At Friday's closing price of 4.05, Washington Mutual (WM) is attractive as a speculative value play, based on a price to tangible book ratio of .32 and a Price to Normalized Earnings of 1.8. For many years WaMu was popular with institutional investors and traded in a range of 35-45 per share before plunging to under 4 this year. The signs of trouble were there – the mortgage operation experienced difficulties starting in 2004, when the housing bubble was in full bloom, and promised corrective actions never resulted in expense reductions or meaningful improvements in the troubled segment.
Confronted with an impending capital crisis, WM raised capital in April, at the expense of considerable dilution to existing shareholders, from private equity firm TPG. Their buy in occurred at 8.75, so at today's price the small retail investor can outwit the smart money, paying less than half of what TPG paid. Admittedly smart money has had trouble in financials recently, witness Warburg Pincus paying 31 per share for MBIA (MBI). However, it is always good to pay less than the smart money paid. Also, private equity normally does due diligence before getting involved, so the investor who comes in later has the implied value of an impartial outside review.
Normalized Earnings - In the transcript of the 2nd quarter conference call, Kerry Killinger states that WaMu continues to earn 6 billion per year pretax and pre-provision; that is, before making provision for expected credit losses. It is reasonably likely that WaMu can avoid raising further dilutive capital, so using the 6 billion figure, reducing it for taxes at 35%, and dividing by current shares outstanding I develop a normalized earnings per share of 2.29. If and when that becomes a reality, a P/E of 12 gives a per share price of 27.
Tangible Book Value – on this basis, I come up with a target price of 25, based on a historical average multiple of 2.3 X 11.03 tangible book value per share. Again from the conference call, management expects to take charge-offs of an additional 17 billion, of which 8.5 has been provisioned. Noting that these are expected future losses which have not yet materialized, I would offset them with the future 6 billion per year pretax pre-provision earnings and look for the company to operate at break-even over the next year and a half. Thereafter, WaMu should be able to earn 2.29 per year.
Short term catalysts - I owned or controlled shares of WM on and off from 2004 through 2007, with modest profits. However, the company from time to time would attract rumors about possible buyouts – it was a Canadian bank, I forget the name. When this happened, the shares would rally briefly and then give it back. At today's prices, such rumors could reappear and might develop a factual basis. In any event, such sudden spikes would make a nice opportunity to take profits while waiting for the turnaround to materialize. Kerry Killinger has not endeared himself to shareholders, based on poor performance. Should a change of management occur, it would be welcome and might generate a rally, as well as future improved fundamental performance.
Risks to the best case scenario consist of possible loan losses above projections, a liquidity incident in the form of a run on the bank, or a more diffuse set of problems arising from concerns about management – the people who created the current serious difficulties are still in charge.
Option ARMS - the most questionable area of the loan portfolio is the Option ARMs, many of which are in California or other distressed real estate markets. In the conference call slide presentation, WM demonstrates that they are reducing the amount of loans outstanding and that resets are for the most part years in the future. LTV at an average 72% is fairly good compared to what I have seen in some of the MBS I have looked at. As a soft point, they do have 14% Option ARMs with LTV greater than 90%. FICO scores are an average 683, troublesome if coupled with high LTV, in my opinion. Without displaying undue enthusiasm, I think the Option ARMs are one way to muddle through – just put off taking the losses until the situation improves.
Capital Adequacy and Liquidity - As of 6/30, WaMu had a strong capital position: from a regulatory point of view their Tier 1 risk-based ration stood at 8.44%, 244 basis points above well-capitalized. Readily available liquidity stood at 40 billion. After the Indy Mac incident there is always the possibility of a run on the bank, but such runs will be minor annoyances for well-capitalized banks.
Hypothetical Capital Raise – By way of dealing with the what ifs, here is my math on a hypothetical capital raise of another 7 billion, the same amount as was raised in April. I assumed the new shares would cost 3.18, reducing today's 4 price similar to the first raise, when new shares sold for 8.75 vs. the 11 price they were trading at in April. Figures are in millions, except per share amounts and ratios:
|Beginning tangible book value||18,802|
|Capital to be raised||7,000|
|Ending tangible book value||25,802|
|Beginning shares outstanding||1,705|
|New share price (4 X 8.75/11)||3.18|
|New shares to be issued||2,200|
|New shares outstanding||3,905|
|New tangible book value per share||6.61|
|Average price/tangible book value per share||2.3|
|Share price target after hypothetical raise||15.20|
Conclusion - WaMu has been very volatile, and I have been trading in and out: as of today I am long a small amount of stock and also some September 5 calls. I am positive on the long term potential here, regard risks as manageable, and plan to accumulate a position over time while monitoring earnings as they come out. It will be important to see if future developments support the idea that WM can muddle through on the Option ARMs. In the meantime, a small position in WaMu is a good way to play for a recovery in financials.
Disclosure: Long WM shares and options.