CFFN - Capitol Federal Financial: Earnings Seem To Be Out Of The Woods (Rating Upgrade)

2024-01-15 23:04:16 ET

Summary

• CFFN’s balance sheet repositioning strategy gives me hope that earnings can turn around soon.
• Loan growth will likely remain healthy due to the interest-rate outlook as well as strong regional job markets.
• The fiscal year-end target price suggests a small price upside. Further, CFFN is offering a high dividend yield.

After last year’s loss, the bottom line of Capitol Federal Financial, Inc. ( CFFN ) will most probably turn around in fiscal year 2024. The biggest catalyst for the turnaround is the management’s balance sheet repositioning strategy whereby it has sold its low-yielding securities. I’m expecting the company to report earnings of $0.36 per share for 2024. The year-end target price suggests a small upside from the current market price. Further, CFFN is offering an attractive dividend yield. Based on the total expected return, I’m adopting a buy rating on Capitol Federal Financial.

Small Blip to be Followed by Relatively Smooth Sailing

Capitol Federal Financial adopted a new strategy in October to sell off its securities and use part of the proceeds to bring down borrowings. According to the details of a recent press release , the company sold $1.30 billion of securities, representing 94% of the securities portfolio, in October and planned to reinvest the proceeds in higher-yielding assets as well as pay down borrowings by the end of December 2023.

The above-mentioned securities had acquired large unrealized losses over the past year as the hike in interest rates had reduced the market value of these securities. As the majority of the devaluation took place before the September-ending quarter, most of the loss from the sale was reported for the fiscal year ending September 2023. However, around $13.3 million of the losses remain, which will be reported in the first quarter of fiscal year 2024 (i.e. the quarter ending December 2023). As a result, the worst seems to be behind us.

There are several benefits of this balance sheet repositioning strategy. First and foremost, this strategy will lift the margin as the asset mix will shift towards higher-yielding assets. Moreover, the company intends to pay down its costly borrowings, which will lower the funding cost. The management estimates this strategy to increase the net interest margin by approximately 60 basis points, as mentioned in the 10-K filing . The margin will also benefit from falling interest rates later this year, and the consequent easing of funding costs. Overall, I’m expecting the margin to increase by 80 basis points in the year ending September 2024.

Secondly, this strategy will reduce the company’s risk level. As 94% of the securities portfolio has been sold, it’s safe to assume that very little unrealized mark-to-market losses would have remained after the transaction.

As a result of this transaction, I expect earnings to have remained depressed in the December-ending quarter, and then bounce back in the March-ending quarter.

Loan Growth Outlook is Mixed

Capitol Federal Financial’s loan growth continued to remain lackluster in the September-ending quarter. However, due to strong growth in the first half of the year, the company’s loan portfolio increased by an impressive 6.8% during fiscal year 2023.

Macroeconomic factors currently provide a mixed outlook for loan growth in FY2024. One-to-four-family residential loans make up around 83% of the company’s total loans. Further, Capitol Federal operates in nine counties in Kansas and three counties in Missouri. As a result, house prices in these two states are an important indicator of credit demand. Unfortunately, house price growth is currently quite high, which bodes ill for the volume of mortgage demand.

Interest rates are also an important determinant of credit demand for CFFN because borrowing costs play a key role in home buyers’ decision-making process. The upcoming interest rate cuts, as projected by the Federal Reserve, can support loan growth later this year. Mortgage rates have already declined significantly over the last few months, as shown below.

Another factor that provides a positive outlook for loan growth is the states’ strong labor markets. Although the unemployment rates in Kansas and Missouri have increased in recent months, they’re still quite low compared to previous years.

Considering these factors, I’m expecting the loan portfolio to grow by around 6% in fiscal year 2024. The following table shows my balance sheet estimates.

Risks Appear Subdued

The company’s overall risk level appears low, as discussed below.

1. The risks from unrealized losses on the Available-for-Sale securities portfolio would have already become negligible following the securities transaction in October 2023.
2. The deposit book also carries subdued risk. Uninsured deposits amounted to $789 million at the end of September, which is only 13% of the total deposit book.
3. The loan book’s credit quality appears to be quite good. Nonaccrual loans made up just 0.12% of total loans at the end of September 2023.

Adopting a Buy Rating

Capital Federal usually distributes 100% of its earnings as cash dividends. It pays a quarterly dividend of $0.085 per share and then pays the remainder through a special dividend in a cash true-up. For FY2023, i.e. the loss-making year, CFFN did not pay a special dividend. The quarterly dividend of $0.085 per share suggests a dividend yield of 5.7%, while a full-year dividend of $0.36 per share (100% of estimated earnings) suggests a dividend yield of 6.0%.

I’m using the peer average price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value CFFN. Peers are trading at an average P/TB ratio of 1.25 and an average P/E ratio of 8.63, as shown below.

Multiplying the average P/E multiple with the forecast earnings per share of $0.36 gives a target price of $3.1 for the end of September 2024. This price target implies a 48.2% downside from the January 12 closing price. The following table shows the sensitivity of the target price to the P/E ratio.

Equally weighting the target prices from the two valuation methods gives a combined target price of $6.4 , which implies a 7.4% upside from the current market price. Adding the forward dividend yield gives a total expected return of 13.1%. Hence, I’m adopting a buy rating on Capitol Federal Financial.

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