Description

CFFN

$13.00ish

Let’s be clear, I don’t think anyone is going to like this pitch.  It certainly isn’t exciting.

Capitol Federal is a small, over-capitalized, regional bank that is essentially unable to grow past the $10b regulatory limit.  There won’t be a buyout anytime soon, the narrative on the stock is unlikely to change, and there’s nothing exciting about the business.

I’ll give some potential scenarios and “market mispricing” later, but here’s why you might be interested:

• Stable, extremely conservative lending with management team reasonably good at capital discipline if you are looking for something defensive.
  
• A short-term outsized dividend not yet priced in to the market, which you may be able to play to your benefit depending on your strategy and constraints.

Background on the above thesis will follow, but let’s cut straight to the chase:

• CFFN pays out 100% of earnings each year because they can’t/don’t want to grow past $10b.  Despite potential regulation changes, regulators have indicated to management the current reporting framework would remain in place as a “best practice” above the $10b threshold.  Estimates are CFFN would need to reach ~$14b in size to break even on increased cost of regulatory compliance, and bigger to be accretive. Not going to happen.
• EPS in FY2018 (ending 9/30/2018) should be ballpark $0.75.  Let’s take a few pennies off for a Q4 (ending 9/30/2018) transition to new online banking provider costs, cessation of daily leverage strategy in Q4 (more later), and acquisition closing costs and call it $0.73 for the year.  
  
• Quarterly regular dividends of $0.085.  EPS of $0.73 less $0.34 dividends results in $0.39 to be paid out to reach 100% payout for the year.  This special dividend is typically paid in November. Add another $0.085 quarterly dividend to be paid for Q4 in November, and you’re looking at $0.475 to be paid out in November on a $13ish stock.  3.65% yield on a timeframe of about a month or of your choosing. This is up from a $0.29 special div a year ago (+$0.085 = $0.375 in Nov 2017) Obviously you’ll need to look at the current stock price and where you believe it will be come the end of your holding period.  If you’re a 1+ year holder, you assume zero accretion from the acquisition, no benefit from leverage strategy, and same net interest margin as YTD 2018 you’re looking at a forward dividend of ~$0.91 and yield of 7% on the dot.
• I believe someone has figured out you can own the stock for October, or even October through some time in the spring, and manufacture a higher yield on the stock than it typically screens.  See October 2017 for what I mean. If this repeats, you can get in ahead of time and much like option dividend games, you can play the same with CFFN.

Details and Background
There is a previous good thread on CFFN on VIC.  https://www.valueinvestorsclub.com/idea/CAPITOL_FEDERAL_FINANCIAL/41051

I won’t go through everything.  To repeat: This is a bank that will not grow past $10b, it will not have world-beating net interest margins, but it makes up for it with great efficiency and high-quality assets.  The financial results are, in a word, average. There won’t be a buyout for years. What you are getting is a little growth (in operations) company with solid capital discipline potentially looking at a yield re-rating.  However, some interesting tidbits:

Dividend Policy
CFFN pays $0.34/year ($0.085 quarterly) in regular dividends.  At year end (Sept close) it pays a special dividend to reach a 100% payout ratio.  This usually is declared in Oct and paid in Nov.

In June, it pays an additional special dividend to reduce excess capital.  This needs to be approved by regulators every year and has historically been $0.25/year since the second-step conversion.  I see no reason for this to change and assume $0.25/share per year going forward. The question is how long this special dividend can reasonably be paid.  Q3 2018 Equity to Assets of 14.8% and Tier 1 Capital to Assets of 13.0%. There’s some further difference depending on whether you include cash already swept from the bank level up to the parent company.  Assume CFFN runs at exactly $10b in Assets and a conservative 11% leverage ratio. That’s $241.3m to be paid out, or at the current annual rate of $33.6m/year, over 7 years remaining. We’re probably looking at a decade of special capital dividends.   

Return on Equity
FY2017 Annual Report Presentation:

Doesn’t look good.  First, recognize that FYE is September, so the above does not include any benefits from the tax change.  With 100% dividend payout, you’re looking at a relative increase in dividend vs FY2017 offset by a flatter curve, less effective leverage strategy, and somewhat higher expenses.

Also, this is an over-capitalized bank.  Excluding the leverage strategy, CFFN has a leverage ratio in the 14.5% - 15.0% range.  Run these results at a 10% leverage ratio and the bank runs at roughly a 10% ROE rate. Basically inline with peers but trading at a 1.4x book multiple vs peers near 2x, depending on who you include.  

To be clear, I don’t believe CFFN at a peer P/B multiple is a particularly good thesis until the capital levels come down many years from now.

Daily Leverage Strategy
The “daily leverage strategy” has been in place for a few years but is no longer profitable.  I do not expect it to be used going forward. Basic idea here was borrowing (and depositing at the Fed) from Federal Home Loan Bank of Topeka carried an interest rate expense but also required owning shares of said FHLB, which carried a dividend that exceeded the expense.  CFFN put this trade on to utilize its excess capital during the last few years. It is no longer profitable with the rise in interest rates, but added a penny or two to EPS in its heyday, with diminishing returns recently. I would not include it in your assumptions going forward, but it can be worth backing out to get an idea of “core” operations and understand that we won’t see the full bump from tax code vs last year’s EPS and Dividend.  

Valuation
Charts from Bloomberg.  I feel TTM gross dividend yield is pretty accurate for a trading range since the 100% payout policy became a clear go-forward assumption.  The bump at 2016 election is an obvious outlier. I assume a 6-7% yield as a pretty reasonable range.

You can certainly go back further in time to find a trading range of 6-8% TTM dividend yield, but I don’t believe the market fully expected or priced the 100% payout prior to 2015.  There’s also the issue of timing in that the two special dividends were issued in close proximity rather than spaced out 6 months prior to 2015 which skews the data set without hand calculating.  I use 6-7%. But FYI


And just for your information, here’s historical P/B, though you should note CFFN is actively paying out book value via its capital reduction special dividend, so I don’t trust this as a market pricing mechanism.


Sum it up, I believe we are at low valuations with a larger than expected dividend to be announced in a month’s time.  There’s really not much else to see here.

It should be noted the company’s average purchase price on buybacks is $11.87.  I believe they actively purchase below $12 and have likely raised that target price recently.  
Value of repurchases on right hand scale.  The 2016 purchase was a private repurchase for a non-public per-share price from a large individual shareholder/estate and I don’t believe you should judge management by it.  Otherwise you can see the clear $12 stock -> repurchase relationship with a likely increased floor in 2018.

You also see evidence of capital discipline through large dividends in 2012 before tax changes, the restraint shown in not empire building, focus on efficiency ratio in bank operations, etc.  This isn’t a world-beating business, but it is well run and they won’t set your capital on fire.

 
Let’s say you believe me on ~$0.91 in dividends for 2019.  7% yield is a $13 stock, 6% yield is a $15.17 stock. I’ll call $12.50 to $14.50 my expected trading range.  There’s no magic or expertise here. 2018’s $0.17 EPS per quarter, less the leverage strategy on a pretty flat curve.  Obviously the curve can and will invert, but CFFN’s assets are slow to reprice.

Reasons to Hold Long-Term
If you’re a long-term investor, there are some reasons to be hopeful here above and beyond an improvement in the rate environment.  Namely, the recent acquisition of Capital City Bancshares. This is a small acquisition (~$400m in assets) that recently closed. The represents CFFN’s first direct venture into commercial lending with both a geographic and conservative underwriting overlap.  Sure, management expects 3% EPS accretion in 2019 (bumping my div number to ~$0.935 or 7.21% on a share dilution of ~1%) but more importantly, it presents an opportunity for CFFN to improve its net interest margin. Here’s Capital City Bancshares composition March 31, 2018:


NPAs/Assets are inline with CFFN and long run CFFN believes efficiency ratio will increase (costs up) but stay in the mid 40% range.  Say taking today’s roughly 42% to 45-47% though I expect that is a conservative estimate.

Compare this with CFFN’s loan composition:

Obviously you get the higher yielding commercial loans.  Furthermore, the existing commercial loans at CFFN were purchased through their correspondence network, all carrying a haircut so the slow move to in-house origination of commercial loans will, at minimum, eliminate that haircut from interest income.

Notice also the availability of redeploying assets from securities into commercial lending without growing the bank past the $10b asset limit:


Liabilities are where we see potential for change in my mind:

One would think CFFN would be replacing 2.1% borrowings with 0.37% Capital City deposits.  

I can’t speak to how much market share CFFN can capture of the commercial lending market.  What I can say is the bank has a good reputation and is the second largest mortgage lender (behind BofA) in the geography.  How many existing homeowner customers would transfer their commercial deposits to CFFN, and how far CFFN can grow the commercial lending portfolio of Capital City on the much larger asset base remains to be seen.  To be absolutely clear, it will be a slow change, but appears to have the potential to be meaningful or at least show the market net interest margins are moving in the right direction.  

I'm interested in the dividend and any market reaction to the announcement, but FYI if you have a longer interest.

Catalyst

Special dividend announced in October following fiscal year earnings report.