As a general matter, I think the US banking industry is ripe for activism. Chronic underperformance is far too often indulged by investors and boards and there are just too many banks in general. My view is that wholesale consolidation in the banking sector would not only be better for investors and consumers, but make the overall banking system safer and sounder. Unfortunately, most activists tend to avoid the banking sector (despite a number of obvious opportunities), so my inclination is to be supportive when a long time bank investor turn activist in the face of clear and persistant underperformance. However, as someone who tries to look dispassionately at these types of things, I can’t help but be impressed with how HomeStreet, Inc. (NASDAQ:HMST) has outmaneuvered Roaring Blue Lion Capital Management, L.P.
Based on HomeStreet’s responses to Roaring Blue Lion, I offer you “How to Finesse an Activist Investor in Three Easy Steps”:
First, address obvious issues proactively:
HomeStreet has a real issue: it is overly dependent on its mortgage business. Roaring Blue Lion does a great job explaining why HomeStreet’s dependence on its mortgage business is an issue and, to be fair, HomeStreet has had a number of missteps with their mortgage business that should concern investors. However, for as far back as I cared to look in HomeStreet’s investor presentations, they have said that their strategy was to diversify away from mortgages by expanding commercial and consumer banking. Unfortunately, building out a commercial and consumer bank is easier said than done—it takes time and there are number of other banks in HomeStreet’s west coast markets (Banc of California, Opus Bank and Banner Corporation are just a few that come to mind) that are aggressively trying to build commercial businesses. The other thing is that the mortgage business generates earnings: they may be “very interest rate sensitive, seasonal and volatile” as Roaring Blue Lion notes, and investors may put a smaller multiple on those earnings than those from a commercial bank, again as Roaring Blue Lion notes, but they are earnings nonetheless and it is hard to exit or shrink a business that has generated the type of earnings that the mortgage business has over the past few years. Also, assuming that HomeStreet trades more on a tangible book value (rather than forward earnings) multiple, those earnings are vital for growing book value. With interest rates rising, HomeStreet (and a number of other banks that have become dependent on mortgage earnings) will no doubt face the type of reckoning predicted by Roaring Blue Lion, but HomeStreet seems to have clearly anticipated the issues raised by Roaring Blue Lion and has at least articulated a plan to change their business accordingly.
Second, request a detailed plan from the activist:
This feels like an easy one, especially if you have followed step one. Given that HomeStreet has already clearly stated that it wants to lessen its dependence on its mortgage business and grow its commercial and consumer bank, which, as noted, is easier said than done, why not invite Roaring Blue Lion to meet with the board and get a detailed plan from them? I am fairly confident that if Roaring Blue Lion could present a detailed and actionable plan on how to effect the changes they desire (which are all pretty reasonable and would benefit all investors), HomeStreet would act on it. Unfortunately, Roaring Blue Lion’s plan was heavy on broad strokes and short on details.
That said, I am pretty sympathetic to Roaring Blue Lion since there is no way I could come up with a detailed plan for making the type of transformation they are looking for, which is why my detailed plan would have been as follows: sell. There are a number of banks who need greater scale in HomeStreet’s markets and who are further down the path of building out their commercial and consumer banks. In addition, while mortgage would still have its issues, if it was a smaller part of a larger bank’s earnings, its inherent challenges would be more manageable. In addition, if HomeStreet’s mortgage business were in a larger bank, the related earnings might get a higher multiple from investors. Finally, addressing another one of Roaring Blue Lion’s points, drastically cutting HomeStreet’s expenses would offer any acquirer the opportunity for significant earnings accretion.
Third, appoint a director with legitimate “investor friendly” bona fides.
I am not familiar with HomeStreet’s board and assume they take their duties seriously and perform them in good faith, so this is not intend to be a slight to them, but appointing the former head of financial services investments at one of HomeStreet’s biggest institutional investors to the board seems like a tactical masterstroke. I am sure that this newly appointed director would be an excellent addition to the board under any set of circumstances, but in terms of stealing Roaring Blue Lion’s thunder (or roar) ahead of a proxy contest, this feels like a real winner.
In conclusion, as a student of these things, my hat is off to HomeStreet for, so far, conducting a master class in dealing with an activist investor. In this situation, I think it is clear that HomeStreet has the upper hand, even though I generally agree with all the points that Roaring Blue Lion has made. Whether HomeStreet retains the upperhand, however, may depend on whether Roaring Blue Lion refashions its objective into something more direct and immediately obtainable.