Hudson City Bancorp: Yielding Total Returns for Option Writers

HCBK:NDQ - Oct. 13, 2009 Close: $13.17

52-week range: $7.46 (Mar. 9, 209) - $18.93 (Nov. 4, 2008)
Dividend = $0.15 quarterly = 4.55% current yield

Hudson City Bancorp, Inc. (HCBK) offers offering traditional deposit products, residential real estate mortgage loans and consumer loans. In addition, the Company purchases mortgages and mortgage-backed securities and other securities issued by United States government-sponsored enterprises. Its revenues are derived principally from interest on its mortgage loans and mortgage-backed securities, and interest and dividends on its investment securities. They have about 131 branches in NY, NJ, and CT. HCBK converted from a chartered mutual savings bank into its current form in two stages. The first came in 1999 and the final step took place on June 7, 2005.

In direct contrast to almost all other banks Hudson City posted record earnings in 2008 and is on track for another all-time high in EPS for 2009. In fact, 2009 will likely be the ninth consecutive year of improved earnings and increased dividends. This is quite a feat in light of the past few years housing market.

As of year-end 2008 about 99% of HCBK’s loans were first mortgages and just 1% were consumer and other loans. They managed to sidestep the worst of the carnage through the use of old time banking standards. Forbes magazine called them “The Best Managed Bank in America” in both 2007 and 2008.

Here are their impressive (split adj.) per share numbers as reported by Value Line:

Year	Mort. Loans	EPS	Div.	B/V	Avg. P/E	Avg. Yield
2001	17.19	0.21	0.07	2.02	16.6x	2.1%
2002	21.19	0.31	0.11	2.14	17.4x	2.0%
2003	23.28	0.35	0.16	2.18	24.1x	1.9%
2004	27.96	0.40	0.22	2.35	28.1x	1.9%
2005	32.99	0.48	0.27	8.83	23.8x	2.4%
2006	46.60	0.53	0.30	8.84	24.9x	2.3%
2007	65.11	0.58	0.33	8.89	23.9x	2.4%
2008	74.49	0.90	0.45	9.43	19.1x	2.6%

First half 2009 earnings per share were $0.52 versus $0.40 and Zacks now sees 2009 – 2010 EPS at $1.05 and $1.15 respectively. That puts HCBK’s multiple at < 12.6x this year’s and under 11.5x next year’s estimates. Compare those P/Es with all the historical valuations in the chart above. HCBK shares are near the cheapest they’ve ever been.

Dividends were initiated in 2000 and have been raised in each year since. The current yield of 4.55% is better than the interest rates on bank CDs, treasury notes and virtually everything else without high risk. It’s also the best yield in HCBK’s history as seen from the chart above.

Value Line notes Hudson City’s financial strength as B+ and gives them 90^th percentile rankings in both ‘stock price stability’ and ‘earnings predictability’ (with 100^th being best). HCBK shares have outperformed 80% of the 1700 stocks in Value Line’s research universe on a long-term basis. Morningstar sees ‘fair value’ for Hudson City as $15/share.

A rebound to just fourteen time 2010 estimates of $1.15 would see HCBK back above $16 /share within about 15 – 18 months. Add in the generous dividend yield and this looks like an attractive total return stock.

Is a $16 target price reasonable? Sure. HCBK shares touched highs of $16.10, $25.00 and $15.90 in calendar 2007-2008 and 2009 YTD. With earnings and dividends now better than ever before, there is no reason these shares shouldn’t attain at least their old highs.

Here’s a way to play with even less risk…

	Cash Outlay	Cash Inflow
Buy 1000 HCBK @ $13.17 share	$13,170
Sell 10 Jan. 2011 $15 calls @ $0.95/sh.		$950
Sell 10 Jan. 2011 $15 puts @ $3.50		$3,500
Net Cash Out-of-Pocket	$8,720

If Hudson City rises to at least $15 (+ 13.9%) by Jan. 21, 2011:

• The $15 calls will be exercised.
• You will sell your shares for $15,000.
• The $15 puts will expire worthless.
• You will likely have received at least $750 in dividends.
• You will have no further option obligations.
• You will end up with no shares and $15,750 in cash.

That 14% (or better) rise in the share price would have generated a $7,030 net profit on an original cash outlay of $8,720 = 80.6% total return over the 15-month holding period.

What’s the downside?

If Hudson City shares finish below $15 on Jan. 21, 2011:

• The $15 calls will expire worthless.
• The $15 puts will be exercised.
• You will be forced to buy another 1000 HCBK shares.
• You will need to lay out an additional $15,000 in cash.
• You will likely have received at least $750 in dividends.
• You will have no further option obligations.
• You will end up with 2000 shares and $750 in cash.

What’s the break-even on the whole trade?

On the original 1000 shares it’s their $13.17 purchase price less the $0.95 /share call premium = $12.22 /share.

On the ‘put’ shares it’s the $15 strike price less the $3.50 /share put premium = $11.50 /share.

Your overall break-even would be $11.86 /share (ignoring dividends) or $11.49 /share (including yield).

HCBK could fall by as much as $1.68 /share (-12.7%) without causing a loss on this trade.

Summary:

Hudson City Bancorp appears to be a well run, conservatively managed community bank with a historically low P/E and a very attractive dividend. Their shares appear poised to rebound to $16 or better by early 2011.

Using the buy/write strategy above any move above $15 by early 2011 will likely translate into 80% total returns over the 15 months until expiration.

You have a built-in margin of safety of almost 13% even if things don’t go as expected.

Disclosure: Author is long HCBK shares and short HCBK options.

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NOTE: Unless HCBK drops below $12.50 /share by Friday afternoon Oct. 16th…

My May 11, 2009 write-up trade on HCBK wil be completed with the best-case scenario 33% return even though the shares only moved up marginally since then. Banking On A TARP-Free Name - Hudson City Bancorp

Comments

[epeon:]

You are too slick for me. I just buy and write covered calls on this one. have for some time. doing ok

Oct 14 10:44 AM

[loonsong:]

Good idea. TCB might be another Tarp free name as well, but w/ lesser yield. I like your work, thanks,
loonsong

Oct 14 09:35 PM

[Paul Price:]

A Bank Stock that Stayed Out of Harm's Way
By TERESA RIVAS - Barrons Online

Hudson City Bancorp, one of the recession's best performing banks, should continue to best rivals in the hyper-competitive New York area.

IN NEW YORK, the city that never sleeps, Hudson City Bancorp (ticker: HCBK) is one of the few financial institutions that wasn't asleep at the wheel in the last year.

The nation's largest thrift has stayed true to its roots, making conservative mortgage loans in New York City and the surrounding suburbs, even as its rivals were engaged in some risky lending during the last real-estate boom.

Hudson City's strategy paid off, leaving it cash-rich and able to take market share from competitors in a difficult banking environment.

At a Glance:
Hudson City Bancorp (HCBK)

Stock Price: $13.30
52-Wk High: $18.93
52-Wk Low: $7.46
Market Cap: $6.5 billion
Est. FY 2009 EPS: $1.08
2009 P/E: 12.7 times
Est. Long-Term EPS Growth: 16.4%
Est. ('10/'09 EPS Growth: 10.2%
Revenue (trailing 12 months): $1.1 billion
Dividend Yield: 4.5%
CEO: Ronald Hermance
Headquarters: Paramus, NJ

* Based on analyst estimates looking ahead three to five years.
Sources: Morningstar, Barron's, Yahoo Finance, Thomson Reuters. "It's one of the best run banks in the country, and you can see that in their performance metrics, even in the worst of times" says Sandler O'Neill analyst Mark Fitzgibbon. "They're still [turning out] returns on average equity in excess of 10%, and their 19% efficiency ratio is the lowest in the industry."

Still, while Hudson City didn't suffer from the steep losses of its peers in the depths of the recession, its shares haven't been bid up in the latest rally: The stock actually fell 1% in the last three months while the market saw double-digit gains.

Trading at just 11 times 2010 earnings, Hudson City is scraping the bottom of its five-year range. The stock is also paying a hefty 4.5% dividend yield, supported by more than $600 million in cash.

"We continue to view Hudson City as a solid bank with good capital ratios and a balance sheet that enables it to capitalize on a favorable net-interest-margin environment," says Ragen Steinke, portfolio manager of the WHG SMidCap Fund.

When Hudson City reported better-than-expected earnings last week, profit rose 11%, as net-interest margin widened and deposits grew. The company has continued to make loans to high-quality residential borrowers with at least 20% down.

Although nonperforming assets did rise during the quarter, it was from a very low point. Growing to 90 basis points of total assets, Hudson City's levels are still well below peers.

"It's not a real risk to the story," says FBR Capital Markets analyst Bob Ramsey, who notes the bank's tangible common equity-to-assets ratio of 8.7% gives them plenty of capital for growth, helped by their strong credit quality. "The proof is in the pudding," Ramsey says of their continued earnings power.

"You could call it a one-trick pony, as it's basically a one-product institution on the lending side, but they stick to what they are extremely good at," says Fitzgibbon.

This mentality helped the company avoid all the toxic-financial products that eventually saddled competitors' balance sheets.

"This is a really terrific management team," says Janney Montgomery Scott analyst Richard Weiss. "They knew when to hang up the phone when other banks bought these products that they really didn't understand."

Bill Bartmann, publisher of the weekly financial newsletter, The Bartmann Report, applauds Hudson City for avoiding "the 'siren song' of quick and easy money and stayed true to their business plan."

Still, though the bank still originates the majority of its loans, about 30% are purchased from other institutions, and some investors may fear the company doesn't have as tight of control over these products.

However, Ronald Hermance, the chairman and chief executive of Hudson City, assures Barrons.com that these loans do not dilute Hudson City's quality portfolio.




"We write specifications that are more restrictive than we would take directly: they have to be jumbo, owner-occupied loans with a 25% down payment in the Northeast," he says. "These are prime loans."

And though the bank has maintained its integrity during the downturn, it shouldn't be left behind the pack in the recovery. Making loans and offering attractive rates to depositors (financed by its enviable capital) have allowed Hudson City to gain market share from weaker rivals.

Hermance says he has "no fear" that the company will be able to maintain this lead, because Hudson City's cost efficiency and lean infrastructure is not something competitors can emulate overnight.

Of course with over 70% of their loans in the New York metro area, any steep deterioration in home prices in the region would adversely affect the company, as would sharply rising short-interest rates. Nor is $30 billion in debt a number to gloss over.

However, the government has indicated that keeping interest rates low is a priority in the near future, and Hudson City's core base doesn't seem in danger of a large housing drop off. Likewise, Hudson City has not been in trouble with its creditors and did not take funds from the Troubled Asset Relief Fund, and has a strong-capital position.

Therefore investors should consider moving into Hudson City.

Oct 27 07:07 PM