People's United: A Smart Banking Play
Bank holding company People's United Financial (PBCT; recent price, $16) has earned Standard & Poor's highest equity investment recommendation of 5 STARS (strong buy), given our view of its high credit quality, excess liquidity, and attractive share price.
In April, 2007, People's United completed its planned conversion from a mutual holding company (i.e., owned by deposit holders) to a publicly held company, raising $3.4 billion. It used a portion of the proceeds to purchase Chittenden Corp., a relatively conservative bank with branches in the Northeast, mostly in Vermont. With the acquisition complete, People's United still has nearly $3 billion in excess capital on its balance sheet.
Although the funds are currently weighing on People's United's net interest margin, as they are invested in low-yielding short-term securities, ultimately we believe that People's United will use most of these funds to buy another bank at an attractive price.
Waiting for an Attractive Acquisition
With banks continuing to experience ongoing credit issues, the industry's market capitalization has declined, with even some of the higher-quality names currently trading at what we view as attractive prices. We believe that given the scarcity of banks with excess capital, People's United should be able to complete a purchase at a favorable price. At the very least, given People's United's excess capital, we think it should be able to expand existing loans at a rapid clip as peers exit the loan arena.
While People's United awaits for an attractive acquisition to emerge, we think the company will likely use some of its excess capital to repurchase shares and in turn support its stock price. People's United's board recently approved the repurchase of roughly 5% of its shares outstanding.
Separately, People's United continues to maintain what we see as solid credit quality compared with its peers. Indeed, annualized chargeoffs accounted for only 0.08% of total loans in the first quarter, and actually declined from fourth-quarter levels, a rarity in our coverage universe.
In addition, People's United seems adequately reserved for further credit deterioration, by our analysis. At the end of the March period, reserves totaled roughly 225% of nonperforming loans, vs. roughly 125% for peers.
With roughly $21 billion in assets, Connecticut-based People's United is a savings and loan holding company for People's United Bank. It has more than 300 branches in six states (Connecticut, Vermont, New Hampshire, Massachusetts, Maine, and New York) and has an agreement with Stop & Shop to offer banking activities within its stores. Currently, 75 of People's United's 162 Connecticut branches are located in Stop & Shop stores, offering added customer convenience.
In 2006, the bank moved from a state charter to a federal charter under the Office of Thrift Supervision. In April, 2007, People's United completed a second-step conversion, raising $3.4 billion. In June, the thrift changed its name to People's United Bank (from People's Bank of Connecticut).
The company offers a full range of financial services to individual, corporate, and municipal customers. In addition to traditional banking activities, People's United provides specialized services tailored to specific markets, including personal, institutional and employee benefits, cash management, and municipal banking and finance.
Acquisition News Depressed Shares
It offers brokerage, financial advisory, and life insurance through its People's Securities subsidiary, equipment financing through People's Capital & Leasing Corp., asset management through Olsen Mobeck Investment Advisors, and insurance services through R.C Knox & Co. Its primary lines of business are middle-market commercial banking, retail and small-business banking, and wealth management.
In June, 2007, People's United announced it had agreed to acquire Chittenden Corp., a bank located in Vermont in a cash/stock transaction valued at $1.9 billion. The deal was priced at 4.2 times Chittenden's tangible book value at the time, relatively high compared with other deals. People's United's stock declined about 25% over the next three months and is currently trading at roughly a slight premium from the lows achieved after the announcement of the Chittenden acquisition. The acquisition was completed in January, 2008. Notably, People's United has over $2.5 billion left over from its second-step conversion.
With the addition of Chittenden, People's United's loan book now has a more commercial bias. The loan portfolio, which totaled roughly $14.5 billion at the end of the 2008 first quarter, is as follows: 29% residential real estate, 26% commercial lending, 31% commercial real estate, and 14% consumer loans. We believe that People's United is a conservative lender, requiring full documentation and offering low loan-to-value loans.
This conservatism is reflected in People's United's low chargeoff levels. Specifically, annualized net chargeoffs totaled only 0.08% of average loans held in the first quarter, down from 0.17% in the fourth quarter. We note that declining chargeoffs is a rarity in our coverage universe given today's difficult credit environment.
COMPANY AND INDUSTRY OUTLOOK
The banking industry continues to come under pressure due to falling home prices and rising unemployment. Median prices for the S&P/Case-Shiller Home Price indices declined 14.1% in the first quarter of 2008 (year over year), while unemployment rose to 5.5% in May from 5.0% in April. We believe the combination of these two factors is putting a further strain on the banking sector, as most companies will likely need to increase provisions due to likely higher writedowns. This, in turn will likely result in some banks needing to raise additional capital or cut their dividends, by our analysis.
Against this backdrop, we favor banks that not only maintained conservative lending standards during the housing boom but also have a high level of capital. We believe such companies will be able to take advantage of the fallout from their competitors' problems and should be able to increase their business despite a weak U.S. economy. People's United is one of these lenders, in our view.
As of Mar. 31, 2008, People's United's Tier 1 capital ratio totaled 23.5%, vs. the peer median of 9.3%. We note that People's United's strong capital level stems from its second-step conversion completed over a year ago, in which it raised $3.4 billion. Although People's United used some of the proceeds to purchase Chittenden, it still has nearly $3 billion of excess capital remaining even after the acquisition.
Stock Has Upside Potential
We highly value People's United's strong capital position and believe that the company will ultimately use most of its excess funds to purchase another bank. Although the timing of a potential new deal is unclear, we think that any bank People's United purchases would be of a relatively large size, concentrated in the Northeast with a commercial lending bias, and with relatively strong credit. We look for a potential acquisition to offer an internal rate of return of at least 20%.
With bank stocks beaten down over the past year, we believe that People's United should have plenty of opportunity to find an attractively priced bank. That said, it may be difficult to get a bank to agree to be acquired at only a modest premium, as bank deals are generally friendly transactions and some banks may want to wait for the market to turn before considering a sale. In People's United's favor, in our view, it is getting more and more difficult for smaller banks to compete against larger institutions, which we think will result in the management of some smaller banks questioning whether it makes sense to exist alone.
We think People's United will also likely use some of its excess capital to repurchase its shares at opportunistic prices. The board recently authorized a share repurchase program for 5% of stock outstanding. We believe that People's United's repurchase activity will lend some support to the stock at current price levels.
Investing in Short-Term Securities
Ironically, what we favor most about People's United is currently hurting its earnings growth, and likely, its short-term stock performance. While People's United likely waits for the right acquisition to arise, it is investing its excess capital in short-term investment securities. Given the Fed's rate cuts over the past year, these investments are being made at low interest rates, as reflected by People's United's net interest margin, which declined to 3.68% in the first quarter of 2008, from 4.01% in the previous quarter. However, with inflation concerns on the rise, we do not look for further rate cuts. And, even if the Fed were to raise rates, we think this would benefit People's United's earnings.
People's United's loan book is conservative in nature, with no subprime, low document, or structured investment vehicles (SIV) exposure. With the addition of Chittenden, People's United's loan book is more diversified, with commercial real estate loans now totaling 31% of loans, vs. 21% the previous quarter (residential real estate, commercial, and consumer make up 29%, 26%, and 14% respectively).
We believe People's United maintained high lending standards throughout the housing bubble by requiring a relatively high equity stake from borrowers. This is reflected by People's United's net chargeoffs, which totaled $9.3 million in 2007 and $2.8 million in the first quarter of 2008, a very small fraction of its $14.5 billion loan portfolio (roughly $9 billion last year). Nonperforming loans totaled 0.46% of total loans at the end of the first quarter, with reserves a more than adequate 226% of nonperforming loans. Although reserves were below those of its peers, at 1.05% of total loans at the end of the March period, we are not concerned. Based on People's United's low chargeoff levels, we do not believe the company's reserves need to be as high as some of its peers.
For the most part, we believe People's United's expenses are in line with peers, as its efficiency ratio totaled 56.4% of revenue in 2007 (the lower the figure, the better). The ratio jumped to 64.5% in the first quarter of 2008, reflecting a combination of the Chittenden acquisition and People's United's lower revenue base, due to its investment in short-term securities. Looking ahead, we think that decreased expenses will gain traction in the second quarter of 2008 as the company has announced a headcount reduction of roughly 420 positions and the closing of 20 branches. All in all, we look for savings of $20 million in 2008 and about $40 million in 2009.
The stock was recently trading at 26 times our 2008 earnings per share estimate of 63 cents. We look for annualized earnings growth of 20% over the next three years. However, given that People's United completed its second-step conversion in April, 2007, we believe it is more appropriate to value the company as a multiple of tangible book value.
Using this metric, People's United's stock currently trades at 1.48 times tangible book value of $11.08 (as of Mar. 31, 2008), in line with its regional bank peers but at a significant premium to most thrifts, which have fallen in value due to poor lending standards. Our 12-month target price of $20 equals 1.70 times our 2008 tangible book value estimate of $11.75, a premium to peers, justified by what we see as People's United's strong capital position.
Sound Corporate Governance
We believe People's United's corporate governance policies are sound. A supermajority of board members (greater than 75%) are independent outsiders. We are also encouraged that both the nominating and competition committees are comprised of independent outside directors. The compensation committee is made up solely of outside directors and has met in the past year. Also, the chairman and CEO roles are separated, and the chairman is an independent outsider.
The primary negative factors we see are a lack of cumulative voting rights for shareholders and that the board is authorized to increase or decrease the size of the board without shareholder approval.
Risks to our recommendation and target price include a further steepening of the yield curve, which would lower People's United's net interest margin. Also, further weakening of the U.S. consumer sector could also result in chargeoffs rising above our projections for both residential and commercial lending. We also think that there is execution risk in integrating the Chittenden acquisition. Finally, we believe that there is a risk that People's United may overpay for a potential future acquisition, thus lowering its tangible book value and consequently putting pressure on its stock price.