Description

Webster Financial (NYSE: WBS)

Investment Summary and Thesis

Webster Financial is a Connecticut based mid-sized bank with $23B of assets and a market capitalization of $3.26B.    I recommend going long WBS at these levels ($35/share) as the risk/reward is fairly compelling with “many ways to win.”   

The keys to the thesis are as follows:

1. Top tier regional bank (#2 deposit base in Connecticut) with higher NIM spreads, higher ROE/ROA, better efficiency ratios, stronger loan growth, and better credit risk management  as compared to its comp set.   

2. Hidden asset in the form of HSA bank that Mr. Market is ascribing minimal value with strong secular growth in underlying HSA market.  Even if the company did not spinoff this business, Webster as the #1 leader will be in a strong position to acquire further HSA assets which provide a cheap long duration deposit base.  

3. Potential bank consolidation target  - Webster participates in industry consolidation – with a solid asset base and concentration in high income geography (footprint covers Westchester County, NY through Boston), Webster would be a solid candidate to partner with another bank looking to meaningfully build out its presence in the Northeast

4. Tail wind from normalizing interest rates

5. Management could engage in share buybacks

In my upside case I see the stock at $70 per share based on a full valuation of the HSA business and in-line comparison to the core business.

In my base case I see the stock at $51 per share based on a more modest valuation of the HSA business and in-line comparison to the core business

In my downside case I see the stock at $30 per share ascribing zero additional value to the HSA business. The risk to thesis is the stock currently trades at a premium to peers on a P/TBV basis and if the company underperforms relative to its comp set.  

Recent Comps:

• BB&T announced the acquisition of Susquehanna at 16.3x EPS-ltm

• RBC is buying City National at 21.0x Forward EPS

As such on a risk/reward basis I see WBS as a compelling buy.

Background Information   

Webster is an 80 year old Connecticut based bank in 4 lines of business: commercial banking (middle market, CRE, ABL, equipment finance, treasury and payment solutions), community banking (personal and business), private banking, HSA banking.  The company has an experienced and capable management team that has stayed ahead of the curve in terms of regional banking by constantly evolving its business model including targeted customer segments, product sets and competitive positioning.  

The company began as a mutual bank by Harold Webster Smith, the current CEO’s father.  Through a string of acquisitions and careful stewardship the company has grown into a formidable regional bank with the following statistics

• $23.6B in assets with $14.8B in loans (majority of which are floating) and $17.3B in deposits (85% loan / deposit ratio)

• 165 banking centers and 314 ATMs

• ROTCE of 12% and P/TBV of 2x

The company has provided guidance on loan growth, deposit growth, pre-provision net revenue, efficiency ratio, as well as credit metrics below.  

Webster trades in line with its peer group as it defined by the Company on its Investor Day presentation back in June – this is despite having a higher ROE/ROTCE and as well as stronger loan growth and better credit risk management.  Looking at the financial targets provided by the company over the planning period including loan growth in the 9-11% annual range, deposit growth adjusting for HSA deposits acquired in the 7-8% range, and an ROE in the 10%+ range (or 14% on a ROTE basis), I see the company having a unique combination of above-peer growth simultaneous with above-peer returns over the longer term.

The key part of my thesis is the understanding of Webster’s HSA division which was formed in 2004 and has grown rapidly over the following decade and in early 2015, Webster acquired the HSA business from JP Morgan.  Today Webster’s HSA division is the leading national health account solutions provider with  #1 in market share in the HSA industry (covering 1.6 million consumer accounts and encompassing 33,000 total employer groups) and over $4.5 billion in footings ($3.5B in long term customer deposits).   

In July of 2014 HealthEquity (HQY) went public providing a public market valuation for an HSA business that is very similar to Webster’s despite being non-custodial.  

Health Savings Account Market and Webster’s HSA division

What are Health Savings Accounts?

Health savings account (HSA) plans offer consumers the ability to manage their health care costs through tax-advantaged savings accounts which are paired with a high-deductible health plan (HDHP).  In a HDHP an individual has certain requirements for deductibles and out-of-pocket expense limits – usually at a minimum $1250 per individual and $2500 for a family.   HSA funds can be used to pay for qualified medical expenses and in 2015 the maximum contribution for an individual is $3350 and for a family is $6650.  HSA funds are owned by the individual (not the employer) and may be rolled over from year to year – they are not taxed and grow in the account tax free. HSAs were authorized by the Medicare Prescription Drug Improvement and Modernization Act of 2003 and entered the market in January 2004. An HSA is usually administered by a bank, insurance company, or approved third-party custodian.

There are several studies showing the HSA enrollment growing as much as 23% per year providing a strong secular growth tailwind for Webster bank.  

There are further reasons to believe that HSA’s will continue to grow in the new Affordable Care Act regime including the taxing of better health plans (“Cadillac tax”).   

How Do Banks Monetize Their HSA Business?

Banks operate as custodians of health saving accounts, offered through employers, health plans, agents/brokers, or directly to consumers. In this role, the bank serves as an administrator and depository of the health savings account. The four primary sources of revenue for HSA providers are 1) account fees, including monthly maintenance fees and account opening fees; 2) interchange fees from the use of debit cards tied to HSA accounts; 3) interest income through the investment of HSA deposits; and 4) investment fees. The primary expense for HSA providers is interest expense on the HSA deposits which for Webster bank has averaged 23 bps per year.  As such HSA deposits provide banks with a low cost, high duration funding source which the bank can deploy into higher yielding loans.  Further HSA account balances grow naturally over time with contributions outweighing withdrawals each year.  

Webster has grown its HSA business at a compounded annual growth rate of almost 30% since 2004 (not inclusive of the JP Morgan acquisition).

Today HSA Bank represents ~20% of deposits and 16% of total PPNR in 1H15. By the end of FY17, this business will represent over a quarter of net income and total deposits (assuming 20%s growth in HSA deposits and mid single digit growth in core bank deposits (ex. HSA) through 4Q17. Such a strong low cost core deposit growth engine could be more highly valued in a rising interest rate environment.

Valuation

The Street doesn’t separate out the fast growing HSA business and just lumps it in as part of the bank when it values the company and relative to its peers.   I think this is not the right way to value Webster.   By doing so WBS stock does not reflect any of HSA Bank’s value today.  

The appropriate way is to 1) Look at the core bank and apply a reasonable multiple and 2) Look at the HSA bank as a standalone entity that can be compared to HQY and also evaluated on the earnings power of the business itself.   

The HSA division should have a higher multiple as it is a high growth engine compounding close to 30% per year with predictable, recurring revenues that are high margin and do not face any credit risk.  HSA division also has high margin contribution (~40% Ebitda margins) without much CAPEX needs.   

HQY, a pure play non-custodial HSA administrator with half the assets of Webster’s HSA bank trades for 16x Price to Sales and 67x Forward PE!    

In my Sum of Parts valuation below I use a range of multiples for the core bank as well as

In early 2015, Kerrisdale Capital put out a report pushing for a spin of the HSA.  I think it is highly unlikely that near term that happens as , the company responded to Kerrisdale Capital’s suggestion to do so in an 8-K filing on March 2 stating,

“We have considered multiple structures for HSA Bank over the years and have consistently found that it is best situated inside Webster. This is because, in our opinion, the economic benefit of these low-cost, long duration deposits greatly exceeds potential revenue derived from brokering deposits to other banks, though our flexible model allows us to do so if we choose. This compelling financial advantage and other competitive benefits derived from being a bank, including end-to-end relationships with our clients and cross-sell opportunities with our customers, are available only if HSABank remains under Webster’s control.”

Value can also be unlocked without a spin.  Since HSA members are relatively insensitive to interest rates (low balances and high transaction rates), the value in HSA Bank’s low cost and sticky deposits should be recognized when rates rise.  In the absence of WBS spinning-off HSA Bank, we think faster net interest income growth as interest rates rise may be the key to unlocking its value In spite of that I still believe shares re-rate based on WBS’ above average loan growth, better-than-comps efficiency ratio, and leverage to the secular growth in HSAs.

Key Risks to Thesis

1. Operating efficiencies trend back lower

2. Loan losses in the credit book

3. Sub par growth in loans and deposits

Catalyst

* Market begins to ascribe value to the HSA business (even if company doesn't spin it out)

* Higher interest rates - leading to strong NIM growth