Second Step Slippery for Converting Mutuals

Under normal circumstances, Capitol Federal Financial in Topeka, Kan., would be wrapping up the process it began more than two months ago to convert from a mutual holding company to a stock company.

Instead, the company is seeking an extension from regulators, after failing to sell the minimum number of shares required to complete the deal. The problem is not with Capitol Federal or its performance, but with the appraisal of its stock: in today's market, it's simply too high.

"Because of the drop in the market, the investment community basically said, "We like the stock, we like the company, but we don't like the price,' " said Eric Luse, a partner at the Washington law firm Luse, Gorman, Pomerenk & Schick P.C.

The dragged-out Capitol Federal deal is one illustration of the difficulties that mutual holding companies are facing in taking the second step to convert their shares. The recent sluggish market for such deals results partly from the drop in thrift share prices — as second-step pricing correlates closely to the overall market — and also to the lackluster debut of shares of recently converted companies.

"In today's market it has been more difficult, certainly, to sell stock than it was a month and a half ago," Luse said.

For Capitol Federal, that has meant seeking a second, independent appraisal in the hope that the new price would come in low enough to entice investors.

Other banking companies are having similar troubles with conversions. FedFirst Financial Corp. in Monessen, Pa., for example, had planned to close its second-step offering on Sept. 3, but in July it requested an extension so it could update its appraisal.

And several others, including Home Federal Bancorp Inc. in Shreveport, La.; Atlantic Coast Financial Corp. in Waycross, Ga.; and Naugatuck Valley Financial Corp. in Naugatuck, Conn., announced plans or applied to convert this summer but have not commenced the offerings.

"That suggests to me that there may be some problems with either the regulators or the appraisal," said Theodore Kovaleff, an analyst with Horwitz & Associates, a brokerage in Riverwoods, Ill.

Robert Larison, Atlantic Coast's chief executive, would not comment specifically on his company's situation. He said he thinks regulators are taking longer to approve transactions as they struggle to rationalize appraisals.

"It's no different than a house, I suppose," Larison said. "The seller probably thinks a house is worth a lot more than a buyer is willing to pay for it."

Officials from Capitol Federal declined to comment, citing their quiet period.

The Office of Thrift Supervision, which regulates thrifts and oversees conversions, requires companies to sell a minimum number of shares when they convert. That number is determined by the appraisal.

The drawn-out process of a second-step transaction poses risks, said Mike Shafir, an analyst with the investment bank Sterne Agee & Leach in Birmingham, Ala.

An appraisal can be filed as long as 60 days before a company receives regulatory approval for a conversion — Capitol Federal's appraisal, for instance, was completed on May 28, six weeks before it commenced the offering. During that period, companies are subject to market fluctuations.

"Valuations just really changed in the marketplace from the initial filing to where we are now," Shafir said of Capitol Federal's offering. "The company really had no control over that."

Another factor in the price of offerings has been the blase stock performance of companies that have completed the second step. In the conversion process, appraisals often are based on the trading price of companies that commenced similar deals, even if those deals were much smaller.

Oritani Financial Corp. in Washington, N.J.; ViewPoint Financial Group Inc. in Plano, Texas, and Fox Chase Bancorp Inc. in Hatboro, Pa., to name a few, are trading below the $10-a-share price at which they debuted after a conversion. (Most shares of newly formed companies typically open at $10 after a conversion.)

Although those companies are trading at about 80% of tangible book value, Capitol Federal's appraisal priced its shares at 92% of tangible book, Shafir noted. The conversion is now expected to close in the fourth quarter.

"While Capitol Federal probably deserves a premium as a function of size and the liquidity that's going to go along with that transaction, from an investor's standpoint it's difficult to pay that premium when you have other companies that are trading significantly below that after going through the process," he said.

Shafir said the new appraisal would likely come in closer to 82% of tangible book, lowering the potential proceeds of the offering from $1.9 billion to $1.5 billion.

Kovaleff said investors may have been wary of Capitol's plan to deploy all that capital. The company hasn't had many acquisitions, and is already flush with capital. It applied to convert because of concerns about converting under a new regulator once the OTS merges with the Office of the Comptroller of the Currency.

In the end, the reappraisal isn't an impediment to getting the deal done, nor does it reflect poorly on the company, Luse said.

In fact, it may be just the opposite.

"If the market is saying that this is really what should be done … you don't really think about it, you just get the deal done," he said. "You want to be perceived as a company that is responsive to stockholders. And you want that stock fairly priced, so there's upside for your investors."