Takeover Speculation Targets a Stronger CalFed : Banking: The thrift gains breathing room with a successful financial restructuring.

With a reverse stock split today, California Federal Bank loses its penny-stock status and begins to look like a going concern again--or so it hopes.

The Los Angeles-based thrift is giving shareholders one new share for each five they now own, boosting the stock’s value on the New York Stock Exchange to $19.375 today from Friday’s close of $3.875.

In a deal largely ignored on Wall Street at the time, CalFed Chairman Jerry St. Dennis in mid-December convinced the firm’s bondholders to convert their $122 million in bonds into stock.

The changeover put a net $86 million more in equity on the company’s balance sheet for 1992, assuring that CalFed would have adequate capital to meet minimum federal requirements for thrifts.

While the debt-for-equity swap didn’t entirely solve CalFed’s need for money, the deal’s success sparked substantial new interest in the $17-billion-asset thrift: Many analysts now see CalFed as a ripe takeover target for big banks, assuming it can work down its mountain of bad loans--the legacy of California’s real estate collapse.

With an enviable 170-branch system concentrated in Southern California and Florida--both considered gold mines for financial firms long term--”CalFed is on a very short list of desirable targets,” says Campbell Chaney, analyst at Hancock Institutional Equity Services in San Francisco.

The clearest sign of Wall Street’s new view of CalFed has been the stock’s action: Adjusting for the reverse split, the stock has zoomed from a low of $6.25 in November to the current $19.375, a 210% rise in less than four months.

The surge has been fueled by three groups of buyers: Small investors attracted by banking “turnaround” plays; institutional investors who believe CalFed will be acquired, and, say some Wall Street insiders, one or more larger financial institutions that may eventually be interested in making a takeover offer.

“I know there is a large bank accumulating the stock,” contends one institutional money manager who requested anonymity.

Whether or not a takeover bid comes, CalFed’s new majority shareholders--its ex-bondholders--have already reaped a huge windfall from the stock’s rally. In fact, the bond swap turned out so juicy it now is one of the most talked-about deals on Wall Street.

Each $5,000 face-value bond was exchanged for 821 (post-split) shares of stock. At their low of $6.25 prior to the restructuring, those shares were worth $5,132.

But as the stock has surged, the ex-bondholders’ wealth has mushroomed to $15,911 in equity per old $5,000 bond as of last Friday.

And because many of the bondholders were savvy “vulture” investors who bought the bonds from panicked sellers at deep discounts earlier last year--when CalFed’s future was far more in doubt--the returns to some of them have been on the order of 300%.

“The bondholders made one of the greatest deals I’ve ever seen,” says Gary Gordon, analyst at Paine Webber Group in New York. Among the bigger bondholders were mutual fund giant T. Rowe Price in Baltimore and money manager Wertheim Schroder Investment Services in Beverly Hills.

Of course, one investor’s gain often is another’s loss: Longtime CalFed shareholders who paid the peak price of $210 (split-adjusted) for the stock in 1986 have lost 90% of their investment. What’s more, they were forced to give away 78% of the company to the bondholders.

The 50-year-old St. Dennis, who became CalFed’s chief in 1990 after nearly 10 years as the firm’s economist, admits there isn’t much consolation he can offer veteran shareholders. But while it may appear that he left too much money on the table for bondholders, their reward has been amplified by surging investor interest in California banks in general this year--which almost no one expected.

In saving CalFed from bankruptcy or seizure by the feds, St. Dennis has at least given shareholders the hope of recouping more of their investment down the road. “It’s pretty clear that we’re going to be a survivor,” he says.

Yet analysts say the risk that CalFed could ultimately fail remains high. So-called core capital--the thrift’s cushion against loan losses--had to be at least 4% of assets as of Dec. 31, by federal rule. The debt-for-equity swap helped boost CalFed’s core capital ratio to 4.71%.

By June 30, however, the government wants to see a core capital ratio of at least 5%. So CalFed must raise additional equity.

St. Dennis has a plan to meet the June deadline, and most thrift analysts believe he’ll succeed. CalFed directors were confident enough to pay him a $325,000 bonus last year, on top of his $400,000 annual base salary.

Still, CalFed is burdened with $1.22 billion in problem real estate loans, a whopping 7.1% of total assets. If the California real estate market continues to slide, and CalFed faces red ink for a fourth straight year, all bets on its survival could be off.

“CalFed is still in a highly vulnerable state,” warns PaineWebber’s Gordon.

St. Dennis concedes that it’s too early to say if California’s real estate market has bottomed. But he also notes that CalFed’s commercial loan troubles showed only a small increase last year. Nearly three-quarters of the problem-loan total now is residential mortgages, which analysts view as encouraging because lenders traditionally lose far less on residential loans than on commercial ones.

St. Dennis expects CalFed’s problem residential mortgages to rise again this year, but “slowly,” he says. In the fourth quarter of 1992, he notes, problem assets overall rose just $5.9 million.

Even with further loan losses, CalFed has told regulators that it expects to earn $42 million this year, or $1.68 a share.

Crediting St. Dennis, analysts say CalFed has good inherent earnings power thanks to extensive cost cutting, a large retail deposit base and a plain-vanilla approach to home-mortgage financing that has yielded steady interest income for two years, despite lower interest rates. A program to boost fee income by selling non-bank products, such as mutual funds, also works well.

“It’s a real simple strategy,” St. Dennis admits. “What wins in this business is execution.”

And what about the takeover talk? “It’s clear that as the California economy stabilizes, there are going to be a lot of people taking a look at (CalFed) as a very valuable and scarce franchise in California,” St. Dennis says. “When these things arise, we’ll take them up.”

He also holds out hope that CalFed could be a buyer rather than a target, though that would require raising major capital. (Rumors have again surfaced about CalFed buying ailing Glendale Federal. But most analysts say such a deal is improbable because of GlenFed’s uncertain future.)

Who might want CalFed? Analysts tick off a long list of major banks that probably will enter California eventually, including Norwest Corp. and Banc One in the Midwest and NationsBank in the South. California banks such as Wells Fargo and First Interstate could also grab significant market share by swallowing CalFed.

The rumors about a potential acquirer accumulating CalFed stock surfaced after heavy trading in the shares early in February, when bondholders were permitted to publicly trade the first third of their shares. (They’ll get the other two-thirds May 1 and Aug. 1.)

On a post-split basis, trading volume in the stock soared to 3 million shares the week of Feb. 1, or 26% of the available stock.

Some money managers believe that if a takeover bid is coming, it will materialize relatively soon. Reason: At $19.375, CalFed stock is trading well below its tangible book value of $26.15 a share. That’s because many investors still aren’t convinced the thrift will survive.

If CalFed’s fortunes improve this year, the stock could rise further as well--raising the ultimate takeover price. So in theory, a buyer with its sights set on CalFed won’t wait for the all-clear in the real estate market, because by then CalFed won’t be cheap.

Hancock’s Chaney figures a fair takeover price for CalFed would be 1.5 times book value, or about $40 a share. Even a $30 bid would be a 50% premium over the current stock price of $19.375.

The caveats here are major, however: Problem loans could get much worse, or CalFed’s plan to raise new capital could fail.

Based solely on what CalFed expects to earn this year, the stock is already richly priced for a thrift. Note too, the stock pays no dividends. To buy now, you have to believe the takeover talk--or you must be a very patient investor.

CalFed’s Lean Years Key financial data on California Federal Bank. Figures are in millions, except per-share information. Bad loans rise even as the bank shrinks . . .

1989 1990 1991 1992 Assets $26,141 $24,452 $18,395 $17,236 Problem loans 601 778 1,027 1,226 Loan-loss reserves 132 247 332 324

. . . causing major losses . . .

Net income or loss $82 -$217 -$170 -$97 Net income/loss per share 15.55 -42.89 -33.12 -16.40 Tangible book value 183.95 136.40 106.50 26.15 per share

. . . but interest and fee income stay strong . . .

Net interest income $421 $482 $430 $439 Fee income 56 50 66 77

. . . and a restructuring boosts capital ratios

Core capital/assets 4.43% 4.09% 4.01% 4.71%

All data adjusted for 1-for-5 reverse stock split. Source: CalFed Inc.