Webster Financial: Following the Smart Money

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Includes: KRE, WBS
by: Tom Armistead

Webster Financial Corp. (NYSE:WBS) is a regional bank, interesting as a value play where the investor has the benefit of the involvement of smart money - in this case, Warburg Pincus.

As a strategy, following the smart money into financials worked horribly during the meltdown, a prime example would be TPG and Washington Mutual. However, the exceptional circumstances which existed last year have now been resolved and/or incorporated into expectations, and this situation makes good sense as contrarian value play.

Overview

Per the 10-Q:

Webster Financial Corporation (“Webster” or the “Company”) is a financial holding company and a bank holding company headquartered in Waterbury, Connecticut that delivers, through its subsidiaries, financial services to individuals, families and businesses throughout southern New England and into eastern New York State. Webster also offers equipment financing, asset-based lending, health savings accounts and insurance premium financing on a national basis and commercial real estate lending on a regional basis.

Difficulties began to manifest at the end of 2007, caused primarily by “the liquidating portfolios of indirect out-of-market residential construction loans and indirect out-of-market home equity loans.”

The company has been focused on its capital structure. From the 2nd quarter conference call:

...the quarter was dominated by developments in capital and credit. Though Webster has enjoyed capital levels well in excess of regulatory requirements, investors in recent quarters have focused intently on tier I common. This is understandable in a time of stressful market conditions.

Our response has been to exchange more than $170 million of existing preferreds in to tier I common equity in the quarter. The exchange can only be described as extraordinarily successful. We offered to exchange common shares and cash for outstanding convertible preferred shares and to exchange common shares for trust preferred securities. We were very pleased that the convertible preferred portion of the offer was oversubscribed at 76% and that 32% of trust preferred securities were tendered.

Gaining US Treasury approval for the part cash exchange was key to its absolute and relative success and was a further testament to the overall strength of Webster’s capital position. Especially notable about the exchange was not just that we added a big chunk of tangible common equity but that we did it at a very attractive price such that the effective issuance price of $14.68 per share was about double the Webster’s share price when we announced the exchange and was actually 2.6% accretive to tangible book value which rose to $13.15 a share in Q2.

On June 30th, our all important tier I common to risk weighted assets ratio climbed to over 6.4% from about 5.25% at March 31. While our tier I risk based equity was 11.7% which of course is about double the 6% ratio required to be considered well capitalized.

On July 27th, private equity firm Warburg Pincus agreed to invest $115 million in Webster through a direct purchase of newly issued common stock at $10 per share, junior non-voting preferred stock, and warrants. Warburg received a seat on the board and will be taking an active advisory role in improving performance and restoring shareholder value.

Warburg Pincus

As a shareholder of MBIA (NYSE:MBI), I am familiar with Warburg Pincus, who made a similar investment in MBI while that company was under concerted attack by a determined band of short and distort bear raiders led by William Ackman.

Warburg has yet to see a profit on this investment, which went sour immediately. I think that is less a question of their expertise and good judgment than it is a testimony to the massive and previously unimaginable damage that has been done to our economic system by the extended reign of lawlessness, ushered in by 20 years of progressively more lax deregulation of the financial markets.

Warburg has extraordinarily good credentials in the niche of re-capitalizing commercial banks. Specifically, they re-capitalized Mellon Bank in 1988 and guided it back to health and prominence. Profits were outstanding, if a long time coming.

The investor who follows their lead into Webster has the benefit of their due diligence (assisted by Ernst and Young) and their implied judgment that capital is now sufficient to avoid further dilution and provide a firm base for renewed growth. He also has the benefit of their considerable experience and expertise in the banking field.

Valuation

The shares, which closed Tuesday at 12.45, are now trading at a P/B of .56, and at a small discount to tangible capital of 13.15 per share as of Q2. The industry average P/B is 1.43. A common and important metric of bank performance is the efficiency ratio, which Webster calculates using SNL’s methodology-non-interest expense (excluding foreclosed property expenses, intangible amortization, goodwill impairments and other charges) as a percentage of net interest income (FTE basis) plus non-interest income (excluding gain/loss on securities and other charges).

Currently WBS' efficiency ratio stands at 66.40, a number that could be reduced to about 55, more in line with industry averages for a bank of their size.

Assuming 1) current loan loss provisions are adequate, 2) efficiency is brought up to industry standards and 3) new loans are made under profitable terms, the P/B should tend toward the industry average. I did some work with tangible book value per share allowing for the Warburg Pincus involvement and the prospective dilution from their warrants, then applying historical multiples I arrive at a target of 27 per share. This will not happen overnight, probably somewhere between 2 and 4 years out.

Risk/Reward

The risk/reward is difficult to quantify here. I personally regard the risk of paying half of book value for a bank capitalized at twice the regulatory standard as trivial, particularly when I have the benefit of seeing an experienced and knowledgeable private equity firm make a large commitment.

Disclosure: Net long WBS and MBI, no position KRE