NASDAQ: HCBK
Recommendation: BUY
OVERVIEW
About the bank
Hudson City Bancorp, organized in 1999, is the bank holding company for Hudson City Savings Bank. Hudson City Savings Bank is the largest asset of Hudson City Bancorp. The bank has 131 branches in the New York metropolitan area, 95 branches in New Jersey, and 9 branches in Connecticut.
HCBK has a traditional banking business model; the bank accumulates deposits and originates loans from the deposit base. Revenue is derived primarily through interest on mortgage loans and investments. Primary funding sources include deposits, prepayments, and funds provided by operations. HCBK primarily originates residential real estate mortgage loans and consumer loans. HCBK does not originate commercial or multi-family mortgage loans. These two types of loans that the bank currently has on the balance sheet are from the 2006 acquisition of Sound Federal. HCBK intends to hold all loans on the balance sheet until maturity.
Management’s capabilities
HCBK management can be described as prudent. Management is primarily concerned with keeping to its business model and providing customers with a quality banking product. This strategy has allowed HCBK to be “Among the Best Managed Banks in America” ranked by Forbes in 2006, 2007, and 2008.
In addition, HCBK consistently has the best or among the best “efficiency ratio” in the industry. The efficiency ratio is noninterest expense divided by the sum of net interest income and noninterest income. According to thestreet.com, at 3Q 2010, the efficiency ratio was 20.27%. It is important because this metric measures bank productivity, or the cost to generate each dollar of revenue. In other words, HCBK uses approximately $0.21 to earn $1.00 in revenue.
Current asset profile
The bank’s primary assets include loans it has originated, plus investments that include mortgage-backed securities and other bonds. As of 12/31/09, the bank had approximately $31.8 billion of loans on the balance sheet. Of the $31.8 billion, nearly 99% of these loans were first mortgage loans. Furthermore, the loans were highly concentrated in the states of New Jersey (43%), New York (18%), and Connecticut (13%).
In addition, the loan portfolio did not experience huge write-downs. Management believes the strong underwriting standards the bank has decreased the risk for loans to become delinquent. As of 12/31/2009, the loan-to-total value ratio of the portfolio was approximately 61%. In addition, non-performing loans to total loans was approximately 1.98%. These numbers are primarily attributed to the fact that the bank did originate or purchase any sub-prime, negative amortization, or adjustable rate mortgages.
HCBK also has securities to earn interest income. Primarily, the bank invests in mortgage backed securities issued by government service entities (GSEs). Other assets the bank owns includes Treasury bonds, Agency bonds, and municipal bonds. Unlike other banks, HCBK does not purchase any unrated or private label securities as investments.
GROWTH STRATEGY
HCBK’s growth strategy
According to the 2009 10-K, HCBK management intends to grow through continued loan origination and additional purchases of mortgage loans. In addition, HCBK has recently started to take customer deposits online. This is beneficial as management intends to fund growth with the bank’s deposit base, and only borrow funds if the deposit base were to shrink.
According to the 2009 10-K, HCBK indicates that the bank has branches in 10 of the wealthiest 50 counties in the United States. Currently, northern New Jersey represents the concentration of the target population of the bank, in addition to its current customers. This area has a large number of higher income professionals and the area is growing as a resort and retirement destination. This should provide a good environment for future growth.
Risk’s to the growth strategy
Key risks to the growth strategy includes slow job creation in the New York metropolitan area, deterioration in the existing prime loan portfolio, increased competition in the jumbo loan market, and lower than forecasted interest rates.
FINANCIAL METRICS
Stock performance
From YE 2000 until today, HCBK has increased in price from $3.16 per share to $12.53. From YE 2000 to YE 2009, the compound annual growth rate (CAGR) was 16%. From YE 2000 to today, the CAGR was 12%. Neither of these growth rates considers reinvested dividends.
In addition, the stock has experience two stock splits. The first was a 2:1 stock split in 2002. The second was a 3.206:1 stock split in 2005. This stock split was done for the second-step conversion in the bank becoming a thrift.
Earnings per share
In 2009, HCBK reported EPS of $1.08 versus $0.92 in 2008. This is a 17% increase over the previous year in a weak economy, where several banks experienced large losses. From 2000 to 2009, the CAGR of EPS was approximately 21%.
According to Yahoo! Finance, there are currently sixteen analysts who cover HCBK. These analysts estimate 2010 EPS to be $1.07. For 2011, analysts estimate EPS to be $0.92. Of the sixteen analysts, there is one strong buy, one buy, thirteen hold, and one sell. No analyst ranks HCBK a strong sell.
HCBK’s business model is highly based on strong fundamentals in the underlying economy, along with a higher interest rate environment. Because so much of the bank’s revenues are dependent upon interest margin versus fee generation, until there is a normalization of economy activity (which includes higher interest rates), overall profitability of the bank should remain flat.
Dividends
From the year 2000 until today, HCBK has increased its yearly dividend from $0.04 to $0.60 per share. Using the yearly dividend through 2009, the CAGR of the yearly dividend was 31%. Through today, the CAGR of the yearly dividend was 28%. Based on a CAGR of 28%, it would imply that HCBK double its yearly dividend about every 2.6 years. Looking over the past ten years, HCBK has increased its yearly dividend approximately every 3 years.
The large dividend increases were largely driven by higher profits because of higher mortgage origination. Dividend increases should not be as large in the future as banks may retain profits in order to maintain a capital cushion should another housing correction occur.
At YE 2009, HCBK had a healthy dividend yield of 4.30%. Based on today’s stock price, the dividend yield is 4.79%. Currently, the 10-yr US Treasury is trading at 3.35%. By owning HCBK, an investor would have approximately 135 to 145 bps of pre-tax excess yield over a 10-yr US Treasury.
The dividend payout has been increasing upwards of 50% in the past ten years. The low was 26% in 2000 versus the high of 59% in 2006. At YE 2009, the dividend payout ratio was 55%. The steady increasing dividend payout ratio is concerning as a ratio consistently below 50% would indicate the ability to continue to grow the dividend at an increasing rate each year. Based on forecasted 2010 earnings, the dividend payout ratio would be 56%.
Finally, the power of compounding is seen if an investor were to reinvest dividends. For example, if an investor invested $1,000,000 at YE 2000, an investor would have purchased approximately 316,000 shares. Based on quarterly dividends paid for 2010, if an investor were to reinvest dividends, annual income would have been approximately $240,000. An investor would have also been able to purchase an additional 92,000 shares over that time period. If an investor would not have reinvested dividends, annual income would have been approximately $190,000 over the same time period.
Return on common equity (ROCE)
ROCE has decreased, in absolute terms, over the past ten years. In 2005, the bank needed to issue equity for its second-step conversion. The large infusion of equity negatively impacts the ROE metric. Since the infusion, ROCE has increased from 5.3% in 2005 to 9.9% in 2009.
Valuation
At YE 2009, HCBK traded at approximately 1.3x book value. This multiple is low given the sound business model the bank employs. With such a low multiple, the market is not confident in the future earnings potential of the bank’s current assets (i.e. loans). Until the economy grows at such a pace where the bank can underwrite more loans at higher interest rates, the market will not reward the bank with a higher stock price. It is interest to note that second-step conversion in 2005, HCBK rarely trades above 1.5x book value.
According to Google Finance, the current P/E for HCBK is 11.19. This P/E is below the 15 P/E most value investors consider acceptable.
RECOMMENDATION
With its conservative business model, sound management, low valuation, and high dividend yield, I would consider buying HCBK. Given the yield premium to US Treasuries, investors are practically getting paid to wait for higher economic growth. If an investor has a longer investment horizon (i.e. 3+ years), HCBK could be a great addition to any portfolio.
This information is for educational purposes only, and the opinions expressed do not constitute a recommendation to buy or sell. Author may have a position in the companies discussed, subject to change at any time. Information on this website obtained from reliable sources, but there is no guarantee of accuracy. Please consult your financial advisor before making investment decisions. Past performance is not indicative of future success.
