Sunday, September 02, 2007

Critique on TFS Financial Corp. Write-Up

Hawkeye901 on Value Investors Club did an investment write-up on TFS Finacial (TFSL) stating that an 'MHC conversion' opportunity existed and the company, "at its current price of $11 per share, the company is trading at approximately 60% of its economic book value of $18 per share."

What is an MHC conversion opportunity? Well, MHC stands for mutual holding company, and it is a business structure available to banks in which the company's owners are its depositors. Some companies in the Northeast have chosen this structure, but these days you will rarely find new companies choosing this route. When MHC's want to go public and raise equity, things start to get very confusing. The company must hold more than 50% of its own shares, but the cash raised from the other shares sold goes straight to the company. Depositors, who were the original owners, get first rights to participate in the MHC's IPO. Now, the problem is how to treat the shares held by the company itself, because if and when these are eventually sold, the money for these will also go straight to the company. This means that looking at conventional shares outstanding and Price to Book or Earnings multiples would provide a very distorted figure, allowing for an opportunity for investors to profit from any misunderstanding.

This MHC opportunity has been well-covered, by me especially, and the opportunities have pretty much vanished as people caught on to the situation. This is why I was so surprised when I saw a VIC write-up with a 6.2 rating on such an opportunity, which claimed post-conversion it was trading at 60% book value. On further investigation, it appears that some optimistic assumptions were made to arrive at that figure.

I was first exposed to the MHC idea by a different VIC write-up done by jim77 on Service Bancorp, SERC. To copy a relevant paragraph from his write-up:

First a few comments on the 'mutual holding company'(MHC) structure. GAAP 'understates' both the P/E and P/B ratios because they fully count the shares the MHC holds...but the shares have never been sold publicly. Others posters on VIC have commented that all the economic value of the enterprise should accrue to the public minority shares only...but I'm afraid that 'overstates' the true
economic reality in most cases. (There is a very large exception where this does hold true, however...and, is in fact, one of the reasons why I recently bought SERC). It's not difficult 'adjusting' P/B and P/E for a publicly traded sub of an MHC at the IPO...but it is a little trickier after it's been trading for a few years. The easiest way is to assume a second-stage conversion at a reasonable
P/B (second-stage conversions are primarily priced according to book). The Mass median P/B is 117% and the national average is 108%. Most recent second-stages have conservatively been priced to go off at a minimum of 75% P/B. Assuming SERC is priced at 75% in any second-stage, the current price is an adjusted 59% P/B (this asumes all the underwriting expenses and a realistic 8% ESOP and 4% MRP expense). SERC will not stay long at that 59% P/B mark with the average Mass thrift trading at twice those levels. But is there anything indicating that the bank would want to convert?

Now, to give some comparisons, when SERC IPO'd, it had 1.65 million shares outstanding, of which it sold 736,000 to the public at $10 a share. Post-IPO, it had 18.4 million in equity, meaning a book value per share of $11.15(counting all shares outstanding). Meanwhile, the share price was at $9.75 when he recommended it, and the benefit from any MHC conversion still hadn't taken place.

In comparison, TFSL currently has 332 million public shares, of which 105 million were sold to the public. Post-IPO, it has 1.9 billion in equity, and a book value per share of $5.72. Yet somehow, they claim that both trade at an adjusted price/book value of 60%, despite SERC's far superior valuations.

The difference is, jim77 is assuming the secondary sale of sells goes off at 75% Price to book value, assuming book value is calculated using all shares outstanding. Hawkeye is assuming 120% price to book value, and hes only using the public share count, meaning 105 million shares outstanding instead of 332 million that would be used in jim's analysis. In truth, jim was probably being too conservative with 75%, especially when he says the average second-step is done at 108%. But hawkeye is using 120%, and a seriously inflated book value number to come at his numbers. Hence my surprise that it received a 6.2 rating... but maybe I'm just behind on a new era in valuations.

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