Downey Financial: Short Thesis Still Intact Based on Latest 8-K

 |  About: Downey Financial Corp. (DWNFQ)
by: Amit Chokshi, CFA

Downey Financial Corp. (NYSE:DSL) recently released data on its latest 13 months up to April 2007 and the short case on the Company still looks favorable. Nonetheless, the stock has rallied considerably based on its positive mention on CNBC’s “Mad Money” program, recent events in some subprime lenders such as Fremont General Corp. (FMT), and comfort levels with financial service firms increasing since the shakeout back in February.

While macro-level events such as Federal Reserve commentary regarding interest rates and tangentially related events such as FMT’s sale of its commercial real estate platform a few days ago and its sale of its subprime portfolio a few weeks ago will impact the value of DSL, recent company-specific fundamentals show that the short case continues to grow in terms of substance. The April results are fairly cursory but provide additional data that supports the short case in a way that can be incorporated to refute some of the key points of the bull case for DSL, which I initially laid out in my analysis back in September 2006.

Refuting the Bull Case for DSL:

Smart investors: Nearly 10% of DSL stock is held by Jeff Gendell/Tontine Capital Partners with Goldman Sachs, AQR Capital Management, and Citadel owning smaller portions. The real “threat” from a short’s point of view is really Gendell and Goldman. AQR and Citadel have minor positions and frankly hold so many positions and manage so much capital that it’s nearly irrelevant that they’re in DSL. In addition, these firms may have DSL as part of a pair trade and may be short another similar lender such as Indymac (NDE).

As for Tontine and Goldman, Goldman has increased its stake over the past 9 months, going from about 1.6MM shares to 2.1MM shares, now owning over 8% of DSL, while Tontine hasn’t really done anything with its shares, maintaining its ownership levels fairly stable. To be clear, Gendell is a phenomenal investor and has done extremely well with many regional banks. However, for any bulls on the stock, the most important aspect is to understand what DSL means to Gendell. Tontine began buying DSL shares years ago and its average cost is probably under $40 per share based on this interview with Barron’s in 2003.

In addition, while Gendell owns $175MM in DSL, that’s the result of significant price appreciation assuming that his average cost is about $40 per share. Further, even at $175MM, the actual contribution to his overall portfolio is not that significant. Going to his latest 13F clearly illustrates how much capital he manages. Note the amount of capital in stocks like Bank of America, Citigroup, Centex, Cleveland Cliffs, Trinity Industries, and U.S. Steel, let alone the absolute dollar volume he reported in the 13-F (which may not reflect total capital he manages through other funds) of $12.2B and the overall “importance” of DSL is minimal.

Option ARM Portfolio Mitigates Interest Rate Spread Compression: DSL’s strategy has been to carry predominantly floating rate assets to offset rising funding costs. Unlike traditional banks that face interest rate compression during periods of rising interest rates due to high levels of fixed rate assets and floating rate liabilities, DSL’s strategy mitigates this compression due to the floating rate assets it carries. In fact, the option ARMs step up at a faster rate than its funding costs so the rate spread can expand. However, the latest 8-K shows that this capability may have already maxed out as the interest rate spread declined from its peak in March 2007, now at levels closer to December 2006 (see Table I).

Table I: Interest Rate Spread Dec 2006 - Apr 2007

DSL table 1

M&A target: There’s been significant M&A activity in the regional bank space and DSL’s franchise in southern California would be attractive to many larger banks. DSL appears to be a cheap target at just 1.4x book value and there has been plenty of M&A at multiples in excess of 2.0x book value. While the 20% stake held by DSL’s chairman, location, and apparent cheap valuation for DSL could make the Company an attractive acquisition target, I expect most acquirers to be hesitant and wait to see what the ramifications of the mass rate resets will be on DSL’s loan portfolio.

Given the volume of option ARMs underwritten in recent years that are now resetting at much higher rates, a prudent acquirer would probably want to analyze the data in terms of how these resets affect the loan portfolio. Since over 80% of DSL’s loans are subject to negative amortization, the increased rates stemming from the step-up in 2005 vintage option ARMs may result in increased negative amortization of DSL’s loan portfolio and result in a larger negative amortization loan balance. With an 88% cap on the negative amortization loans, a loan could reach its limit within 12-18 months and be recast under more onerous conditions for a borrower that’s probably a worse credit prospect at that point and more adverse to DSL’s long-term loan portfolio. Consequently, unless a bank really is confident in regards to the future credit quality of DSL’s loan portfolio, one could expect a bank to hold off on establishing a valuation for the portfolio until it becomes more mature in regards to the option ARM step-ups.

This could be especially true when looking at what’s occurred in the subprime space. While DSL is not a subprime lender, stocks like FMT rallied when big sales of their loan portfolio were made. In those cases however, the stocks rallied from major lows in terms of valuation reflecting the significant discount that was paid by acquirers for the loan portfolios. With DSL’s valuation being unchanged despite some portfolio degradation, one could expect a potential acquirer to take a wait and see approach.

Valuation: Similar to the basis for a buyout, DSL’s key valuation metrics make the bank look like a bargain. However, as previously discussed in other postings, the P/E and book value metrics have been obscured over the past year by increased reliance on capital interest income as opposed to cash interest income. As a result, DSL’s stock valuation is actually more expensive now than it was a year ago because a larger portion of its income and book equity/retained earnings has been due to increased contributions from capitalized interest income.

Favorable Sellside Support: Most sellside analysts are bullish on DSL for the reasons cited above. Further, DSL missed Q1 estimates by a wide margin but analysts remain bullish on the Company. DSL’s 1Q07 EPS was $1.54 while consensus estimates were $1.84 yet the stock remained unfazed. This may have been due to an increase in the net interest margin but as April data indicates, this has now shrunk. In addition, the consensus is generally comfortable with the increasing level of NPAs (further increasing through April 2007) and declining deposit base as illustrated in Table II.

Table II: NPA and Deposit Growth

DSL table 2

With anemic deposit growth it may be difficult to justify the deposit premium some analysts believe DSL should command.

Disclosure: Author manages a hedge fund that is short DSL

Earlier articles: The Short Case On Downey Financial (10/23/06); Downey Financial: Underlying Fundamentals Continue to Deteriorate (2/26/07); Still Short Downey Financial Despite Jump on Earnings (4/19/07)