower level of loans.  First quarter non-interest expenses were ~$6 mm, so I'll assume $25 mm for the full year, just for the bank.

 

Admittedly, difficult to project.  Last year was its best year, generating roughly $0.40 in eps.  Compared to 2011, origination volumes grew 70% and margins increased generating a total increase in Mortgage Banking income of 119%.  The first quarter of 2013 was up 57% over last year's first quarter.  Origination volumes and margins should be lower this year; I assume $0.20 is eps or roughly $6 mm in net income.

 

Pre-Second Step Analysis
Average interest earning assets of $1,500 mm and 2.65% net interest margin for ~$40 mm in net interest income.  Non-interest income at the bank equal to provisions.  The provision is currently 2x non-interest income but I am assuming they converge over time.  Non-interest expenses of $25 mm.  Pre-tax income of $15 mm for the bank and $9 mm for the mortgage bank generates ~$16 mm in net income or $0.51 in eps.  ROE of ~8%.  Equity/Assets of 12.7% and more than meeting all capital ratios. Waterstone is over-capitalized even prior to second step.

 

Current book value                $207.1

Current shares                       31.4 mm

MHC %                                   73.53%

New issue price                      $8

Underwriting expenses           8%

 

Exchange ratios from S1

 

Min     0.8986

Mid     1.0572

Max    1.2158

 

The current stock price is assuming the deal will get done at the max, i.e. $8 * 1.2158 = $9.72.  So I will use the max exchange ratio.

 

Amount raised = $8 * 31.4 * 73.53% * 1.25158 * (1 - 8%) = $206.3 mm.

 

Adding to current book of $207.1 mm generates $413.4 mm of post second step book value.

 

New shares outstanding of 31.4 * 1.2158 = 38.1.

 

Post second step book value per share of $413.4 / 38.1 = 10.85.

 

Implied post second step price to book of 8.00 / 10.85 = 73.7%.

 

For argument's sake, let's assume the deal is priced at the min exchange ratio of 0.8986.  I won't bore you with the details, but this implies a post second step book value per share of $12.76 or a P/B of 62.7% at the time of the second step.  The stock would then need to trade to 83.2% of book or $10.63 for an investor who buys at the current price to get back to even as $10.63 * 0.8986 = $9.55.  Clearly there is a risk that the deal prices at the min or mid exchange ratio, but most of the time the market has a good idea of where the deal is going to price and even if it prices at a lower ratio I would expect the deal to trade up to the pre second step implied pricing.

 

Post Second Step Impact
Assuming the max exchange ratio, Waterstone will have $206.3 mm in additional assets and capital.  To be conservative I will assume it yields 130 bps (most recent yield on securities) or $2.7 mm.  Combined pre-tax income would be $27 mm, net income of $18 mm and EPS of $0.47.  Equity/assets of  22.5%.

 

One year following the deal, I'll assume Waterstone generates another $18 mm in net income so book value will be $447.4 mm or $11.74 per share.  If the stock continues to trade below book value, I expect management will aggressivley repurchase shares as was the case prior to the financial crisis.

 

Waterstone is on the path to recovery and assuming credit trends/capital levels continue to improve, the MOU could be lifted relatively soon although no one knows for sure.  I would expect the second step accelerating the lifting of the MOU.  Secondly, an MHC must wait three years following its second step to sell.  Doug Gordon, President and CEO since 2007, joined Waterstone in 2005 and owns 1.39% of shares outstanding.  Prior to Waterstone he spent 15 years with Security Bank where he was EVP and Chief Lending Officer prior to its sale to M&I.  My guess is he is ultimately interested in selling Waterstone so why not start the three year clock as soon as possible.  Execute the second step, credit continues to improve, buy stock back aggressivley and sell.

 

Effective December 11, 2012, the FDIC and WDFI (two primary regulators) replaced a previously issued (November 25, 2009) Consent Order with an MOU.  The MOU requires maintenance of a minimum Tier I capital ratio of 8% and a total risk based capital ratio of at least 12%.  It also prohibits the paying of a dividends without regulatory approval.  Waterstone's Tier I capital and total risk based capital ratios were 16.07% and 17.34%, respectively, as of 3/31.  The second step will only increase both ratios.  As mentioned, impossible to predict when the regulators will lift the MOU but improving credit and second step proceeds will only improve the already sufficient capital levels.

 

1.  The second step is pulled

2.  Deal is done at the min or mid exchange ratios

3.  Credit worsens

 

You want to own prior to the second step as I expect immediate appreciation following the deal.  Second steps tend to be priced appropriately; the increased liquidity and known playbook attract investors.  ROE will remain depressed until management is able to buy back stock (one year anniversary of the second step) given significant excess capital so appreciation will take time.  Stock won't immediately trade to book, but even assuming 85% of an increasing book translates to an attractive risk/reward and at these levels I do not see much downside.  Famous last words, but barring Waterstone pulling the deal I expect this will work.  Patience is a must.

1.  Completion of the second step, probably late third quarter

2.  Lifting of the MOU

3.  More aggressive capital allocation following one year anniversary of the second step