Description

Note: I've decided to re-post my submission idea for the broader VIC community.  It's certainly not the cheapest security I've ever looked at, but I see a very plausible path to adequate return without significant chances of severe permanent impairment of capital:

Investment Mechanics

This is a paired trade recommendation which should yield synthetically created shares in American Savings Bank Hawaii (“ASB Hawaii”) prior to its official spin-off from Hawaiian Electric Industries (HE) expected sometime in 2015.  The specific recommendation is to short 0.2413 shares of NextEra Energy (NEE) for every 1 HE share purchased long.  Short interest in NEE shares is negligible and I’ve found cost of borrow is at the general collateral rate.  Although NEE is expected to pay a quarterly dividend of $0.725 (2.9% yield), the long (and larger) side of the investment (HE) offers a 3.9% dividend yield.  Liquidity in both NEE and HE is sufficient for all but very large firms.

NEE / HE Merger or “Why the Opportunity Exists”

On 12/3/14 NEE and HE announced a merger whereby HE shareholders will receive 0.2413 shares of NEE and a $0.50 one-time special cash dividend.  Contingent upon, and immediately prior to, the deal closing (expected within 12 months of announcement), HE will spin off its 100% ownership of ASB Hawaii to its shareholders.  The deal will be a taxable event, although NEE has agreed to cover the majority of tax liabilities, and thus the deal can essentially be thought of as tax-free to ASB Hawaii shareholders.  The deal's announcement can be found here: http://www.nexteraenergy.com/news/contents/2014/120314.shtml

Investment Recommendation

I recommend synthetically creating ASB Hawaii shares at ~$7 (which assumes a 1:1 ratio for the spin-off).  I believe shares are worth $10+ and should trade toward this target within a reasonable period after spinning from HE.  Further I see limited permanent impairment of capital so long as the NEE/HE deal closes, which I certainly expect will be the case.

Structurally this investment reminds me of the very recent Vista Outdoor (VSTO) spin-off from Alliant Techsystems (ATK) which occurred immediately prior to ATK’s merger with Orbital Sciences (ORB).  In that situation (technically a “regular” Morris Trust) shares of VSTO could have been synthetically created in the mid-to-high $20s as recently as December 2014.  Shares of VSTO closed at $39.30 on its first day of regular way trading (2/10/15), and currently trade in the low-$40s.

My ~$7/share (or more accurately $724mm market capitalization, which is spin ratio agnostic) calculation is as follows (using 3/6/15 closing prices and an estimated year/four Qs of dividends until deal close): 1) Buy one share of HE; 2) Sell short 0.2413 shares of NEE; 3) Receive $0.50 cash as a special dividend (the only taxable component for HE shareholders); 4) Receive 4x quarterly $0.31 dividends per HE share long; and 5) Pay 4x quarterly $0.725 dividends per NEE share short. 

ASB Hawaii

Now that we know the cost, let's examine what we're buying.  ASB Hawaii is Hawaii’s 3rd largest bank by deposits with 56 branches (of which 15 are owned) and 1,162 employees.   The bank is conservatively capitalized, decently well-run, and operates solely within the hard-to-enter market of Hawaii.  Hawaii’s economy is thriving and, from where I sit (NJ unfortunately) should only improve given how big a role oil plays as a cost of everyday island living (thanks, Jones Act!) and the state’s reliance on tourism.

According to the FDIC, ASB Hawaii had $4.57B in deposits at 6/30/14 for a 12.5% market share within the state.  This is behind First Hawaiian Bank (part of BNP Paribas) with 36% share and Bank of Hawaii (public, ticker BOH) with 33% share.  Hawaii is unique in that mega-banks have largely avoided entering the market given the high cost of entry and a total state population of 1.4mm, which simply doesn’t warrant new investment (this article discusses the topic: http://money.cnn.com/2012/11/28/pf/banks-hawaii).

ASB Hawaii's CEO, Richard Wacker, helped rebuild Korea Exchange Bank after the Asian financial crisis as its CEO and appears to be well-regarded.  On the call he seemed enthusiastic about ASB's prospects post-spin:

With good capital levels and good ongoing profitability, we expect ASB to target a healthy 30% to 40% dividend payout ratio. As an independent company, the bank will have additional capital management flexibility to boost EPS growth through share repurchases, additional balance sheet growth, as well as allowing management to pursue attractive strategic opportunities.

ASB is well-positioned as one of Hawaii's leading residential, commercial, and commercial real estate lenders, third by loan and deposit share in Hawaii's attractive, deposit-rich market. [...]  Ultimately, we are confident that the bank is well-positioned to thrive into the future and HEI shareholders will have the opportunity to participate in American Savings Bank's upside potential following the spin-off

By my calculus, ASB Hawaii’s implied market capitalization is currently ~$724mm, or 1.4x 12/31/14 book value of $535mm, 1.6x TBV of $460mm, and just above 12x P/E on my 2015 estimates (which adjusts for Durbin re-exemption benefit, see below).  From 2010 through 2013, return on average equity had been running at between 11-12% (note that the bank was also profitable throughout the financial crisis).  In 2014 ROAE ticked down to 9.62% due to lower mortgage refinancing activity and lower interchange fees due to regulatory caps attributable to the Durbin Amendment.  Following the spin-off however, management has stated that it will regain its exemption from the Durbin Amendment which should yield about $6mm in after tax income.  This $6mm alone would have pushed 2014 ROAE to 10.7%.  Further, as part of the spin-off, ASB Hawaii’s assets will be written up to fair value expected to create a ~$165mm tax-deductible DTA (assuming an $8/share post-spin trading price).  I expect to gain clarity around these items and others (for instance the underlying balance sheet source(s) of HE's dividend over the next year) once a Form 10 is filed.  

Given the oligopolistic structure of the Hawaiian banking industry (top 3 banks make up >80% of deposits), supported by the high cost to enter Hawaii, I expect stable 11%+ future returns on equity for ASB Hawaii, especially if interest rates begin to rise.  Should the company trade at 1.8x BV (2015) post-spin, shares should fetch slightly north of $10 (and would then trade at an 18x adjusted P/E).  Bank of Hawaii, ASB Hawaii’s only pure-play public comparable trades at 2.5x BV (and it's traded around that level for some time), though it admittedly earns a ~15% ROE.  Ultimately, I think a 1.8x multiple of book value is reasonable given ASB Hawaii's conservative balance sheet, the insulated and high deposit market in which it operates, Hawaii’s thriving economy, interest rates that might not be able to go much lower, and the multiple the market ascribes to BOH.

I should note that in the NEE/HE deal press release, HE seemed to endorse the $8/share in average value ascribed to ASB Hawaii shares by six sell-side HE analysts.  In addition it noted that the aforementioned DTA should be about $165mm (again assuming an $8 post-spin trading price), representing about $1.60 in value per share.

Key Risks

• Should the deal break, one is left with a short "acquirer" / long "target" position, which is not ideal.  NEE has essentially traded flat/slightly-down since the deal was announced while HE has jumped 12%.  I would expect this to reverse should the deal break.  I note that HE and NEE have already submitted applications to the PUC and FERC and seem to be proactive around each agency's likely concerns (i.e. 4 year freeze on rate base).
• Hawaiian economy slows (unlikely given the positive effects low oil should have on a tourism/imported goods-driven economy). 

Catalyst

• Spin occurring concurrent with the NEE/HE merger expected sometime in late 2015.
• Re-rating a bit closer to BOH once it becomes a standalone company and gets sell-side coverage
• Interest rates rise helping to expand NIM and ROA
• Potential acquisition by larger financial institution