Description

HomeStreet Inc. (HMST)

Long Trade Idea

Share Price HMST: $17.50

Market Cap: $400mn

52-week high: $19.89

52-week low: $15.95

Summary Thesis

HomeStreet is a small ($3.5bn assets), underfollowed regional bank that has transitioned from a crisis recovery phase to a rapid growth phase, and it is about to close a transformational acquisition that should drive 50%+ upside to the stock. Specifically, this merger will create a rapidly growing Commercial & Consumer bank generating an 11% ROATCE, tethered to an even more profitable Mortgage bank; the stock currently prices Homestreet at a no-growth 11x multiple on PF 2015E EPS for the Commercial and Consumer Bank, throwing in the Mortgage bank for free. Additionally, we see little downside, as the stock is trading at a small discount to tangible book.

Business Overview

On March 1^st, HomeStreet will close a transformational acquisition with three major benefits for the bank and for the stock. The largest of these benefits is scale: growing assets 25%—to nearly $5bn—will cause HomeStreet’s efficiency ratio should fall and profitability to increase. This jump in scale should provide additional benefits to the stock as it transitions from microcap territory into small cap territory. The second benefit is in business mix, as growth of the Commercial & Consumer Banking division relative to the Mortgage Banking division should decrease earnings volatility and demand a higher market multiple. The third benefit is capital relief, as the transaction provides HomeStreet with additional capital to fund its growth.

HomeStreet traces its roots to a Seattle community bank founded in 1921. After nearly ninety years of family ownership, the bank took significant impairments during the financial crisis, and 3^rd-generation CEO Bruce Williams stepped down in 2010. He was replaced by turnaround veteran Mark Mason, who shrank the balance sheet, brought NPA/A down to ~1%, and led the bank through an IPO in early 2012 to recapitalize. The bank is now growing rapidly with $3.5bn in assets and branches in three states (Washington, Oregon, and Hawaii) and mortgage lending centers in four others (California, Idaho, Utah, and Arizona).

Homestreet operates through two main business segments: commercial & consumer banking and mortgage banking, and both are growing rapidly. HomeStreet’s substantial mortgage banking division is core to the bank (they have the longest existing relationship with Fannie Mae of any bank), and it performed very well during the crisis (delinquencies for single-family mortgages never crossed above 3%). The 2012 mortgage refinancing boom led to record profits for the bank (2012 EPS of $6!) and helped to fund its recovery, but it also caused the mortgage bank to outgrow the C&C segment. This asymmetric growth was problematic, putting the bank in a difficult position relative to Basel III capital requirements (Basel III is particularly punitive to mortgage servicing rights) and leading the market to value HomeStreet as a mortgage bank, rather than as a more diversified regional bank. To address this issue, the bank recently sold a block of MSRs, closed two small acquisitions, and is now preparing to close a larger one.

The pending acquisition is Simplicity Bancorp, a Los Angeles-area thrift that arose from Kaiser Permanente’s credit union. From Simplicity’s perspective, this merger is the culmination of a strategic review flowing from the acknowledgment that Simplicity—with $900mn in assets—did not have the scale to earn an adequate return on capital for shareholders (ROTCE was 3.9% last year). Simplicity’s, size, location, and banking mix left it with relatively few suitors (WaMu and others rolled up most West Coast thrifts last decade), such that HomeStreet is paying a very modest price (0.96x TBV at announcement). The deal is structured as a 1:1 stock exchange, enabling investors to become HomeStreet shareholders through SMPL or HMST stock.

Pending Acquisition is an Inflection Point

Backing out HomeStreet’s mortgage bank, and considering the synergies guided, the table below illustrates why this transaction is so attractive: it takes two subscale community banks and builds a regional bank capable of earning an attractive return on capital. Another way to consider this transaction is to back the anticipated synergies out of Simplicity to calculate a “buyer’s multiple” for Simplicity: 45% efficiency ratio, 132bps ROA, and 8.5x PF 2014 earnings.

Second, by shifting HomeStreet’s revenue mix away from mortgage banking, it should smooth overall earnings and lead the market to view HomeStreet less as a mortgage bank and more like a diversified regional bank. The smoother earnings profile should also support a regular dividend, which management expects to initiate after the integration is complete. These changes should lead to multiple expansion. It should also be noted that this transaction will provide immediate capital to support HomeStreet’s continuing growth (Simplicity’s TCE/TA = 15%).

HomeStreet’s strategy is to continue to synergistically grow its mortgage and C&C banking divisions. Its preferred approach is to enter new markets within the Western United States by opening mortgage loan centers. It then looks to expand its C&C banking into that market through acquisition (e.g., using Simplicity to expand into Southern California). As it continues to grow and gain scale, it is targeting an efficiency ratio in the low 60s% and an ROE of 15%+. HomeStreet’s track record has been strong, and it is a reflection of CEO Mark Mason’s opportunistic approach: gobbling up market share in mortgage banking when other players pull out of a region, then using the windfall from the 2012 refi boom to fund the growth of the C&C bank. We view this strategy as ideally suited for the current banking climate, where low mortgage origination volumes are forcing some players to leave the market and regulation is squeezing community banks (greater compliance costs raising the scale threshold) and national banks (SIB surcharges and capital requirements) alike, favoring opportunistic and acquisitive regional banks such as HomeStreet.

Management & Owners

CEO Mark K. Mason is a banking veteran with experience in multiple turnarounds over the past couple of decades. In addition to leading the turnaround of HomeStreet, he led the turnaround of Los Angeles-based Bank Plus (d.b.a. Fidelity Federal Bank) in 1994 and 1999. He exited the latter turnaround through a sale of the bank for 2.4x TBV in 2001. Mr. Mason owns ~400,000 HMST shares (1.8%), representing 8x his 2013 total compensation and 2x his 2012 total compensation. Director and former CEO Bruce Williams (of HomeStreet’s founding family) owns ~800,000 shares (3.5%).

What is it worth?

We value HomeStreet as follows: 13x 2015E PF C&C EPS (excluding mortgage banking) of $1.65ps gives $21.50ps for the C&C banking division only. Adding $5.00ps (1.0x TBV) for the mortgage banking division gives $26.50: 50% upside from the current price. This implies a 1.4x TBV multiple for the whole bank, which seems reasonable given 2015E PF ROATCE of 10-12%. This multiple is low relative to the peer group of West Coast regional banks, and it is low relative to HomeStreet’s long-term ROATCE target of 15% and aggressive growth plans.

We also think there is significant downside protection at these levels. Q4 2014 TBVps was $19.39 (though the dilution and integration costs of the Simplicity transaction adjust that to a bit under $19ps).  Given the market’s tendency to anchor price to TBV for community banks, we find it hard to see HomeSteet trading too far below this number. Also, the current shareprice implies a conservative 11x multiple on 2015E PF C&C EPS, with no value assigned to the mortgage banking division; in other words, the market is currently offering a growing commercial & consumer bank for a no-growth multiple and throwing in a mortgage bank for free!

Why is it undervalued?

•  Minimal Coverage—HMST is a small bank covered by two analysts.
• Volatile Mortgage Bank Earnings Obscure Core Bank Earnings —Mortgage banking results have dominated quarterly earnings, leading to volatile earnings that have been awarded a low multiple. This transaction should dampen that effect and lead to a rerating; also, integration expenses from the acquisition of two small Washington state banks in 2013 have also weighed on earnings.
• Turnaround story —HomeStreet was under a cease-and-desist order from the OTS/Federal Reserve from May 18, 2009 to March 26, 2013; as recently as early 2013, HomeStreet was still taking large provisions to ALLL.
• Negative sentiment and regulatory attention for mortgage banking —The financial crisis, the decline in mortgage origination volumes nationwide, and Basel III’s treatment of mortgage assets have created a negative climate that has seen many mortgage banking participants scale back/exit the market (ironically, this market pullback has provided a pricing tailwind to the participants that have remained).

Key Risks

• Market fails to recognize the value—While this transaction should strengthen and highlight the core C&C bank, this thesis relies upon the market to see beyond the volatile mortgage banking earnings and award the bank a higher multiple.
• Synergies are not realized—If the stated synergies are not realized, the benefits of the transaction are minimal.
• Mortgage origination volumes dry up—given HomeStreet’s low dependence upon refi originations (they were profitable in Q2 2014 w/ just 20% refi in the mix, vs. 40% national average), their volumes should be less susceptible to rising rates. On the purchase origination side, volumes are just 12% above the 25-year low (set in 2011) and 75% below the 25-year average, so the downside appears low.
• Mortgage origination becomes more competitive—HomeStreet has been a beneficiary of some market participants pulling back. This trend seems likely to continue—at least in the medium term—as rates seem unlikely to fall to new lows, and regulations have made mortgage origination less attractive to the bigger players.
• Economic recession—as a bank, HomeStreet has levered exposure to its local economy.

Catalyst

1.      The merger is completed and combined results are reported as the projected synergies are realized.

2.      The larger size of the combined entity garners more attention from the market.

3.      Additional acquisitions and organic growth continue to boost size and scale.

4.      Starts paying a regular dividend (as hinted on the deal CC).