Washington Federal Sees Strong Positive Leverage, But The Cost Of Doing Business Is Rising

Washington Federal (NASDAQ:WAFD) (“WaFed”) has done well since my last update, rising almost 7% (and beating regional banks by around 12%), with the stock getting a big boost on strong fiscal fourth quarter results, including excellent operating leverage and credit quality. The bank likewise posted healthy loan growth and decent deposit performance at a time when these metrics are getting closer scrutiny by the Street.

I still like WaFed, but operating conditions are going to get more challenging from here. The bank is going to have to rely more heavily on more expensive sources of funding for its loan growth, and that’s going to impact profitability. At the same time, I don’t see how credit can get much better for the bank. On the flip side, there are still opportunities to drive attractive loan growth in markets like Texas, Arizona, Nevada, and Utah, and I believe the shares do still offer some upside from here.

 

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 Washington Federal Sees Strong Positive Leverage, But The Cost Of Doing Business Is Rising

Operational Execution And Strategic Risk-Taking Is Benefitting Washington Federal Meaningfully

Allocating capital and managing risk are critical duties for bank managers, and I think Washington Federal (NASDAQ:WAFD) ("WaFed") has been doing a better job of it than I'd expected when I last wrote about the company. While I liked WaFed and saw improvement, I didn't think there was quite enough undervaluation to merit a bullish stance. Since then, the shares are down slightly, but have outperformed smaller regional peers by about 5%.

WaFed still doesn't look like a remarkably cheap bank, and there are some risks to the outlook (including management's own guidance for slowing loan growth). The company has made good progress on costs, though, and I can see a clearer path now toward a higher-quality, lower-cost deposit base to support a quality, growing loan portfolio. An economic slowdown over the next 12 to 18 months is certainly a risk (particularly in key states like Texas), but I do lean more positively on this under-followed company.

 

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Operational Execution And Strategic Risk-Taking Is Benefitting Washington Federal Meaningfully

With Rates Set To Rise, Washington Federal Looks To Leverage Better Growth

 

Writing about Seattle’s Washington Federal (WAFD) back in October of 2020, I wasn’t all that impressed with what I found. I was concerned about the bank’s deposit franchise, as well as its ability to compete head to head with larger banks to grab a larger share of commercial lending in its more attractive markets. There were also issues like expense efficiency to consider, with an ongoing consent order related to Bank Secrecy Act / Anti-Money Laundering (BSA / AML) shortfalls impacting results.

Since then, the shares have outperformed the S&P 500 handily, but have underperformed its smaller-bank peer group by more than 30%, so I don’t really regret my call that there were many other more compelling ideas out there.

Since then, the bank has made some improvements, including a noticeable improvement to the deposit mix and some interesting shifts in the loan book. I’m more bullish on the growth outlook now, but it’s a stretch for me to get to a near-term fair value much above the high-$30’s, making this more of an “improving hold” to me than a clear buy now.

 

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With Rates Set To Rise, Washington Federal Looks To Leverage Better Growth

Washington Federal May Be A Little Undervalued, But There's Not A Lot To Argue For It As A Buy

It's been a while since I've updated my thoughts on Washington Federal (NASDAQ:WAFD), a Seattle-based bank with over 230 branches across eight states. I wasn't all that bullish on the bank back in 2016, as I was concerned about the ongoing deposit share loss and scale challenges competing with larger banks as the company looked to diversify its loan book into commercial lending. Since then, the shares have lagged regional bank indices by about 5% to 10%, depending upon which index you use.

I remain concerned about share loss in the core Seattle and Washington markets, but the core deposit mix has improved, and management has made real progress in diversifying the loan book without material erosion in credit quality. Management has also been aggressive in returning capital to shareholders, with meaningful share buybacks and dividend payments. This isn't a bad bank, but the return potential still strikes me as pretty pedestrian today, and I don't really see the sort of sticky, low-cost deposit franchise that would make this a high-priority acquisition target, though expense synergies could certainly appeal to a bank with a meaningful existing franchise in the Western U.S.

 

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Washington Federal May Be A Little Undervalued, But There's Not A Lot To Argue For It As A Buy

Washington Federal Hoping A New Model Can Drive More Growth

Until relatively recently, Washington Federal (NASDAQ:WAFD) was pretty much a thrift - residential mortgages made up a large majority of the loan book, and the company financed those loans with a funding mix that skewed heavily toward savings accounts and CDs. In recent years, though, this multi-state Western regional bank has tried to become more like larger peers such as Wells Fargo (NYSE:WFC), U.S. Bancorp (NYSE:USB), and Umpqua (NASDAQ:UMPQ), with a turn toward more commercial lending.

I don't like how Washington Federal has been losing deposit share in many states, nor the already-high loan/deposit ratio. As the bank is not very asset-sensitive, I worry that the near-term drivers for near-term growth are relatively limited. I do believe that management is making a good call in diversifying its loan book, but I'd like to see more progress on accumulating lower-cost deposits and a willingness to look a little harder for better uses of capital.

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Washington Federal Hoping A New Model Can Drive More Growth

Umpqua Seems Short Of Growth Drivers

Oregon's Umpqua (NASDAQ:UMPQ) is something of a case-in-point as to why I'm reluctant to overpay for stocks (and bank stocks in particular). When I last wrote about this high-quality bank back in 2014, I thought the shares looked expensive. Since that time, the shares are actually down about 5% - rare for most bank stocks and all the worse when compared to the performances of regional rivals like East West (NASDAQ:EWBC), Washington Federal (NASDAQ:WAFD) and Pacific Continental (NASDAQ:PCBK).

What's worse is that even after this run of underperformance, the shares still don't look all that cheap. Not only is Umpqua not all that asset-sensitive, it also lacks real leverage in more than a handful of major markets. Add in a loan book that is overweighted to commercial real estate and multi-family residential lending, an elevated cost structure (which is liable to be tough to tame) and weakening yields, and it's a tough near-term outlook. While there is definitely room for improvement, Umpqua may find it hard to go much above 10% ROE in the foreseeable future, and that limits the value proposition today.

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Umpqua Seems Short Of Growth Drivers

Investopedia: More, Better, Faster Please

If a part-time investor can read all of Citigroup's (NYSE:C) earnings and not get a headache, that is an impressive accomplishment. After all, just consider the impact of credit value adjustments (CVA) in this period - Citi incorporated a $1.1 billion loss into its earnings because its debt actually became more valuable. So, things are getting better at Citi, and that causes them to recognize a loss. That is just part of the fun-filled, anything-but-logical world of bank accounting, but investors who can maintain the patience and inner peace to look through all of this might still find an interesting recovery/rebound prospect in this stock.

The Quarter That Was
Okay, here is a quick run-down of the major salient points of Citigroup's fiscal fourth quarter earnings. Revenue (excluding that CVA) was down about 6%. Weakness in investment banking (fixed income revenue was down almost one-third sequentially) certainly hurt, but a 3% net interest income was pretty feeble in its own right, as was the decline in net interest margin to below 3% (2.97%). Consumer banking was "stable" overall as pretty good overseas performance covered up for a 5% decline in North America.

Credit was better, as the NPA ratio improved 44 basis points (to 3.25%) and the NCO ratio declined as well, as non-performing loans dropped 13% sequentially. Feeling better about credit, Citi released about $2.3 billion from its loan loss reserves (that is, the company's charge-offs exceeded the provisions it took for bad debt), with a little more than half of that coming from the consumer business. On the other hand, the company is having to build its litigation reserves - a common issue these days for large banks like Citi, Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC) and others facing legal disputes with mortgage borrowers, mortgage insurers (like Assured Guaranty (NYSE:AGO), and mortgage buyers like Fannie and Freddie.

More Trouble Still to Come?
Speaking of Freddie and Fannie, Citi may not really be out of the woods here just yet. The company spent about a quarter-billion dollars this quarter buying back mortgages, but a Bloomberg report suggests that Citi has still been selling an unacceptably high percentage of bad loans to Freddie. Still, it would seem likely that the worst of the mortgage repurchase issue is over for Citi, at least as it pertains to the GSEs Fannie and Freddie. After all, if Bank of America got a pennies-on-the-dollar deal, why would Citi not expect the same? 


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BMO Buying Marshall & Ilsley

There was a widely held view that Bank of Montreal (NYSE:BMO) was going to expand its U.S. business, and the company did exactly this today - announcing that it was acquiring Wisconsin's Marshall & Ilsley (NYSE:MI) in an all-stock deal. Provided the deal closes as expected, this deal will make BMO the 15th-largest bank in the United States (it is already No.3 or No.4 in Canada, depending on the metric used to measure this), and the No.1 bank in Wisconsin (with 20% deposit share), as well as a leading bank in Arizona and several Midwestern states like Illinois.

The Terms of the Deal 

To acquire Marshall & Ilsley, BMO will exchange 0.1257 of its own shares for each share of MI - a deal that gives an implied value of $7.75 per share to MI. That's a 34% premium to where MI closed Thursday afternoon, although movement in BMO shares will change that imputed valuation and premium. All in all, it is a $4.1 billion deal for BMO, though the company will also be launching a nearly $800 capital raise as part of the deal and will be repaying MI's $1.7 billion TARP obligations.

A Weak Bank = No Premium 

Like the earlier deal between M&T Bank (NYSE:MTB) and Wilmington Trust, BMO is paying a fairly minimal premium to do this deal. In fact, BMO is taking out Marshall & Ilsley at a price that is roughly equal to its tangible book value. (For related reading, see Willmington Trust Sold For Tangible Book Value.)

So why is MI selling for so little? Well, BMO's comments about the deal suggest that MI was still in rough shape. In fact, BMO will be writing off about 12% of MI's loan book right off the top - a charge that will cost about $4.7 billion and means that cumulative losses for MI will be around 21% (if things get no worse from here). That is a pretty staggering amount of bad debt and a sharp indictment of management's decision to expand from the "boring" Midwest into hot real estate markets like Arizona and Florida. (For more, see Banking Merger Mania.)

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