Overview
September 11, 2006
Research Associate: Amita Bizla, MBA
Editor: Nachiket Moghe, CFA
Sr. Editor: Ian Madsen, CFA imadsen@ 1-800-767-3771 x417
155 North Wacker Drive ( Chicago, IL 60606
Golden West Financial Corp. (NYSE - GDW) $74.17
Note: All new or revised material since the last report is highlighted.
Reason for Report: GDW shareholders approve WB merger. Previous Edition: July 28, 2006
Overview
Headquartered in Oakland, California, Golden West Financial Corp. (GDW) is one of the nation's largest financial institutions with assets over $125 billion as of June 30, 2006. The company has one of the most extensive thrift branch systems in the country, with 285 savings branches in 10 states and lending operations in 39 states. Information on Golden West is available at . GDW operates on a calendar year basis.
In summary, the key positive and negative arguments are addressed below:
|Key Positive Arguments |Key Negative Arguments |
|Fundamentals |Fundamentals |
|Impressive strength in ARM originations expected to continue with Fed |Declining mortgage originations and the looming credit downturn expected |
|expected to put an end to its tightening campaign. |to decelerate loan portfolio growth. |
|ARM payment options flexible enough to be able to remain competitive |High prepayment speeds expected to slow portfolio growth. |
|without giving up required profitability/rates of return. |Net interest income growth is limited. |
|Better earnings quality and growth potential even with a flattening yield |NIM remains pressured by refinance activity, strong competition for |
|curve. |deposits, and rising short-term interest rates. |
|Excellent credit quality and strong credit risk management. |The acquisition is subject to approval by various regulatory authorities. |
|Superior expense control. |Macroeconomic Concerns |
|Operating leverage expected to rise due to its stronger balance sheet and |Increasing competition may affect market share. |
|loan portfolio. |Flattening yield curve expected to pressure net interest margin and slow |
|Well positioned to face any potential credit storm given the stringent |originations as the option ARM product becomes less desirable. |
|credit quality standards, and a rising level of provision. |WB acquisition has led GDW’s stock to no longer trade on fundamentals to |
|WB-GDW acquisition could foreshadow further acquisitions of this nature. |some extent. |
| | |
GDW originates ARMs (adjustable rate mortgages). This is the focus of its business, and most of the analysts agree that the company is one of the best in this sphere. In a rising rate environment, GDW’s ARM product is more attractive than fixed rate mortgages, and its volumes have generally improved over the years. GDW offers ARM payment options flexible enough to be able to remain competitive without giving up required profitability/rates of return. It offers ARM to prospective borrowers at competitive payments in initial periods, but still generates attractive returns. This is due to the fact that GDW retains all of its loans for its own portfolio, and can customize its products to fit its needs and the needs of its borrowers. Its competitors, on the other hand, typically sell many of their loans, and therefore must structure the loans to fit the needs of the buyer of the loans.
In May, 2006, GDW entered into a definitive agreement to be acquired by Wachovia. The combination of WB and GDW will create a commercial banking giant with substantial geographic coverage. Golden West believes the combination will provide its customers with additional products and services that they desire. In Golden West’s key markets, analysts estimate Wachovia’s combined market share will increase to 20.6% in Florida, 4.6% in California (ranking 6th), 2.0% in Texas, and 4.2% in Arizona.
Recent Events
On August 31, 2006, Golden West Financial Corp. shareholders approved the company's sale to Wachovia Corp.
On July 17, 2006, Golden West Financial Corporation declared a quarterly dividend of $0.08 per share at its July 14, 2006 Board of Directors meeting. The dividend will be distributed September 11, 2006 to shareholders of record as of August 15, 2006.
Golden West announced on May 7, 2006 that the company has entered a definitive agreement to be acquired by Wachovia for $25.5 billion (based on WB’s closing price on May 5, 2006 of $59.39). The transaction is structured to be a combination of cash and stocks with each GDW share converted into 1.051 WB shares plus a cash component of $18.65. The deal values GDW at $81.07 per share and represents 15% premium over GDW’s pre-announcement price. The deal is expected to close in 4Q.
Revenue
The tables are current as of 09/11/06.
Following the 2Q06 earnings release, the Digest average was calling for 12.8% growth for NII in 2006 and 3.6% growth for non-interest income in 2006. Following the release, the growth expectation for NII decreased to 10.3% while that for total non-interest income increased to 17.2% for 2006. Following this update, the growth expectation for NII increased to 10.9% while that for total non-interest income decreased to 15.6% for 2006.
|$ in millions |
|Positive |3 |
|Neutral |14↓ |
|Negative |1 |
|Not Rated |2 |
|Average Target Price |$76.67↑ |
|Digest High |$82.00 |
|Digest Low |$68.00 |
|Number of Analysts |21 |
Risks to the price target include market and interest rate risk, competitive pressures, general economic or business conditions, asset quality, and expense management; as well as the market value of the company's equity holdings of Coca-Cola common stock. The Wachovia stock may also under perform and affect GDW's valuation.
Please refer to the separately published GDW spreadsheet for additional details and updated forecasts.
Capital Structure/Solvency/Cash Flow/Governance/Other
GDW did not repurchase shares in 2Q06, disappointing the expectations from most analysts. GDW has 17.7 million shares remaining under its current authorization.
One brokerage firm (Keefe Bruyette) points out that the company has stated that the first priority for use of capital is to support asset growth. In the absence of growth opportunities, the company uses capital to opportunistically repurchase shares. The company does pay a dividend, but it is small, equaling roughly a 5% payout ratio, and the firm does not expect a meaningful increase. The question of share repurchase is critical, in the firm’s view, because the firm is assuming a considerable slowing in balance sheet growth this year. Another brokerage firm (Janney Montgomery) believes that capital is likely to expand as the company generates high returns and balance sheet growth slows. Although there are 17.7 million shares remaining in its current repurchase program, the firm does not expect the company to repurchase shares given the current share price appreciation.
Federal Housing Finance Board, regulator for the Federal Home Loan Bank (FHLB) System, issued a proposal that would increase retained earnings requirements for individual FHLBs in March, 2006. Since the San Francisco Home Loan Bank would have one of the highest retained earnings requirements under the new regulations, it is possible that dividend payments on its stock may be suspended. In a worst-case scenario where dividends on the FHLB shares are eliminated for a period of time, one firm (Lehman) expects that this would result in annual lost income of $0.11 to $0.14 per share for Golden West, assuming the company did not adjust the FHLB investment position.
Acquisition by Wachovia
The sale of Golden West Financial to Wachovia comes as something of a surprise, but appears to make strategic sense.
The deal terms/description is as follows:
• GDW shareholders will receive 1.051 WB shares and $18.65 in cash for each GDW share, which represents a 15% premium to May 5, 2006. Based on the May 5th closing price, WB is paying 2.8x tangible book value, a 30% deposit premium, and 13.1x GDW’s 2007 EPS estimate.
• GDW is the second largest thrift in the U.S. with $127 billion in assets. It has a 4.1% deposit market share in California, a 2.2% share in Florida, and a 1.3% share in Texas. The majority of GDW’s deposit franchise is CDs and higher cost money market accounts, as GDW has historically pursued high balance, rate sensitive customers rather than competing for low balance checking accounts like many of its regional bank peers.
• GDW’s mortgage operation ranks 16th on a national basis, and has a portfolio made up entirely of adjustable rate mortgages, which analysts believe is well positioned for a less restrictive Federal Reserve.
• The break up fee is $995 million.
• The deal is expected to close in the fourth quarter of 2006.
Co-CEO, Herb Sandler stated that a primary reason for the sale was that GDW, as a mono-line company, would need additional products and services to continue generating strong earnings growth and that WB was the right company to combine with due to the compatibility of the corporate cultures and product menu. Sandler expressed strong support for WB management and noted that he and Co-CEO Marion Sandler will become top ten shareholders.
Although analysts are not surprised by GDW being acquired, they maintained it occurred earlier in the mortgage cyclical downturn than they would have anticipated. They believe the announcement would foreshadow further acquisitions of this nature, albeit later as the downturn becomes more evident. They were not surprised by the market’s positive reaction. That said however, they think the potential premium and time to make such a transaction for other mortgage mono-line companies should be a function of 1) how little the business model relies on gain on sale income, 2) how much reliance there is on direct forms of origination (as opposed to conduit/correspondent channels), 3) how little the exposure is to sub-prime, 4) the quality of deposit franchise, and 5) potential for cost savings.
Wachovia’s acquisition is scheduled to be completed in 4Q06, and therefore there is the possibility that the deal may fall through, which would negatively affect the stock price, according to one analyst (Citigroup). However, given the large break up fee ($995 million), this risk appears to be minor.
One brokerage firm (AG Edwards) does not expect any other bidders to emerge given GDW’s size and specialty lending focus. It believes the competitive environment and the bull market in housing could have played a role in the company’s decision to sell. One firm (Sandler O’Neill) thinks this transaction has substantially more to do with WB establishing a branch network in California. Another analyst (Friedman, Billings) believes the acquisition of one of the largest option ARM lenders by a knowledgeable financial company gives additional validation to the product that many equity investors fear.
It is worth noting that Golden West is a highly regarded and highly rated savings institution, not a commercial bank. One analyst (Bear Sterns) believes it will require considerable time and resources to lure bank customers from competitors such as WFC and BofA in GDW's principal markets. Still, the analysts believes acquiring GDW and its outstanding mortgage business would be a much faster way to expand geographically than de novo branch openings or a series of small acquisitions.
Competition in the Option ARM market has increased significantly over the past 21 months, as some national players have expanded their capabilities. Golden West was the leader in the market and has prudently managed its balance sheet through conservative underwriting and portfolio growth. The market has changed to more aggressive underwriting and the development of a secondary market. In the past, Golden West could change its minimum payment rate and others would follow. That has not happened this time and this, along with the flat curve, has likely impacted loan growth.
In this specific transaction, Wachovia gains:
a) The 2nd largest thrift in the U.S. with $127 billion in assets and nearly $61.6 billion in deposits;
b) A 10-state depository and a 39-state mortgage origination franchise;
c) A depository that is the 20th largest nationally with a 0.83% deposit share. In terms of deposit share by state, Golden West has an approximate 4.1% share in California, a 2.2% share in Florida, a 7.3% share in Colorado, and 1.3% share in Texas. The combined entity will have $348.1 billion in deposits and a 5.9% national deposit share. In Golden West’s key markets, Wachovia’s combined market share will increase to 20.6% in Florida, 4.6% in California (ranking 6th), 2.0% in Texas, and 4.2% in Arizona;
d) The mortgage franchise ranks nearly 16th nationally with a 1.7% share of originations. It is, however, among the largest ARM originators in the country ranking 6th with a 3.4% share of that particular product.
e) Golden West would reinforce Wachovia’s position as the 4th largest bank franchise by assets in the U.S., increasing by 23.6% and modestly narrowing the gap between itself and J.P.Morgan Chase;
f) A countercyclical mortgage operation given the structural CODI-based pricing lag built into the balance sheet;
g) A highly efficient, quickly adaptable franchise to changing conditions in the mortgage market;
h) A franchise that is likely as good as it gets fundamentally, with extremely strong return metrics;
i) A substantially more balanced national franchise, as Wachovia has historically been an East Coast franchise with a Southeast focus;
j) Wachovia also picks up a franchise that has not been a serial acquirer, hence, will have a more limited tangible book value impact; and
k) Additional, provides major access to California, one of the fastest growing states in the U.S. Wachovia’s first foray into California occurred earlier in the year when it acquired WestCorp ($3.42 billion) and the remaining 16% stake in WFS Financial not held by WestCorp.
Wachovia’s acquisition is scheduled to be completed in 4Q06, and therefore, one analyst (Citigroup) believes there is the possibility that a higher bidder may appear. This would potentially increase the stock price to whatever the higher bidder would offer. However, given the $995 million break-up fee, the likelihood of a higher bidder (which would likely have to take on that fee) appears remote.
One brokerage firm (Keefe Bruyette) believes that coastal housing markets are slowing and that mortgage credit issues are developing. Although the timing is uncertain, the firm expects mortgage credit to be a significant issue by mid 2007, as it believes that housing supply is accumulating while home prices are stagnating. The firm also believes that GDW will be given the benefit of the doubt by investors when credit problems start to materialize in the industry based on the company's historical credit metrics produced during previous mortgage credit cycles.
WB and GDW won shareholder approval on August 31, 2006 for their merger, which would combine the fourth-largest U.S. bank with the No. 2 U.S. savings and loan bank. The acquisition of Oakland, California-based Golden West would give Wachovia its first significant branch presence on the U.S. West Coast, and significantly expand its mortgage operations. Wachovia is based in Charlotte, North Carolina. The companies valued the merger at $25.5 billion when they announced it in May and expect it to close in the 4Q06. Golden West shareholders would receive 1.051 Wachovia shares and $18.65 in cash for each of their shares.
Upcoming Events
|Events |Dates |
|FOMC meeting |September 20 |
|FOMC meeting |October 24-25 |
|Expected 3Q earnings release |Mid October |
Potentially Severe Problems
There are none other than those discussed in other sections of this report.
Long-Term Growth
One brokerage firm (Citigroup) notes that GDW has produced a nearly 40-year earnings growth record that has established the company, not only as the nation's leading thrift, but also as one the nation's leading depository institutions. Golden West has grown EPS at a compounded rate over the past 35 years, 15 years, 10 years, and five years of 19%, 17%, 22%, and 23%, respectively. The company's business model is built around its disciplined strategy of focusing on the origination, (for its own on-balance sheet portfolio), of prime, pure (not hybrid) monthly adjustable-rate mortgages (ARMs).
This is a strategy that minimizes credit risk (almost no net charge offs in the past eight years), interest rate risk, and operating risk (efficiency ratio of 28%). The strategy has also enabled the company to prosper throughout mortgage finance/interest rate cycles.
Analysts are impressed with GDW’s ability to originate adjustable-rate mortgages in almost any interest rate environment. Its entire sales culture is based on promoting the ARM product over fixed-rate mortgages. GDW continues to originate and retain a significant volume of ARMs; its primary headwind has been a declining interest rate environment, which has enticed refinancing and pre-payments. Given the flatter yield curve and relatively low, long-term rates, some borrowers have begun to select FRMs over ARMs. However, given the heightened consumer awareness of the Option-ARM product and the flexibility it allows the borrower, one analyst (UnionBankSwitz.) believes ARM originations for Golden West should remain relatively strong going forward. Added to this, GDW’s ability to navigate successfully through the tougher parts of the credit cycle and to take advantage of the easier parts of the cycle cushions it from any potential credit storm. GDW currently operates in 39 states. Long-term growth opportunities include both expanding its penetration within those states, and expanding its footprint.
Over the long term, one analyst (FTN Midwest Res.) continues to believe that GDW is a core holding given the company is able to generate a higher ROE via its cost structure, despite a relatively low NIM. Further, in addition to a relatively high profitability level, management has been able to expand the company rapidly, and EPS growth is likely to outpace peers, despite its relatively large size.
One analyst (Citigroup) believes GDW enjoys best-in-class attributes including low costs, superior sales and underwriting, and steady management, which should help set the company apart from other financial services franchises over the long term.
One firm (Janney Montgomery) does not expect significant deterioration in credit quality over the near term and is comfortable with Golden West’s underwriting standards over the long term.
Individual Analyst Opinions
POSITIVE RATINGS
Fox Pitt – Outperform ($77) – (8/15/06): The firm reiterated an Outperform rating and $77 price target INVESTMENT SUMMARY: - It believes GDW has been a great franchise with sound operating fundamentals in all environments.
Sandler O’Neill – Buy ($82) – (7/20/06): The firm has increased the target price to $82 from $81 on lower EPS estimates going forward. INVESTMENT SUMMARY: As a result of the lower than expected 2Q06 EPS and the continuing decline in the company's margin, the firm has lowered the 2006 EPS estimate by $0.08 to $5.09 and the 2007 EPS estimate by $0.05 to $5.64.
NEUTRAL RATINGS
AG Edwards – Hold – (7/20/06): The firm believes the 2Q06 earnings miss (3 cents below consensus) was primarily a result of slowing total core revenue growth, without a likewise slowing in expense growth. INVESTMENT SUMMARY: The firm thinks 2Q06 was a tough quarter for GDW, with originations slowing substantially and spread income growth virtually non-existent on low earning asset growth and a sliding NIM.
Stifel Nicolaus – Hold – (7/20/06): Since the company is the target of announced acquisition, the firm rates the shares Hold at this point. INVESTMENT SUMMARY: Based on the weaker than expected quarterly results, the firm has lowered the fiscal 2006 and 2007 EPS estimates to $5.14 and $5.70, from $5.28 and $5.94, respectively.
Zacks Investment Research – Hold – (7/20/06): The firm has maintained the Hold rating and $76.50 price target which represents a moving target, based on the fixed exchange ratio and the price of WB shares. INVESTMENT SUMMARY: The firm does not follow WB and expect the shareholders to consider the relative value and appreciation potential of WB common also while evaluating GDW shares.
B. of America – Neutral ($77.50) – (9/8/06): The firm has reduced its price target from $81.75 to $77.50 and believes that GDW is conservatively managed with an industry-leading cost structure and best-in-class credit quality. INEVSTMENT SUMMARY: It believes that GDW's valuation, provides limited upside potential for the stock in the near term. The announced sale to Wachovia and quickly closed merger also suggest limited upward valuation momentum prior to the deal closing, and GDW's stock should trade mostly in line with that of WB.
Bear Stearns – Peer Perform ($77) – (7/20/06): The firm has lowered the rating to Peer perform from Outperform while maintained the target price at $77. INVESTMENT SUMMARY: The firm believes GDW shares are now largely dependent on the movements in WB shares given the approaching acquisition of GDW by WB.
Citigroup – Hold ($82) – (7/31/06): The firm believes GDW enjoys best-in-class attributes, including low costs, superior sales and underwriting, and steady management, which should help set the company apart from other financial services franchises over the long term. INVESTMENT SUMMARY: It also expects near to intermediate-term results may soon get a lift from the completion of the recent Fed tightening cycle, as GDW’s index-based asset yields finally catch up to the re-pricing of mostly market-rate funding sources. It also expects improved overall portfolio growth in 2006, as refinance activity should continue to slow and purchase mortgage growth remains solid
Friedman, Billings – Market Perform ($80) – (7/20/06): Due to the pending sale and to remain consistent with the firm’s rating on Wachovia, it maintained the Market Perform rating. INVESTMENT SUMMARY: The firm is not particularly concerned about the 2Q06 earnings miss because it views the margin contraction as temporary. It adjusted the 2006 EPS estimate to $5.22 to reflect the 2Q miss, although it recognized that the pending merger with Wachovia makes the full-year estimate less imperative.
Janney Montgomery – Neutral – (08/15/06): The firm believes that, if Wachovia can integrate Golden West properly, the long term benefits will likely be a catalyst for WB. INVESTMENT SUMMARY: The firm expects that NIM compression should continue in 3Q06 and, depending on the severity, it could reduce its EPS estimates slightly. Further, it believes that GDW should trade in line with the expected merger with Wachovia.
Piper Jaffray – Market Perform ($81) – (7/20/06): The firm has maintained Market Perform rating while lowered the target price to $81 from $83. INVESTMENT SUMMARY: It has reduced 2006 and 2007 EPS estimates to $5.06 (from $5.25) and $5.85 (from $6.15) based on estimated lower margins, lower growth and higher expenses going forward.
NEGATIVE RATINGS
MorganStanley – Underweight ($68) – (7/20/06): With the stock trading above its price target, the firm sees better value elsewhere in the group, where the flattening yield curve should be less of a headwind. INVESTMENT SUMMARY: If the flat yield curve environment continues, which is what the fixed income markets expect, then the attractiveness of ARMs will suffer, according to the firm.
Coverage Dropped
FTN Midwest Res. – (8/2/06): The firm has dropped the coverage due to the pending acquisition by Wachovia.
Copy Editor: Sudeshna.S
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Zacks Research Digest
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