WAFD - Washington Federal Stock Now Looks Cheap Amid Wider Bank Worries

2023-08-20 03:06:01 ET

Summary

• Washington Federal shares have been largely flat in the two years since I initially covered the bank, with that mainly coming as a result of recent turbulence in the industry.
• The bank faces the same headwinds as peers. Funding costs are up, net interest income is down, and asset quality is bound to deteriorate to some degree from here.
• As a result, and near-term uncertainty notwithstanding, these shares now look much cheaper than they did a couple of years ago.

I didn't see much value in the shares of Washington Federal ( WAFD ) when initially covering this regional bank a couple of years ago. The stock hasn't been up to much since then, though it is a sign of the times that 'flat-to-down' actually translates into noticeable outperformance versus the various peer-group indices.

Whether the above tells us anything specific about this bank is an interesting question in light of the industry's recent tribulations. Washington Federal has a good track record on the longevity front - a point I opened with last time out - and that may stand it in good stead as it navigates a potentially tough short-term outlook. I also liked the fact that the bank had been making strong efforts to shift its deposit base more toward transaction accounts, helping to increase its margins and profitability.

The above is obviously very relevant today given the pressures that regional banks are currently facing. Despite past good work, Washington Federal is ultimately swimming in the same waters as its peers, with funding costs having risen and earnings prospects diminished. While the industry no doubt faces more near-term uncertainty, this bank does now look quite cheap on a tangible book value basis, and I'm upgrading it to Buy.

Margin Pressures

Consistent with most other regional lenders, Washington Federal has seen a steep rise in funding costs in recent months. Total deposit balances have remained relatively static compared to the start of its fiscal year, but the mix has shifted toward more expensive account types. Total transaction balances had fallen around $1.4B YTD (~11%) as of its fiscal Q3 (which maps to the calendar Q2), while more expensive time deposits have risen by a similar dollar amount over the same period.

As a result, net interest income and margin have likewise both fallen in recent quarters. Q3 net interest income was down 3.6% sequentially to $168.7m, having fallen around 4.3% sequentially in fiscal Q2. Net interest margin ("NIM") of 3.27% was down 24bps QoQ and 42bps from its Q1 recent peak.

Although margins appear to be stabilizing - June NIM of 3.21% was only 5bps lower than the March figure - year-on-year comps will begin to get tougher, having previously been soft. Note that the bank lacks any significant fee-income lines, with net interest income ultimately accounting for over 90% of total revenue.

An Eye On Credit Quality

Recession concerns may be getting a little long in the tooth, but asset quality will decline if not for the simple fact that it currently remains at historically strong levels. Washington Federal hasn't yet seen any meaningful deterioration in its own asset quality, with non-performing assets ticking up 9bps sequentially to 0.30% but with that remaining in line with comparable-period 2019 levels (and that was a good year for credit quality too). The increase was down to one particular large account within its C&I book.

Washington Federal: Non-Performing Assets To Total Assets

The health of commercial real estate lending is a particular concern for the industry right now. At Washington Federal, CRE represents a little over 15% of the loan book (~1.8x tangible common equity). So far, CRE credit quality remains benign, with non-accrual loans down sequentially. Office lending - a particular concern within the commercial real estate space due to additional work-from-home pressures - only represents around 5% of net loans here.

Shares Appear Cheap

Washington Federal shares change hands for $28.70 at the time of writing, representing a circa 8.5% decline since first coverage. With tangible book value per share ("TBVPS") up by nearly 20% in that time to $27.58, these shares have undergone a significant de-rating in their P/TBVPS multiple:

To an extent, this captures the bank's diminishing earnings outlook. As per Seeking Alpha, current FY23 and FY24 EPS estimates land at $3.96 and $3.73, respectively. That is down from around $4.35 (FY23) and $4.60 (FY24) prior to regional banking turmoil that began in March.

Current EPS estimates still map to an average 2023-2024 ROTE of around 13-14%. Absent a serious recession, recent history would suggest that a 1x TBVPS multiple tends to mark a low point for the stock, with 1.3-1.4x TBVPS probably a fairer value for the shares.

Multiple expansion is something I expect to see over the medium term, but at these levels it's not necessary for adequate shareholder returns, assuming the bank can earn the average 10% through-the-cycle ROTE it has done in its recent past:

Washington Federal: Annual Return On Tangible Equity

To pin some numbers on that last statement, the bank is only paying out around 25-30% of its earnings by way of a dividend. The dividend yield right now is 3.5%. On a 10% ROTE, it should then be able to add around 7.0-7.5% per annum to TBVPS from the implied level of retained earnings, resulting in 10%-plus annual returns on a flat multiple. Notwithstanding the uncertainty in the industry, these shares now look much better value than last time out, and with that I'm upgrading to Buy.

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