Washington Mutual: The worst may be over
The mortgage lender's stock already reflects the weak housing market - and the next move could well be up.
NEW YORK (Money) -- Washington Mutual stock had several big runs between 1995 and 2002 thanks to the housing boom and the bank's nationwide expansion.
By the time the Fed began raising interest rates in 2004, shares of the Seattle-based lender had risen sevenfold over the previous decade. Since then, however, the stock has gone nowhere and has suffered occasional declines as the mortgage-lending business deteriorated.
In fact, the opposite is true. Widely anticipated weakness in the housing market is already reflected in WaMu's share price. And there's good reason to believe that the high-yielding stock is now significantly undervalued.
Start with the fact that Washington Mutual now trades at only 10 times next year's projected earnings and that the shares currently yield 4.8 percent.
From a short-term perspective, that seems justified. Mortgage lending is down by a quarter from its peak, and further defaults on existing loans are increasingly likely.
In addition, short-term interest rates are a little higher than long-term rates. That uncommon condition - known as an inverted yield curve - squeezes the profit margins of all lenders that have to borrow money short-term to finance long-term loans.
As a result, Washington Mutual's earnings are expected to rise a negligible 2 percent this year. Value-oriented investors will find, however, that the longer term picture is much brighter.
For starters, WaMu has been actively reducing its exposure to mortgage lending, selling off some of the riskiest loans. Instead, the company has been boosting its retail banking and credit-card lending, which now account for more than three-quarters of total profits.
Second, Washington Mutual has been trimming costs and pulling back a bit from its overly ambitious expansion plans. Although the bank continues to open new branches, it has announced plans to close 80 existing branches.
To bolster growth, the company is reducing fees, offering special bonuses and stepping up its online presence. So far, that has brought in more than 400,000 new checking accounts. And the bank expects to add more than a million new accounts by the end of the year.
At this point, it appears that Washington Mutual has minimized its risk exposure and that its more cost-effective growth strategy is working.
Analysts now project a double-digit earnings gain in 2007, with profit growth continuing at that rate over the next five years. Those growth prospects will be greatly helped at the point that the Federal Reserve allows interest rates to fall.
Moreover, there is widespread speculation that Washington Mutual will be acquired by one of the U.S. banking giants within the next few years. Given the relative P/E ratios of the major banks, J.P. Morgan Chase (Charts) would likely receive the fastest payback from such a merger, though Citigroup (Charts) also gets mentioned as a possible suitor.
As with any contrarian investment, there's no way of knowing for sure when Washington Mutual's earnings growth will pick up again or whether the bank will indeed be acquired. But with the yield close to 5 percent, shareholders can certainly afford to wait.