Washington Federal Upgraded - Analyst Blog

We are upgrading our recommendation on Washington Federal Inc. (WFSL) to Neutral from Underperform.
 
The company’s fiscal first quarter (ended Dec 31, 2009) earnings of 7 cents per share were a nickel short of the Zacks Consensus Estimate. This also compares unfavorably with the earnings of 23 cents in the year-ago quarter.
 
The results significantly deteriorated from the prior-year quarter due to a huge increase in provision for loan losses and a loss on real estate acquired through foreclosures. However, credit quality slightly improved during the quarter. Also, declining deposit rates helped improve funding concerns to a great extent while capital position remained strong.
 
As Washington Federal primarily generates revenue from the spread between the cost of   deposits of the general public and the returns on loans of various types, growth of loans and deposits should be a good health indicator for its business. Washington Federal has had a good loan and deposit growth story.
 
The company generated net loans of $9.0 billion at the end of fiscal year 2009 ($9.5 billion in 2008, $8.2 billion in 2007, $7.1 billion in 2006, $6.0 billion in 2005 and $5.1 billion in 2004), representing approximately 71.4% of its total assets.
 
Deposits are the primary source of Washington Federal’s funds for use in lending and other general business purposes. The company enjoys a competitive advantage in obtaining funds as it prefers to rely on a greater variety of deposits.
 
Washington Federal mainly concentrates on term certificate accounts and other deposits that have no fixed term and pay interest rates that are more responsive to market rates than passbook accounts.
As a result, the net interest margin (NIM) has benefited tremendously in the current environment of falling rates. We expect the NIM expansion to continue for the next few quarters as funding costs are expected to remain low for some time.
 
However, the major concern for Washington Federal is the quality of its asset portfolio. Real estate loans comprise more than 75% of its total assets. While Washington Federal’s conservative underwriting practices and high loan-to-value ratios have so far kept the delinquencies below the peer group average, the credit quality has been deteriorating based on conditions in the real estate markets throughout the company’s eight-state branch network. Going forward, we expect the increase in non-performing assets and net charge-offs to continue until the housing market recovery gains momentum.
 
Also, Washington Federal seeks to moderate the risks inherent in its loan portfolio by sticking to specific underwriting practices. These efforts include the analysis of a borrower’s prior credit history, financial statements, tax returns and cash flow projections, valuation of collateral and verification of liquid assets.
 
Even if the company’s underwriting criteria are satisfactory for the various kinds of loans it offers, like other companies, it may incur losses on loans that meet its underwriting criteria. Also, given the current economic downturn, Washington Federal’s allowance for loan losses may not be adequate to cover actual losses as it is primarily based on the company’s historical loss experience.
 
Though increased market share through acquisitions will be a great support going forward, we are concerned about the company’s significant exposure to real estate markets and suspect that it will further experience credit quality deterioration.
 
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