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Did Wells Really Do Well?

Wells Fargo surprised no one Wed morning by reporting nearly the same earnings they had pre-announced earlier this month; $3 billion in the pre-announcement, $3.05 billion in the earnings report.

As usual, there was some good news, some bad news and some confusing news.

The good stuff:
Record pre-tax, pre-provision earnings of $9.2 billion

Record revenue of $21 billion

Core deposits up

Confirmed expected annual savings of $5 billion with Wachovia merger

Wachovia merger reported to be going as planned

Tangible common equity (TCE) and Tier 1 capital ratios both up

Nearly $23 billion in loan loss reserves, a $1.3 billion increase from last quarter and enough to cover 12 months of expected consumer losses and 24 months of expected commercial losses

A lot of Wachovia's really toxic stuff was heavily marked down with the acquisition. As a result, WFC asset quality is probably quite a bit better than their peers.

The rest:
That $3.05 billion profit is before paying out $661 million in preferred dividends, income to common share holders was $2.38 billion. $372 million of that dividend payment was to the U.S. Treasury on the TARP preferred.

Mark-to-market accounting appears to have played a significant role. Using the recent accounting changes, WFC reduced their unrealized losses by $4.4 billion before taxes, $2.8 billion after taxes. I agreed with the accounting rule clarifying/relaxing mark-to-market. However, if I read the footnotes correctly this was effectively the source of WFC's profit for the quarter and it's a one-time event.

Other comments and summary:

Mortgage refinancing is going very strong and should continue to generate good revenue from originations for WFC for a while.

WFC's comments in the release indicate they believe their loss reserves are more than adequate and that some of the reserves will come back at some point in the future.

I continue to believe WFC is one of the best managed big banks, however near zero Fed rates, the refinance boom and mark-to-model accounting loss reductions won't continue indefinitely. Furthermore, I don't see where the funds to repurchase the Treasury preferred will come from without credit losses leveling off and there isn't much sign of that.

After all the hype from WFC and other banks about record quarters and improving business conditions, I was disappointed to find that (I think) the profit was essentially due to an accounting change. If anyone familiar with accounting has looked at the WFC release, I'd appreciate comments either correcting or confirming my take on the accounting change.

I have owned WFC stock for sometime now and continue to believe they will survive and eventually thrive. However, after reading the earnings release, I straddled the fence between a continued rough near term view and positive long-term view by selling about half my shares. I feel pretty confident that some piece of bad news in the banking sector will pop up over the next few weeks or months and give me the chance to buy them back at a lower price. But not confident enough to sell all of it.

Comments: View Comments |  Thursday April 23, 2009  |  Stocks: ,

Leveraged, Mortgage Backed Securities a Buy??? - Hatteras Financial (HTS)

The 17 November 2008 issue of Barron's reprinted their Daily Stock Alert titled "When Mortgages Are Loveable" by Fleming Meeks. Mr. Meeks gives Hatteras Financial (HTS) a favorable write-up and I decided to do a little research. I wasn't able to find the article online; apparently it was only in Barron's print edition.

HTS is a mortgage REIT. They have been operating since September, 2007 and went public on April 30, 2008. The HTS website describes the REIT, "Hatteras Financial is an externally-managed mortgage REIT formed in 2007 to invest in adjustable-rate and hybrid adjustable-rate single-family residential mortgage pass-through securities issued or guaranteed by U.S Government agencies or U.S. Government-sponsored entities, such as Fannie Mae (FNMA), Freddie Mac (FHLMC), or Ginnie Mae (GNMA)." HTS leverages up by borrowing via repurchase agreements. All of the assets are Level II under FASB 157, meaning they're based on market data, but not on data for identical securities. From the 10-Q, "The estimated fair values of MBS are generally determined by management by obtaining valuations for its MBS from three separate and independent sources and averaging these valuations." Seems like a fair approach.

The 10-Q for the quarter ended 30 September shows assets of $5.1 billion. Nearly all of the assets are mortgage backed securities (MBS). There are $4.6 billion of liabilities, nearly all repurchase agreements.

Over the quarter ended 30 Sep, the average cost of funds was 2.9%. The vast majority of the repurchase agreements have a term of less than 30-days and at end of quarter the average rate was a little over 3%. To limit the risk of financing longer term, ARM backed securities at short term rates, the company purchases interest rate swap agreements. They only buy interest rate swaps to cover a portion of the repurchase agreement financing. On 30 Sep, HTS had swaps covering $1.4 billion, so nearly one-third of their borrowing was covered. The manager has the flexibility to determine what level of interest rate hedging is prudent.

The primary reason for owning a REIT is dividend income and HTS really shines here. The company has only been public long enough to pay two dividends. Annualizing those two payouts gives a 14% yield based on the 28 Nov close. Annualizing just the last quarterly dividend gives a yield of over 16%.

As most investors know, yields this high don't come without some risk.

The income producing assets are all US Government backed securities, so default risk is near zero. There is a pre-payment risk; as the underlying mortgages get paid off either by refinancing or selling the home, the principal associated with the mortgage gets returned to the security holder. I'm not sure what happens in the event of foreclosure, I assume principal is returned with the government guarantee covering any shortfall from selling the property. Other than that, about the only asset risk would be if the government was to change its policy on backing Fannie and Freddie securities.

On the liability side, the risk is much clearer. Since HTS borrows using short-term repurchase agreements and buys longer term assets, a rapid rise in short term rates would hurt earnings. That risk is partially mitigated by the use of interest rate swaps and by the fact that the MBS are adjustable rate. But, the liabilities are only partly covered by swaps and the MBS rate adjustments have much longer terms than the repurchase agreements the company uses.

Another similar risk would be if the market narrowed the spreads between the MBS and short-term repo agreements. If this business model is solid, it's reasonable to expect more players to compete in the market which would narrow the spreads.

As long as the government continues to back Fannie and Freddie paper and the Fed continues to keep short term rates low, HTS should continue to deliver high dividend income. The company looks attractive, but HTS has rallied more than 15% over the past week. If I was going to buy it, I'd wait to see if it pulls back a few bucks before hitting the order button.

Disclosure: At time of posting, I have no position in HTS.

Comments: View Comments |  Friday November 28, 2008  |  Stocks: ,

Two TARPs for Citi (C)

We've all seen the news of Treasury pumping more money into Citigroup (C), but how do the details play out for shareholders or prospective shareholders?

The Treasury Dept issued a term sheet with some of the capital injection details. Stepping through them should give some insight into how good or bad a deal shareholders and taxpayers got.

One key element of the plan is government guarantees for $306 billion of C assets. Citi isn't totally off the hook here. They absorb the first $29 billion of losses on these assets. Losses above that are shared 90/10 between the gov't and Citi. The TARP takes the next $5 billion in losses, the FDIC owns the next $10 billion. After that, the Federal Reserve covers the losses with a loan at 300 basis points over the Overnight Index Swap (OIS) rate. There appear to be several different types of OIS transactions and the terms sheet didn't specify details, but I assume the base tracks the Fed Funds rate pretty closely. The government share of the loss is covered by non-recourse loans, meaning all the Fed can do is seize the assets. And those assets will be worthless if the situation deteriorates to where the Fed has to seize them.

In exchange for this guarantee, Citi is issuing $7 billion of preferred stock ($4 billion to Treasury, $3 billion to the Fed) at 8%. In addition, there's a management oversight kicker, "[Treasury] will provide institution with a template to manage guaranteed assets. This template will include the use of mortgage modification procedures adopted by the FDIC, unless otherwise agreed."

One restriction I didn't see covered widely is dividends. Under this agreement, Citi cannot pay a dividend of over 0.01 per share per quarter for the next 3 years. Anyone buying the stock because a quote summary shows a 17% dividend yield is going to be very disappointed.

That covers the asset guarantee. Cost to Citi, $560 million per year in preferred dividends, they still own the first $29 billion of losses and 10% of everything above that. If losses on the guaranteed pool top $44 billion, Citi is covered, but only by loans from the Fed. And the common stock dividend is cut to the bone.

The other component of the rescue agreement is the government's TARP preferred investment. This one is a little simpler. The gov't is buying $20 billion of preferred with an 8% yield. Unlike the earlier TARP buys, the yield doesn't step up after five years. The same dividend restriction is in place, but the government would look favorably on a request to hike it if Citi successfully raises more private capital.

Citi also needs to submit an executive compensation plan for Treasury approval. Sayonara big paychecks and bonuses.

Treasury also gets warrants for $2.7 billion worth of common stock at a strike price of $10.61.

Summarizing, Citi shareholders got a better deal than an FDIC takeover or the very dilutive bailouts FNM, FRE and AIG got. In those deals the government took warrants for 80% of the companies at strike prices of near zero. Citi also has to follow the FDIC's mortgage modification procedures and we don't know how much of this loan pool fits that model.

Citi got $20 billion in cash and a cap on loan losses at terms better than they could have gotten in the market. The statement doesn't say, but it's safe to assume the $306 billion assets pool is the really ugly stuff. We don't know how much that may have already been written down or how much farther it has to go. Citi actually only gets covered for $13.5 billion of losses, the 90% government share of losses between $29 and $44 billion. If I read the term sheet correctly, the Fed guarantees losses above $44 billion, but those guarantees are loans to Citi, not outright coverage. Dividend payments to the government on the preferred will cost Citi $2.16 billion per year.

From a taxpayer perspective, the deal isn't bad, but isn't as good as it could have been. If Citi survives, the 8% coupon on the preferred is a pretty good return and the warrants give some upside if the stock price gets up into double digits. I think the 80% dilution in previous bailouts was excessive, but I would have liked to see a much lower strike price for our warrants in this deal.

The deal is punitive enough that I doubt we'll see banks lining up saying "me too."

One thing the government hasn't done with this deal is provide any consistency. Bear, Stearns was allowed to fail, Fannie and Freddie were bailed with massive dilution through warrants, the Fed stepped in to save AIG under similar terms to FNM and FRE, Lehman was allowed to fail, TARP was originally supposed to buy bad assets, then it was a capital investment program, now we have a new template for the Citi intervention.

The key questions remaining are whether this will be enough and who's next.

This plan takes a zero stock price off the table, but about the best that can be said for it from a shareholder perspective is it's better than the alternative. The 8% payout on the preferred is a substantial expense for a company that isn't making money.

I don't have a position in Citi and don't plan on buying or shorting it. The easy stocks are tough enough.

Comments: View Comments |  Monday November 24, 2008  |  Stocks: ,

A Bank That Said "NO": Tompkins Financial (TMP)

Friday afternoon was the deadline for banks to apply to the Treasury's TARP program and was full of announcements from banks that were or were not participating.

I decided to dig a little deeper into one of the banks that opted out on the theory that any bank turning down the government funds must be pretty confident in their prospects. Tompkins Financial (TMP) was the first 'thanks, but no thanks' announcement I saw, so decided to peel back a few layers of the onion.

TMP is a financial holding company headquartered in Ithaca, NY. They are the parent company for Tompkins Trust Company, The Bank of Castile, Mahopac National Bank, Tompkins Insurance Agencies, Inc., and AM&M Financial Services, Inc.

The company's homepage has a link to a statement by CEO Steve Romaine that includes the following, "Unlike the banks and Wall Street firms that are requiring government bailouts or filing for bankruptcy, Tompkins Financial has not engaged in subprime mortgage lending nor have we invested in securities backed by subprime mortgages. Tompkins Financial does not hold any shares of Fannie Mae, Freddie Mac, Bear Stearns, Merrill Lynch, Lehman Brothers, AIG, or Washington Mutual stock." Sounds like Mr. Romaine should be on the short list for CEO of a bigger bank or maybe Treasury Secretary.

On 22 Oct, the company reported earnings for the quarter ended on 30 Sep. I didn't find a conference call announcement or transcript so assume they don't hold earnings calls.

The first statistic that jumped out was the earnings comparison with the year ago quarter. Earnings for quarter ended Sep '08 were 0.81 per diluted share, up from 0.70 per diluted share last year. TMP actually grew year-over-year earnings in one of the most difficult financial environments in history. I don't have statistics, but the 'banks with growing earnings' club must have a pretty short membership list. Motley Fool's CAPS screener returned 108 banks with positive earnings growth over the past three years, but there isn't a screen option for 1-year earnings growth. I checked a few of the banks and many would not have passed a 1-year earnings screen.

Net charge-offs are growing, but are well below industry comparables. Loan loss reserves are just over one percent of total loans. That's a little lower percentage than most other banks, but TMP's loan losses are also running well below other banks'. The loan loss provision increased by $3 million over the first nine months of the year and is nearly 140% of nonperforming loans.

The market cap is a little under $500 million. At Friday's closing price of $46.06, the company is trading at a price to tangible book value of 2.61 and 14.44 times estimated 2009 earnings. Both numbers are at the high end of valuation for banks. Based on the good loan performance, growing earnings and sound balance sheet, the company deserves to trade at a premium to its peers. The 52-week trading range is $34.66 - $59.30.

The dividend yield is 2.90%, much lower than many competitors. With a 42% payout ratio and solid earnings, that dividend appears safe.

TMP proves that there are some strong banks out there. Loan losses are well below industry averages. Year-over-year earnings growth is particularly impressive. The stock trades at a premium to most banks, even other sound banks. That premium appears warranted. If I wanted to buy this stock, I'd be patient and hope for a pull back of 10-15% from here, although it may not come down that far.

The list of banks that said 'thanks, but no thanks' to the Treasury should be a decent start to a shopping list for anyone interested in sound, smaller, regional banks. The other banks that announced they would not be participating in TARP on Friday are: Kearny Financial (KRNY), First Financial Bankshares (FFIN), Commerce Bancshares (CBSH) and Charles Schwab (SCHW). According to the AP, there are 110 banks participating in TARP. That leaves a lot of companies who decided not to play. I'll leave researching those names to others for now.

Disclosure: I have no position in TMP at time of posting.

Comments: View Comments |  Saturday November 15, 2008  |  Stocks: ,

Processing a Tough Economy - Graham Corporation (GHM) Earnings Review

Graham (GHM) is a small company that was just included in the Russell 2000 this past summer. GHM manufactures processing equipment; the big heat exchangers, ejectors and vacuum equipment used in refineries, chemical processing and other process industries. This was by far my biggest dollar and percentage winner from the two Strategy Lab Open rounds. The stock has been very volatile over the past year with a split adjusted 52-week trading range of $12.50 - $54.91. The 6 November close was near the bottom of the range at $14.15.

GHM reported earnings for their fiscal 2009 2nd quarter on Mon, 3 Nov. The numbers were only fair and the forecast wasn't as strong as the market would have liked. Earnings were 43 cents per share, missing analysts' estimates by 10 cents. CEO Jim Lines added, "Bookings this past quarter were down considerably and totaled $17.5 million. We believe the third quarter bookings may be light as well."

Nearly half of second quarter sales were to the refining industry and much of the business was outside the US. Refineries will continue to need repair, maintenance and upgrades, but it's tough to imagine that business gaining a lot of strength until the economy starts to improve.

Chief Accounting Officer Jennifer Condame presented the order backlog, "At the end of the second quarter, backlog was $69.7 million up 23% compared with $56.8 million at the end of the second quarter of fiscal 2008." However, the backlog decreased from $76.0 million at the end of the 1st quarter. Still, a nearly $70 million order backlog is great news for a company with a market cap of just over $140 million.

During the Q&A, an analyst noted that in past years, bookings for the next year nearly always accurately predicted sales for the year. However, this year, the company's guidance is slightly below the 2009 orders that were in hand at end of fiscal 2008. Mr. Lines explained that orders aren't being canceled, but some customers are extending projects.

The company has a strong balance sheet and is interested in pursuing acquisitions at the right price. When asked about plans, Mr. Lines stated, "...the acquisition size would be below $100 million, it would be engineered to order products that fit our brand, that are in the energy sector. Now in the energy sector, we are not just talking about oil refining and petrochemical. We are talking about power generation, alternate energy, [waste] energy, geothermal, areas where the Graham brand is exceptionally strong..." GHM has nearly $43 million of cash on the books and virtually no debt. With a balance sheet like that, they don't need to worry about tight credit markets. But some of their customers do.

Oil sands are a potential growth area for GHM, but many of those projects may be on hold at current oil prices. It wasn't mentioned in the call, but many alternative fuel processes require the type of equipment GHM sells.

In both my Marketocracy virtual portfolio and real life, I sold off most of my GHM holdings during the spring-summer run up, but have kept a few trophy shares to participate in future growth. GHM does pay a small quarterly dividend, but even with a raise in Sep and the share price drop over the past few days, the yield is below 1%.

GHM trades at value stock type multiples with a forward PE below 6. Unlike many companies, the strong backlog and long order-build-deliver cycle make earnings projections fairly believable. Countering that is a weak economy. At prices near $14 a share, the company looks cheap. It may stay cheap or get cheaper, but should be a good stock to average in and wait for the economy to improve. The stock is fairly volatile, so an active trader may be able to do well with it. With over $4 a share in cash and no debt, the company isn't in any danger of failing. Add in EBITDA of 3.6 and the company might look attractive as an acquisition target.

In summary, a former high flying, IBD momentum stock that's corrected to value territory. GHM probably isn't in the right business for the present economic cycle, but seems to be very well managed, has an outstanding balance sheet and could turn into a double or triple from current prices when the economy picks up again.

All conference call quotes from the transcript at

Comments: View Comments |  Thursday November 6, 2008  |  Stocks: ,

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