Washington Federal’s (WFSL) second-quarter (ended March 31, 2010) earnings of 73 cents per share substantially surpassed the Zacks Consensus Estimate of 11 cents. Results were helped by significant gains from its acquisition of Horizon, a failed bank based in Bellingham, Washington as well as tax benefits. The quarterly results also compare favorably with the earnings of 10 cents in the year-ago period.
 
Besides the noteworthy gain on the acquisition of the failed bank, the stupendous results in the reported quarter were supported by strong deposit inflows and new account openings. On the other side, feeble loan demand disappointed management due to the tepid economy.
 
On-going soft market conditions continued to force the company to aggressively write down problem assets. Though the overall level of non-performing loans and real estate owned through foreclosure is showing early signs of improvement with a gradual decline, it remains above our comfort zone.
 
Behind the Headlines
 
Net income available to common shareholders for the reported quarter came in at $82.1 million, compared to $8.4 million in the prior-year quarter.
 
In response to the improving credit conditions of WFSL’s loan portfolio though mixed pertaining to the real estate market’s health, it has recorded a provision for loan losses of $63.0 million in the reported quarter, marginally up from $54 million in the prior-year quarter. Allowance for loan losses was $195 million as of Mar 31, 2010.
 
WFSL’s net interest income (before provision for loan losses) for the quarter increased 4% year over year to $97 million. This increase was primarily the result of a considerable decline in deposit costs and growth in the balance sheet, partially offset by reduced yield on earning assets. As of Mar 31, 2010, the interest rate spread decreased to 3.05% from 3.11% as of the end of prior-year quarter.
 
FDIC-assisted acquisition-related expenses, increased employee incentive compensation, and higher FDIC insurance premiums significantly raised total operating expenses for the quarter to $40 million from $25.1 million in the prior-year quarter.
 
According to the agreement terms of the failed bank, WFSL recorded a pre-tax gain of $85 million related to the transaction. The company also resolved a potential tax liability with the IRS resulting in a tax benefit of $39 million in the quarter.
 
As a result of some non-recurring events during the quarter, efficiency ratio was among the lowest in the industry at 21.3%.
 
Evaluation of Credit Quality
 
WFSL’s credit quality remained mixed during the quarter. Lower delinquencies and non-performing assets were partially offset by increased net loan charge-offs. Non-performing assets as a percentage of total assets decreased 47 basis points sequentially to 3.90% at Mar 31, 2010, though net loan charge-offs increased from $16 million to $59 million on a year-over-year basis.
 
It is notable that though loan losses have increased in the reported quarter, mortgage loan modifications were higher and foreclosure rates continued at or near a record pace.  Management expects loan losses to remain high through the remainder of 2010 as a result of the continued weakness in the real estate market.
 
Evaluation of Profitability
 
Profitability metrics for the quarter improved both sequentially and on a year-over-year basis. Return on equity was 18.24%, compared to 1.80% in the prior quarter and 2.40% in the prior-year quarter. Return on assets was 2.44% compared to 0.25% in the prior quarter and 0.27% in the prior-year quarter. The remarkable expansion of both these ratios resulted from improving asset quality trends.
 
Though WFSL’s net income expansion and decreased non-performing assets will be a great support going forward, we are concerned about varied indications of the real estate market’s health to which the company is significantly exposed.
 
On Thursday, the shares of WFSL closed at $20.67, up 0.8%, on the New York Stock Exchange.
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