2023-03-14 07:30:00 ET
Summary
- TFSL is a high yield bank stock that is grossly misunderstood by Mr. Market.
- It has also been unfairly punished by Mr. Market in the wake of the failure of the Signature and Silicon Valley Banks.
- We share why we believe it is a very attractive buy right now.
As many of you are already aware, a couple large banks (SVB Financial Group ( SIVB ) and Signature Bank ( SBNY )) recently ran into significant trouble, prompting the Federal Deposit Insurance Corp., to announce the closure of Silicon Valley Bank, the California bank subsidiary of SIVB, as well as SBNY shortly thereafter.
These banks encountered difficulties due to borrowing short and lending long in the face of rising interest rates. As a result, their deposit bases began to disintegrate. To prevent this situation from spiraling out of control, the US government stepped in and announced that it will protect the deposits at these banks:
"After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary [Janet] Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer."
Leading economist Mohamed El-Erian in an interview today emphasized that depositors are now fine and that this move by the government should calm jitters across the banking system. Furthermore, he predicted that the Federal Reserve would have to surrender on further interest rate hikes in the wake of this incident as it cannot raise much more without further breaking the country's financial infrastructure.
Goldman Sachs ( GS ) had a similar appraisal of the ramifications of this incident:
In light of recent stress in the banking system, we no longer expect the FOMC to deliver a rate hike at its March 22 meeting with considerable uncertainty about the path beyond March.
Bill Ackman had a similar commentary, highlighting that regional bank stocks now offer very attractive risk-reward in light of the government's actions and that the changing outlook for interest rates - which plunged on the latest events - benefit regional banks as well.
That said, it is imperative to keep in mind that many regional bank stocks ( KRE ) remain very risky, as evidenced in market sentiment today even following these announcements by the government.
However, there are a few regional banks in particular that we believe offers exceptional risk-reward at the moment. One of these - which we believe has little risk exposure to the SIVB and SBNY calamities and yet trades around COVID-19 lows at the moment - is TFS Financial ( TFSL ).
TFSL is a federally chartered stock holding company that primarily engages in retail consumer banking, including mortgage lending, deposit gathering, and other financial services. Approximately 81% of the Holding Company's outstanding shares are owned by a federally chartered mutual holding company, Third Federal Savings and Loan Association of Cleveland, MHC (Third Federal Savings, MHC), with the rest owned by the general public via the company's publicly traded stock.
Why We Like TFSL
We are bullish on TFSL for the following reasons:
#1. Very Strong Balance Sheet Driven By Customer Loyalty
The balance sheet is in strong shape with a Tier 1 Capital to Average Assets ratio of 11.38% and a Total Risk-Based Capital ratio of 20.87% (both more than double the "well-capitalized" 5% and 10% respective thresholds).
Furthermore, the company gets a significant amount of its capital from low-cost deposits (checking, savings, and CD accounts) via a loyal deposit customer base. TFSL cultivates this deposit loyalty through:
(1) Its physical presence in Ohio and Florida, where it has a total of 37 full-service branches and 5 loan origination offices. They generate high average deposits per branch, reflecting the strength of their approach and customer base. In an age that is becoming increasingly digital with offshoring of customer service, TFSL continues to emphasize human-touch customer service to differentiate itself from competitors. This superior customer service has earned it a 5-star rating from independent rating agency Bauer Financial for more than 100 quarters (over 25 years) in a row, putting it in an elite category among its peers. Even more importantly, online the company has a 4.7-star average rating among 3,230 reviews with 94% of reviewers recommending them positively.
(2) Offering higher savings rates than competitors in order to economically incentivize customers to remain loyal to TFSL. Out of 3,230 reviews online, TFSL earns a 4.9-star average rating for competitive rates.
#2. Very Conservative Underwriting
Its underwriting practices are very conservative, and the company is also growing its loan portfolio at a solid clip. The loan portfolio grew by a robust $1.75 billion for the past fiscal year. In fact, TFSL had a banner year in loan originations in 2022 despite the overall home lending industry slowing significantly due to rising interest rates.
The underwriting also continued to perform very well with a meager 0.18% delinquency rate, with net recoveries reported in each of the past six fiscal years.
The average FICO score during the quarter was a whopping 774, reflecting the excellent credit quality of borrowers that TFSL lends to. As of the end of the quarter, the average FICO score on its mortgage loans was 761 with an average loan to value of 66%, and its average FICO score on its HELOC loans was 770 with an average loan to value of 60%.
On top of that, ~70% of their loans are located in Ohio and Florida - two pro-business states which are likely to be much better insulated against a sharp housing value downturn than locations with sky-high housing prices like what is found on the West Coast, Chicago, and major cities in the Northeastern United States. Ohio in particular - where the majority of its loans are located - is likely to be well-insulated against declining housing prices given that it is definitely not one of the bubble markets.
Last, but not least, ~80% of their total loan portfolio is in 1st lien residential mortgages, giving them a very conservatively structured loan portfolio.
In summary, we can conclude that a meaningful housing value and/or broader economic downturn is unlikely to hurt them significantly at all given the strength of their underwriting results, the high credit quality of their borrowers, the conservative loan to value ratios of their loans, the economic vitality of their geographic focus, and their emphasis on very conservative 1st lien residential mortgages.
#3. Deep Value
The company continues to generate shareholder value, with book value per minority share increasing from $34.50 to $34.73 sequentially in the latest quarterly earnings report. Meanwhile, the dividend per minority share was well-covered by net income with a very reasonable 67.93% payout ratio for the quarter.
One positive from the latest quarter was that the companies weighted average yield on loans receivable increased by 28 basis points, including a very strong 118 basis point jump in its HELOC and ELOAN average yield.
That said, as expected (based on our recent interview with TFSL), the company's cost of borrowing also increased meaningfully during the quarter. Its weighted average cost of deposits rose by 53 basis points and its weighted average cost of borrowings rose by 16 basis points. Its overall interest rate on borrowings and deposits increased by 41 basis points sequentially from 1.74% to 2.15%. As a result, its interest rate spread declined sequentially from 177 basis points to 164 basis points.
The good news is that the loan portfolio continues to grow, which is helping to offset some of this tightening of the interest rate spread. Furthermore, the weighted average maturity of the CD portfolio (which is over 40% of their total source of funds) is pretty long at over 19 months and only half of CDs are expected to mature within the next twelve months. As a result, they should not see too sharp of a rise in their weighted average cost of funds moving forward. On top of that, they still have plenty of cushion in their capitalization levels, so they can always dip into that if needed to sustain earnings per share through the current rising interest rate environment.
#4. Attractive & Sustainable Dividend Yield
With a very healthy payout ratio and a rising book value per share, the dividend and long-term shareholder value creation profile remain very attractive and secure. The company has emphasized repeatedly that supporting its dividend is a top priority for them, and they have the balance sheet strength to do so even if interest rates keep rising for the foreseeable future. As a result, we view it as a good time to add further to our position and lock in an 8% dividend yield.
Ultimately, between its strong balance sheet, conservative underwriting, and massive discount to book value, TFSL possesses low long-term risk while offering a very lucrative current dividend yield.
In fact, the positive risk-reward offered by TFSL is illustrated by its long-term significant outperformance of the mortgage REIT ( MORT ) sector:
Yet today, it trades at just a little over one-third of its book value per minority share while the leading mREITs like Annaly Capital ( NLY ), Arbor Realty ( ABR ), and AGNC ( AGNC ) are trading at much higher ratios relative to their book values:
With less risk than mREITs offer (due to lower leverage and higher quality loans in its portfolio) and much greater upside potential to book value, TFSL is a no-brainer buy in our view. This is especially true on a relative basis to mREITs and residential equity investments given that we are likely headed into a housing market and broader economic downturn.
Why Mr. Market Misunderstands TFSL
Given its many strengths, why does TFSL trade at such a steep discount to its book value and offer such a high dividend yield?
The answer lies in two main themes:
(1) The market has been rather bearish on mortgage lenders given the dramatic slowdown in the sector due to rapidly rising interest rates. That said, this impact is only relatively minor given that TFSL trades at a much deeper discount to its book value than most mREITs do and TFSL traded at a very deep discount to its book value even before the market soured on mortgage lenders.
(2) The most important driver behind this deep discount to book value is the fact that TFSL has a quirky corporate structure such that virtually all stock screeners misrepresent the business' true value. Over 80% of the company is owned by a federally chartered mutual holding company that does not receive any dividends or cash flow. As a result, less than 20% of the company is owned by the public. If at some point in the future the rest of the company were to go public, the amount of equity in the company would increase by many times over, resulting in a more accurate GAAP screening.
Investor Takeaway
TFSL stock - thanks to its quirky structure - is arguably the most misunderstood high yielding banking stock in the market today. As a result, we view it as probably the most attractive risk-adjusted way to gain exposure to the regional banking sector today, especially given where we are in the cycle.
Between its stellar management, long-term outperformance of the mREIT sector, very conservative underwriting and geographic targeting, balanced interest rate exposure, attractive and sustainable dividend, and deep value, we are happy to make it our largest position and will gladly collect the outsized dividend while waiting for eventual substantial appreciation in the long-term.
Furthermore, given that we believe interest rates are likely near their peak with inflation slowing down and TFSL's demonstrated resiliency this past year in the face of soaring interest rates, we think the stock price could finally receive some positive catalyst action later this year. As a result, we rate it a Strong Buy and hold it as one of a select few highly opportunistic picks in the financials sector amid the broader carnage.
For further details see:
TFS Financial: Don't Throw This Bank Out With The Bathwater