- Flagstar Bancorp has not achieved consistent profitability since the financial crisis.
- Hidden non-operating income makes it appear profitable in the last fiscal year when it actually is not.
- Rising interest rates present significant future headwinds for FBC.
- It's hard to see any value above tangible book value for the stock.
Flagstar Bancorp (NYSE:FBC) is in the Danger Zone this week. This Midwestern savings and mortgage bank has been consistently unprofitable since the financial crisis, yet accounting distortions allowed the company to report a sizeable profit last year. With headwinds on the horizon in the form of rising interest rates, it's hard to see how FBC can turn around its business and achieve the consistent profitability that the market expects.
Lack of Profitability
For the past five years, from 2009-2013, FBC's operating results have been woeful. Its average after-tax profit (NOPAT) has been -$162 million and its average return on invested capital (ROIC) has been -9%. Figure 1 shows the drastic difference between FBC pre and post-2008.
Figure 1: FBC Net Operating Profit After Tax (NOPAT)
Sources: New Constructs, LLC and company filings
FBC managed to earn a small profit in 2012, but a sharp decline in loans originated in 2013 sent the company back into the red. FBC sells almost all of the mortgage loans it originates, so less loan originations mean less loan sales and less revenue.
Appearance of Profitability
Figure 2 shows the same NOPAT trend from Figure 1, but with GAAP net income overlaid. While NOPAT and GAAP net income have been similar for years, they diverged sharply in 2013. FBC's GAAP net income was $247 million for the most recent fiscal year while its NOPAT was -$187 million.
Figure 2: Disconnect Between Income and NOPAT
Sources: New Constructs, LLC and company filings
Three key issues account for this discrepancy. One is well known and easy to spot on the income statement, but the other two are hidden and can only be found in the financial footnotes.
- Unusual Tax Benefit: FBC had a $343 million non-operating tax benefit due primarily to the reversal of the valuation allowance on its deferred tax assets. This item showed up on the income statement and was mentioned in the company's fourth quarter conference call. The other two items were not so easy to spot.
- Decrease in Reserves: FBC decreased its loan-loss allowance by $98 million in 2013, and this decrease artificially flowed into pre-tax income. Interestingly, FBC then turned around and increased this allowance by $100 million in the first quarter of 2014, which suggests they may have been using clever reserve accounting to meet their year-end numbers.
- Hidden non-operating income: FBC also recorded a $49 million gain due to the settlement of litigation with Assured Guaranty (NYSE:AGO).
These three items account for the significant difference between GAAP net income and NOPAT. FBC may look at first glance like a company making the transition back to profitability, but a closer look reveals that it's still mired in steep losses.
The Fed has begun tapering its bond-buying program and looks set to start raising interest rates sometime next year. This should hurt FBC, which acknowledges in its 10-K that, "pricing competition increases when interest rates rise, which generally reduces consumer demand, thus decreasing spreads on origination and compressing gain on sale."
Increased pricing competition should especially hurt FBC since it currently is operating at a loss while a competitor like Comerica Inc. (NYSE:CMA), which has a 6% ROIC, can afford to sacrifice margins slightly.
There are also many signs of management failure at FBC that also cast doubt over the ability of current management to lead the bank to success going forward. The funny reserve accounting going on is a major area of concern as it suggests that management is more focused on hitting quarterly numbers than on creating long-term value for the bank.
Significant asset write-downs are another sign of management failure at FBC. Since 2007 accumulated asset write-downs have been increasing every year, and they currently stand at 11% of net assets. Write-downs are a sign that management is destroying value for shareholders and allocating capital poorly.
Finally, reviews from the company's own employees suggest an overall lack of strategic vision. Online employee reviews should be taken with a big grain of salt, but the same complaint recurs so often in the employee reviews on Glassdoor that it's hard not to believe there's something to them.
About every other review on Glassdoor says that the company is constantly changing its focus and strategy. A former assistant branch manager complains about the constantly shifting, ineffective promotional campaigns. A current mortgage loan officer complains that the company fails to set goals for employees and is generally unorganized. Another employee writes, "Company is reactive rather than proactive."
If it were just one or two employees voicing these concerns that wouldn't be an issue, but the bulk of negative reviews with similar complaints, combined with the poor operational results, suggests that FBC really does have some issues to address with upper management.
Simply put, there's no realistic scenario where FBC can justify its stock price based on cash flows. FBC's current valuation of ~$17.50/share implies that the company will immediately achieve pre-tax margins of 10% (double its highest margin since 2008) and grow revenue by 10% compounded annually for 21 years. Given the company's track record and the specter of rising interest rates, that level of growth and profitability is not realistic.
In fact, I don't see any reason to suggest that FBC can achieve consistent profitability going forward, which suggests that the company should trade near its tangible book value. FBC's tangible book value currently stands at $15.59/share, a 12% downside to the current valuation.
However, the company's consistent losses and write-downs suggest that FBC's book value could decrease going forward. Also, the bulk of FBC's tangible book value comes from its deferred tax assets, which are only applicable of there's a greater than 50% chance of the company having positive accounting income in the next reporting period. FBC determined this to be the case at the end of 2013, but I'm skeptical of that assertion. Continued poor results could force the company to take those deferred tax assets off the balance sheet, which would put a significantly lower floor on the stock.
FBC insiders have sold a net of 34,000 shares (7% of shares held) in the past six months. This is far from a mass selloff, but it suggests that management is perhaps not quite as confident in the future of the company as they are leading investors to believe.
Avoid These Funds
In addition to steering clear of FBC, investors should also avoid funds that allocate heavily to such a dangerous stock. The following two mutual funds in particular should be avoided due to their 3+% allocation to FBC and Dangerous ratings.
- RBB Fund, Inc.: Schneider Small Cap Value Fund (MUTF:SCMVX): 7% allocation to FBC and Dangerous rating.
- Hennessy Funds Trust: Hennessy Small Cap Financial Fund (MUTF:HISFX): 3.3% allocation to FBC and Dangerous rating.
Sam McBride contributed to this report.
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.
Photo credit: Paul Sableman (Flickr).