No Place Like HomeStreet

 | Oct 23, 2013 | 12:00 PM EDT  | Comments
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Stock quotes in this article:

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HomeStreet (HMST), a regional bank in the Pacific Northwest, was one of the best-performing small-cap stocks in 2012. This bank had benefitted from the refinance boom brought on by low interest rates and government programs allowing Fannie Mae and Freddie Mac-backed mortgage holders to refinance, even if they had little to no home equity.

As you might guess, HomeStreet has been punished by rising interest rates and the subsequent decline in refinancing volume over the last few months. Since March of this year, HomeStreet has fallen to $19.30 from around $25 per share -- a drop of almost 23%.

But in classifying HomeStreet simply as a refinance play, I believe the market is in error. Actually, for most of its 90-plus year-history, HomeStreet's biggest source of revenue has been purchase mortgages, a strong market given the region's positive demographics and economy. In addition, this company has been on the path to diversify into commercial and industrial lending as well as multifamily construction loans.

There are many good reasons to like HomeStreet. With a return on equity of more than 16.5% so far this year and more than 20% in its mortgage segment, this is a very efficient bank. And it's rather conservative: Its Tier 1 Leverage ratio of 11.89% is well above its regulatory requirement of 5%. Most compelling of all, however, is this bank's current valuation: After dropping by nearly 23% it now sits at only 1.05x book value. Bargains are difficult to find these days, but I believe this is one of them.

The Growth Case

Going forward, HomeStreet will grow by returning to its purchase mortgage roots and by diversifying, thereby becoming more levered to the Pacific Northwest economy as a whole.

As we can see in the chart above, management expects the drop in refi volume to hurt earnings temporarily. Continued strength in home purchases, however, will drive earnings. In fact, the Puget Sound area has only two months inventory on the market, less than the usual six. Demand continues to be strong in this region.

Instead of fighting the uphill battle to enter commercial and construction lending organically, HomeStreet has opted to acquire smaller banks concentrated in this sector. In July, HomeStreet announced it would buy Seattle-based Fortune Bank and central and eastern Washington-based Yakima National Bank. Both names have substantial commercial and industrial lending businesses and together increase the branch count by six.

In the future, HomeStreet will be less levered to the ups and downs in refinance volumes and more levered to the Pacific Northwest economy as a whole. What won't change is the bank's best-in-class returns and conservative capital structure. Last year was a great one for HomeStreet shareholders. This year is less so, but this is a best-of-breed bank in one of the economically stronger areas of the country. Refi volume has hurt earnings, but to focus on this is to lose sight of the big picture: This bank is not destined to be at the mercy of home refinancing volumes for long. And at just 1.05x book, the price is certainly right.

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