Hudson City Bancorp: Yielding Total Returns for Option Writers

| About: Hudson City (HCBK)
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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. (NASDAQ: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 90th percentile rankings in both ‘stock price stability’ and ‘earnings predictability’ (with 100th 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