Description

WM is the country's dominant thrift which is in the process of building a nationwide consumer banking franchise with out of the box thinking. Rather than a thrift, WM views itself as a retailer of financial services that provides a diversified line of products and services to consumers. WM currently operates more than 2,700 consumer banking, mortgage lending, commercial banking, consumer finance and financial services offices throughout the nation. They have established a low cost, consumer focused strategy which has driven industry leading growth; however they currently sell at just 9 times the low end of next years estimated eps of $4.30. In addition currently the dividend yield is 4.2% and the dividend is relatively safe with a payout ratio of only 26.24%. The typical thrift sells for 12 times next years earnings and WM having generated growth of 13% annualized over the last ten years in the slow growth thrift industry clearly deserves a premium. Concerns about their mortgage franchise business, integration problems and believes they are a slow growth thrift rather than a complete financial services company primarily account for the inexpensive price. This stock is owned by well known value investors such as Bill Miller of Legg Mason and Bill Nygren of Oakmark Select. In fact it is Bill Nygren's largest holding accounting for more than 15% of Oakmark Select and he is the largest shareholder of the company with over 5%.

WM's goal is to revolutionize the delivery of financial services to the mass consumer market invoking comparisons to such category killers as Wal-Mart, Costco, and Home Depot. Their strategy through the 90's was to zero in on the consumer while other banks left the consumer and focused on commercial lending. During this time they built the the second largest home lending business in the country with 12% of the market. WM used strong presence in home lending along with targeting what consumers disliked about their current banks by offering checking accounts with no fees and ATM's with no fees in order to get their foot in the door with the customer. From 1992 to 2002 they completed 13 acquisitions to help them build a presence around the country. Currently they serve 12.3 million households and have a combined mortgage and retail banking presence in 28 of the top 50 MSA's. They have also achieved 30% household market share in 12 of the top 50 MSA's. This presence gives them a good foundation but they also have plenty of room to grow.

Currently they are expanding by starting there own branches which they call stores to disassociate themselves from thinking as a bank and focus on retailing. In 2003 they started approximately 260 stores and the project to open 250 stores in each of 2004 and 2005. They have been perfecting there model for new stores for some time and have really started ramping up new store openings since 2000. Rather than modeling the stores after the traditional bank branch they have designed there stores more like the retail industry with an open colorful feeling and hip music in the background. There is no counter with a line of tellers. Salesmen roam the store asking to help you and work stations are positioned out in the room. The salesmen are paid on commission and are extensively trained on cross selling other products to the customers. This strong sales mentality has been paying off as they have consistently raised the average products and services sold per household from 4.14 to 5.51 over the last 5 years. This retail thinking I like because it is unique and shows management is willing to consider things in a different way but what I really like is there cost structure for these stores.

Their average capital cost in starting their past stores is $830,000. In comparison Bank America has stated it would open 550 branches spending $1.2 billion by 2005 or an average of over $2 million per branch. The stores are bare-bones without a vault or security guards. The salesmen don’t even have cash. WM uses a computer system that prints a receipt with a code and the customer then uses this at a separate ATM like machine inside the store called a cash station which provides the cash etc. Because the salesman do not have a cash drawer the laborious open and closing procedures are eliminate allowing end of day procedures to occur in a few minutes rather than 30 or more minutes. This lower cost model gives WM a competitive advantage as they can be profitable quicker and are more able to focus money on attracting and keeping customers. The typical store takes about 18 months to be profitable and I don't think WM has been given credit for the major investment they have already made in new stores with a lot of the cost being expensed.

The result to date in their de novo expansion has been an increase in retail checking accounts of 17% annualized since 2001 which WM likes to measures as checking accounts tend to be stickier as customers are less likely to switch checking accounts once they get comfortable with one. WM analysis shows that they average 45.6 new checking accounts per month per location while their closest competitor is Bank of America with 24.7 per month per location. In addition growth in retail banking fees has been 23% annualized over the same period. Further customers satisfaction with WM format can be seen in a study done by Forester Research, Inc. recently which indicated of the major banks WM was the most likely for customers who were already customers to consider their current provider for additional services.

WM appears to have developed a model which gives them a competitive advantage and with growth of 13% annualized over the last 10 years and return on equity near 20% during the same period why is WM so cheap?

First they missed earning estimates and are now estimated to earn in the neighborhood of $4.15 to $4.25 from the $4.30 range. Also people are concerned, with rising interest rates; their mortgage loan origination business is going away which has been very profitable for WM over the last few years. However WM also is one of the largest mortgage loan server and with rising rates their service contracts become more valuable as they will earn the fees for a longer period of time with less refinancing. In fact over the last few years they wrote off substantial amounts of the service contracts as the likelihood of refinancing increased and rising rates could help them recover some of this value. Further to protect itself WM primarily keeps adjustable rate mortgages in house and sells fixed rate mortgages. It appears WM has balanced its risk fairly well. A quick rise in interest rates may squeeze WM's margins temporarily however it should not pose a long term problem.

People also worry they have grown too fast and are having integration problems. However through the 90's WM had experience integrating a number of systems and they are clearly operators understanding the processes and making changes to old systems to develop advantages. Kerry Killinger their aggressive CEO for 13 years has said that the decrease in the mortgage loan business will allow them to shift their focus to further operational improvements. Items they have identified they estimate will save $1 billion over 6 quarters. Further integration appears to be an opportunity for the company.

With any bank or thrift you have to worry about credit of their loans. WM recently sold Washington Mutual Finance for a large profit which contained its lowest quality loans leaving it with much higher quality loans. Nonperforming assets have decreased to their lowest percentage of .78%. Comparing WM to the top 10 banks (WM would be the 7th largest) WM has an annualized net charge off ratio of only .28% the lowest of any of its competitors. By comparison the loan loss reserve WM has is the second largest of it competitors at 3.9% which is substantially higher then all the major banks with the exception of one that has a reserve of 4%. Management indicates that their credit quality is better than anytime in their history.

I believe because of the current environment and fears this is the opportunity to buy a company with a unique competitive and cost advantage with the opportunity for long term growth at a substantial discount.

Catalyst

Stock repurchases. Management has indicated they are buying back twice there prior rate in the fourth quarter. They purchased 62 million shares in the last 4 quarters or over 6% of the outstanding stock which would put them on par to buy back 3% of the stock this quarter.

High dividend yield which should continue to increase given managements past history and low payout rate. With change in tax law for favorable treatment of dividends should help focus attention on stock.

Fall of mortgage business and WM's demonstration they can continue to generate current levels of income without reduced mortgage business due to diversified portfolio which will help offset impact and cost cutting.