Note – hat tip to RonMexico for the idea
First Financial Northwest Corp. (NASDAQ:FFNW) is an underfollowed and misunderstood thrift conversion that possesses a variety of attractive characteristics we look for in an investment. In particular, an attractive absolute and relative valuation, limited downside risk, insider ownership and buying, near to medium-term operating momentum, a few internal and external catalyst(s) to bring about the realization of underlying value, and last but not least, significant upside potential under almost any future outcome we can imagine.
FFNW also happens to be a combination of a classic special situation (i.e., thrift conversion) and what Tom Brown likes to call the 'Buy Banks That the World Thinks Are At Death’s Door' approach (B-B-T-W-T-A-A-D-D) to investing - a reference towards banks that (1) have a significant amount of bad assets (2) are currently losing money (3) may continue to lose money for a few more quarters and (4) that the market believes will either fail outright, or at minimum will need to reorganize and/or raise a significant amount of value destroying new capital. Essentially, these are banks that although they own a significant amount of bad assets, things actually appear superficially worse than they really are – and more importantly, these are banks that will almost certainly work through their current credit problems and come through the credit cycle just fine. So, in other words, it should be no mystery as to why FFNW is both overcapitalized and mis-priced.
Also, it’s important to note that in the fourth quarter of last year FFNW entered into an informal supervisory agreement with the OTS which subjected the company to both (1) more stringent regulatory examinations (likely resulting in more of its current loans being forced into the non-performing category) and (2) requires the company to obtain approval prior to paying a dividend or buying back stock. Notably, this regulatory action was taken because FFNW decided to buy back $1.2M shares of stock (i.e., because they decided to essentially ignore their regulators suggestions to conserve capital). In our minds this was in some sense reckless – but to be honest, its also kind of awesome - you can certainly come to your own conclusions on this one :).
First Financial Northwest, Inc. operates as the holding company for First Savings Bank Northwest that provides community-based savings banking services in Washington. Its deposit products include noninterest-bearing accounts, checking accounts, negotiable order of withdrawal accounts, money market deposit accounts, statement savings accounts, and certificates of deposit. The company focuses its lending activities primarily on loans secured by first mortgages, such as one-to-four family residences, commercial real estate, multifamily real estate, and construction/land development loans. It also offers various secured consumer loans, including savings account loans and home equity loans, which comprise lines of credit and second mortgage loans, as well as provides short-term unsecured loans. In addition, the company, through its other subsidiary, First Financial Diversified, Inc., offers escrow services. It serves King, Snohomish, Pierce, and Kitsap counties in Washington through a full-service banking office and automated teller machines.
In October 2007, the company did an IPO in conjunction with its conversion from a mutual holding company to a stock holding company at a price of $10/share. FFNW is the 19th largest bank in Washington with .83% deposit market share. In King County (i.e., Seattle) the company is the 8th largest bank with 1.81% deposit market share. The company was founded in 1923 and is headquartered in Renton, Washington.
What Assets Comprise FFNW’s Book Value?
FFNW’s loan book can be generally thought of in 3 separate pieces. With that in mind, book value consists primarily of (1) Seattle based residential real estate loans (as noted above, most of the company’s credit issues/problem loans were derived here) (2) A commercial loan portfolio, which notably is much smaller, and consists mostly of office building and warehouse loans (the commercial side of the equation has been less of an issue credit wise given it’s a much smaller piece of the overall loan book and its devoid of a lot of the riskier retail and/or strip mall loans that have caused so much of the problems within the commercial space) and (3) its investment portfolio. On the investment side of the equation, FFNW owns almost entirely government guaranteed loans, so no worries here.
Is FFNW Sufficiently Capitalized Or Will It Need Value Destroying New Capital Or A Reorganization?
FFNW’s balance sheet is fortress-like - and their capital ratio’s prove it - with Tier 1 leverage of 11.33%, Tier 1 risk-based capital at 16.43%, and total risk-based capital at 17.73%. Notably, the company also has roughly $50m in additional capital at the holding company level. Clearly, these are very strong numbers and this isn’t your average priced as if death is at the door regional bank.
Is FFNW A Conservative Underwriter?
The company has been a conservative underwriter historically. Before the fourth quarter of 2009 the company hadn’t had any REO on its books in over twenty years (REO stands for real estate owned by the bank that they had to foreclose on). The average LTV at origination is 60% for owner occupied residential loans, 75% for construction loans, and 80% for non-owner occupied residential loans. According to management, realized loan loss severity so far has ranged from 0-25% (realized losses on OREO sales were 11.1% in Q1 2010).
In our minds, understanding this point is a hugely important piece to the FFNW puzzle - this is not a bank with a history or culture of poor underwriting (i.e., their recently poor credit performance is abnormal considered historically and certainly isn’t systemic across their loan book). Given that 95% of FFNW’s NPA’s can be traced to only 15 borrowers - primarily Seattle based residential builders who had been clients of the bank for decades (fwiw, most of which have signed personal guarantees on the loans in question) - one can begin to see why we feel that the company’s recent credit problems are both highly unusual and unlikely to migrate into other areas of FFNW’s loan portfolio.
The bottom line here in our opinion is that FFNW’s loan portfolio was badly damaged over the last year or so due to both internal (i.e., excessive concentration relating to long time clients) and external factors (i.e., a one of a kind real estate bust coupled with a severe economic recession) – in other words, a systematic breakdown in underwriting standards across FFNW’s loan book this was not.
As we see it, in order to understand the abnormally large credit losses one needs a little historical context, both to understand the nature of where the problem loans came from (more on this below) as well as the unique circumstances that brought these credit losses about. The simple answer is that FFNW made too many residential construction loans during the housing boom and when the bubble burst, its credit expenses soared. Fast forward to today and the company has been losing money for several quarters, and will likely lose money for a few more before things fully return to normal. In the meantime, we think that leading indicators of credit quality have already and should continue to markedly improve going forward and that FFNW’s credit costs are set to dramatically decline. So much so in fact that we think that FFNW will likely return to profitability by the end of the year. Why?
Because FFNW’s Book Value Will Stabilize & Eventually Recover
The heart of FFNW’s credit problems - both in terms frequency and severity – have been almost entirely related to the banks residential construction and land development loans underwritten during the housing boom. To get a sense of just how toxic these loans have been for the bank, consider that the doubling of NPA’s it has experienced over the last year or so is due almost entirely to this area of its book. In our mind, this isn’t too surprising given the underlying characteristics of C & D loans, which are both more likely to default on average and more importantly, when they do default, the loss associated with the default in question is considerably more severe. Why? There are a few reasons, the first of which is that they tend to be very large loans with short-term maturities. In addition (due to the nature of the loan), they typically don’t generate any cash flows to soften the blow when the developer in question gets into trouble, and hence generally cannot be refinanced. Also, in recessionary situations, demand for these types of projects tends to fall off a cliff, so when you take that into account along with the fact that these properties typically don’t generate any cash flows, it is in some sense intuitive that the value of the collateral underlying these loans tends to collapse (surprise, surprise).
So given what we know about the underlying characteristics of FFNW’s C & D loan book (both frequency and severity wise), the obvious question is how close are they to moving past these issues (if at all)? Assuming you believe the company will not only survive, but eventually prosper as we do, this is important – if for no other reason than because it helps investors get a feel for both how long it will be before FFNW’s abnormally large credit losses cease, as well as when one can roughly expect the bank will return to profitability. With that said, the following few paragraphs will discuss the various reasons we think FFNW is likely in the 9th inning of working past its credit issues:
First and foremost, we think that management has been conservative as it relates to dealing with the company’s credit problems – our sense is that they have honestly identified problem credits and have been aggressive in writing them down and resolving them. Management remains confident they will be able to cut the company’s NPA’s in half over the next six months. Something else to keep in mind in this regard is that given how significantly overcapitalized the company is, management can actually afford to aggressively blow out their NPA’s. Unlike the head’s of the run of the mill regional bank, that is struggling under the weight of a significant amount of toxic assets, FFNW’s management isn’t in danger of losing their jobs and/or their bank failing, and hence lack the rationale and incentives to deceive and/or play extend and pretend in hopes of buying time to earn their way out of their particular credit issues.
Also, given that FFNW (1) stopped underwriting new C & D loans in the fourth quarter of 2007 (2) has been building reserves for over a year now and (3) has already classified as non-performing roughly 70% of their C & D loans and roughly 17% of their non-owner occupied residential real estate loans, and (4) their C & D loan portfolio as a percentage of their total loan book has declined 34% yoy, it seems very likely in our opinion that for purposes of reporting income and taking reserves against its balance sheet, FFNW has already assumed the worst of its NPL’s.
Additional incremental evidence in this regard can be gleaned from the fact that 43.1m of Q1’s new non-performing assets (NPA’s) are still current on their borrowings (yes, you read that right, these “non-performing” loans are actually still performing i.e., they are still continuing to pay the company interest on its borrowings). If most of the company’s new NPA’s are actually current, then is this (1) not a sign of management’s conservatism at this point in the cycle (or maybe just that the regulators have potentially forced them to be so) and/or (2) not considerably more likely that a good portion, if not all, of the face value of these non-performing loans will eventually be recovered?
Last but not least, the fact that the Seattle housing market is showing signs of recovery and may have in fact bottomed is incredibly bullish for the company and its fortunes going forward. Once residential real estate prices begin to move meaningfully higher, mortgage credit quality should improve in lock step - giving more borrowers the chance to refinance rather than face foreclosure. Assuming this virtuous cycle resumes, the ultimate severity of FFNW’s realized losses will not only decline, but the company should actually be able to rid themselves of their NPA’s at a meaningfully accelerated rate. Recent data points support such a conclusion (or at least that the Seattle housing market is at the very least stabilizing), namely the (1) meaningful increases in recent home sales activity (2) the moderation of housing price declines (fwiw, Seattle housing prices are down 30%+ since 2007), and (3) the fact that affordability indexes in FFNW’s markets are back to 2003-2004 levels.
To reiterate, given how tied FFNW’s NPA’s are to the fortunes of the Seattle housing market, any stabilization or improvement there would obviously be a tremendous positive, given that it would simultaneously (1) reduce the inflows of NPL’s (2) reduce the severity of realized losses and (3) meaningfully increases the probability of a full resolution of existing problem loans which would then in turn cause the banks NPA’s to decline at an accelerating pace.
So, given FFNW stopped underwriting new C & D loans (i.e., the company’s toxic assets) in the fourth quarter of 2007, the abnormally high % of problem loans already classified as NPA’s, the rapid decline in the company’s C & D loan book yoy of 34%, and the fact that the Seattle housing market may finally be on the mend, it’s not unreasonable in our minds to expect that non-performing assets/loans have peaked and FFNW is finally firmly back on the path towards profitability.
Management has clearly made its fair share of mistakes of late (fwiw, we think they have definitely learned their lesson), but all things considered, we think they have plenty of industry experience and are more than capable of leading this business towards brighter days in the years ahead. As we see it, they have been particularly impressive on the capital allocation front. By buying back shares with the company’s excess capital at massively accretive discounts to TBV - instead of pursuing an empire building strategy (and with it, much riskier strategy with much more uncertain returns) – they have been in our opinion focused on the right things – especially in the current environment.
Consider for a moment that the company has been buying back stock hand over fist since going public. In the fourth quarter of 2009 the company bought back 1.2m shares at an average price of $6.50/share. Since going public the company has spent roughly $40m dollars on buybacks in total, repurchasing almost 5m shares at an average price of roughly $8.23/share. If the sheer volume of company specific buybacks doesn’t grab your attention, consider that as recently as May, the company’s CEO and CFO purchased 5,000 and 4,000 shares respectively at roughly $5.00/share in the open market (notably, a few months before that the CEO bought roughly 4,000 shares at roughly $7.50/share). In addition to the company’s executives, a few of the company’s directors purchased over 5,000 shares for their personal accounts as well over the last few months.
So again, given the current environment and that this is a spread lending business, we feel that Management’s willingness to both own and repurchase stock is particularly important. This is true, both because (1) buybacks are a good indication of managements conviction in the current level of the company’s undervaluation (i.e., that its NPA’s are set to decline significantly in the coming months and year ahead) and (2) because of the rapid acceleration in per-share value that these buybacks can produce for shareholders. The fact that management refused TARP funds due to the restrictions on dividends/share buybacks that would come along with it is further indication that management’s is shareholder friendly/orientated.
Regarding the assets, we are comfortable assuming RonMexico’s overly conservative stress test estimates for our base case scenario – i.e., that the bank encounters a 50% loss severity on its REO, a 40% loss severity on its non-performing construction and land development loans, a 25% loss severity on its other non-performing loans and an additional 3% on all of its current performing loans. This compares to its current 36.4MM loan allowance implying a worst case need for $51MM in additional provisions, which would cut tangible book value to $153M or $8.17/share. In other words, FFNW is trading at roughly half of its worst case tangible book value (i.e., despite FFNW’s toxic assets, its shares are incredibly cheap). Notably, even with $51M in additional provisions the company would still have tangible common equity north of 11.6% (and therefore wouldn’t require a dime of additional capital). Again, we feel that these estimates are likely very conservative given the severities that the company has realized to date (of between 0-25%) as well as all of the reasons listed above regarding current credit trends. To take our conclusion one step further (to prove a point of course), even if we assume a 100% loss severity of all currently NPA’s, the company would still have roughly 75m in common tangible equity, a common tangible equity ratio of over 6.0%, and a stock price of $4 or around where it currently stands today. Given FFNW’s significant earnings power it is probable that even in this almost ridiculously conservative “scorched earth” outcome the company would still not need to raise additional capital at this point.
Normalized Earnings Power
FFNW has consistently generated roughly $3m in pre tax pre provision earnings per quarter over the last year or so and management expects that once credit trends normalize the company can bring its PTPP closer towards $5m or $0.75 per share. If correct, that would peg FFNW at roughly 4x its normalized earnings power – again way to cheap in our opinion (a multiple of roughly 10x normalized earnings power seems more appropriate).
So in other words, the company’s current valuation clearly implies FFNW is destined for bankruptcy, which as one can see (all things considered) is incredibly improbable in our opinion given all of the actions the company has taken to address its existing problem loans, its enormous capital cushion, and significant normalized earnings power (of between $10 - $20m/year) – notably, even under the incredibly draconian and unlikely scenario’s outlined above, not only will FFNW not need to raise capital, its capital ratios would still be quite healthy on an absolute level and relative to most of its peers.
Given that FFNW appears to (1) be on the cusp of working through its current credit problems and (2) has enough more than enough capital to survive even the most draconian outcome we can imagine, the company’s current price of $4.03 per share is just way to cheap (based upon the companies massive discount to its TBV of roughly $11/share and/or relative to our mid-single digit estimate to its normalized earnings power - obviously expectations could hardly be lower) and provides investors at or around today’s price with tremendous downside protection. A multiple to worst case TBV of roughly $8/share – or roughly 100% above the current price - seems like a much more reasonable valuation in our opinion.
To reiterate, we think the above price target is conservative for all the obvious reasons, but especially because even if you assume that all of the company’s current NPA’s are worthless (i.e., that you think the worst, worst case level of losses described above is a conceivable potential outcome), FFNW would (1) still be trading at roughly 1x TBV (2) have a clean loan portfolio (3) be writing new loans at very attractive rates (given current NIM’s) and (4) face significantly less competition than it has historically as a public company (given a significant percentage of FFNW’s competition is likely to fail over the coming year) – all factors that warrant a premium to TBV on an absolute level mind you – investors in FFNW at or around the current price would likely still not lose money. Heads We Win, Tails We Don’t Lose.
Credit may not improve (and could be much worse than expected)
A severe recession in Seattle and/or any resumption of falling home prices within the Seattle housing market could potentially be an issue for the bank. With that said, even in this scenario we don’t think it would spell disaster or material impair the value of the enterprise. Such an outcome would certainly make it harder for the FFNW to dispose of its problem loans, and the company would likely also suffer marginally higher losses on their existing NPA’s (severity wise) – yet, in our opinion it would take a depression-like scenario for the company’s loan book to deteriorate to the point where investors would suffer a permanent capital loss.
Continued issues with regulators is a risk to keep an eye on, given the significant restrictions they have and can continue to enact on the bank. The company at this point is requires permission by the FDIC before it can grow its assets greater than 5%, change its funding mix and/or declare or pay a dividend.
Due to the very nature of a regional bank, there is always some risk, no matter how slight, that the banks Real Estate portfolio could end up spoiling what appeared to be a great investment. In FFNW’s case, the chance of that happening is very low in our opinion. Between the company’s reserves, its tremendous capital position, the higher quality of nearly all of its newly non-performing loans (i.e., the new non-performing loans that are actually performing), and its ability to generate somewhere between $10 and $20 million in cash a year – FFNW has one huge cushion to cover future loan losses.
Again, it’s pretty hard to lose money in our opinion given that (1) the company is priced for bankruptcy as it currently trades hands at a drastic discount to its tangible book value and roughly 4x our estimate of its normalized earnings power, (2) its capital rich, relatively non-levered and shouldn’t have to engage in a dilutive, value destroying capital raise or reorganization even under a scorched earth scenario (3) its run by a fully incentivized, shareholder friendly management team with an impressive history of intelligent capital allocation (i.e., massively accretive share repurchases) and (4) its operating performance has likely stabilized and is poised to significantly improve going forward. It appears that no matter which way you slice it, it’s only a matter of time before FFNW’s shares will reflect the value embedded in the company.
Catalyst(s) – So When Will FFNW Trade Higher?
Continued Improvement In Credit Trends – If management is successful in hitting its goal of cutting its NPA’s in half by the end of the year, rapidly rising earnings will certainly follow
FDIC Assisted Acquisition(s) – Given the significant issues many of the company’s competitor’s face and the fact that many of them may collapse at some point over the next year or so, FFNW’s capital position puts them in an ideal position to both gain incremental market share as well as to potentially participate in future FDIC assisted deals (which are almost always low risk and value accretive)
Dividend Reinstatement – if management is allowed to reinstate its dividend of .085/share investors will likely take notice. Notably, management has stated that once the OTS approves this, they may in fact do a special dividend, roughly in the amount of all of the dividends that have not been paid since its initial dividend suspension. Obviously further improvement in underlying credit trends will result in regulators allowing buybacks to commence at some point (notably, even if management is way off with their projections this should happen at some point within the next 12 months)
Value Accretive Buybacks – Aggressive capital allocation in this manner can be an incredibly powerful driver of investors in FFNW’s ultimate return here. Clearly (given the trouble it has caused them) FFNW’s management team has more than enough balls to aggressively repurchase stock when eventually given the go ahead to do so.
Continued Insider Purchases
Disclosure: No position at this time