Executive Summary / Key Takeaways

• Capitol Federal Financial (CFFN) is strategically transitioning from a traditional retail-focused savings bank to one with an increasing emphasis on commercial banking, aiming to diversify its loan portfolio and enhance profitability.
• The company's recent financial performance shows improving net interest income and margins, driven by the shift towards higher-yielding commercial loans and decreasing deposit costs, despite a slight decrease in overall loan balances.
• Asset quality remains strong with historically low delinquency and charge-off rates, although management notes potential risks in the economic outlook and specific concentrations in the commercial portfolio.
• CFFN is investing in technology, including commercial loan pricing software and digital banking enhancements, to support its strategic shift, improve efficiency, and enhance the customer experience in a competitive landscape.
• While regulatory constraints related to the pre-1988 bad debt recapture tax currently limit capital distributions and share repurchases, management anticipates sufficient taxable income in fiscal year 2025 to potentially enable distributions from the Bank to the holding company in fiscal year 2026.

A Foundation Built on Retail, Evolving Towards Commercial

Capitol Federal Financial, Inc., rooted in a history stretching back to 1893 through its subsidiary Capitol Federal Savings Bank, has long served the Midwest with a focus on traditional retail banking, particularly one-to-four-family residential lending. This historical emphasis built a stable, community-oriented franchise with a reputation for low-risk lending practices, reflected in consistently low delinquency and net charge-off rates over many years.

However, the banking landscape is dynamic, and CFFN recognizes the need to evolve. The company is currently undergoing a significant strategic pivot, actively shifting its focus towards commercial banking. This involves expanding its offerings in commercial real estate (CRE), commercial and industrial (C&I), and commercial construction loans, alongside building commercial deposit and treasury management relationships. This transition is not merely an addition but a fundamental reorientation, evidenced by the suspension of its one-to-four-family correspondent lending channels in fiscal year 2024. The goal is clear: to diversify the loan portfolio, capture higher yields available in the commercial sector, and enhance overall profitability.

In this competitive environment, CFFN faces a diverse set of rivals. Larger national players like JPMorgan Chase (JPM) and Wells Fargo (WFC) offer vast scale, extensive branch networks, and significant technological advantages, enabling faster processing and lower costs per transaction. Regional competitors like Capital One (COF) and American Express (AXP), while perhaps more focused on specific niches like credit cards, also compete for consumer deposits and loans and possess strong digital capabilities. Fintechs like SoFi (SOFI) represent a growing threat with their purely digital, lower-cost models. CFFN's competitive moat is primarily built on its deep regional presence, a network of 54 branches fostering strong community ties, and a reputation for personalized service. This local expertise and customer intimacy can translate into higher customer retention rates compared to larger, more impersonal institutions. Furthermore, CFFN's historical focus on lower-risk lending has contributed to a more stable operational profile, potentially offering a cost advantage in specific niche lending areas. However, CFFN acknowledges its lag in digital innovation compared to its larger and fintech competitors, which could impact efficiency and market share capture if not addressed.

Central to CFFN's strategic evolution and its ability to compete is its investment in technology. While the company doesn't appear to detail a single, unique "core differentiated technology" in the way a manufacturing company might, it highlights crucial technological initiatives supporting the commercial pivot and broader efficiency goals. The Bank recently implemented and began utilizing commercial loan pricing and profitability software. This technology is designed to provide pricing and profitability analysis based on the full customer banking relationship, offering a more sophisticated approach to commercial lending decisions. Management intends to implement additional modules of this software in fiscal year 2025 to gain market insight into competitor pricing, directly aiding loan officers in crafting competitive loan offerings. This investment aims to improve the effectiveness of their commercial lending efforts. Beyond commercial lending, CFFN is also focused on enhancing its digital banking experience for all customers. A new deposit account onboarding platform was implemented in November 2024, and digital banking enhancements for debit cardholders are projected for the fourth quarter of fiscal year 2025. The strategic intent behind these digital initiatives is to create a seamless customer experience, which management believes will be key to attracting and retaining deposits in a digitally-driven market. The "so what" for investors is that these technological investments, while not necessarily a unique moat against larger, more technologically advanced peers, are critical operational improvements designed to support the strategic shift, enhance efficiency, and maintain competitiveness in key areas like commercial lending and deposit gathering. Their success will be vital in realizing the potential profitability benefits of the commercial focus and defending against rivals' digital advantages.

Performance Reflecting a Portfolio in Transition

The strategic shift is beginning to manifest in CFFN's financial results. For the six months ended March 31, 2025, the company reported net income of $30.8 million, or $0.24 per share. This represents a significant increase compared to net income of $16.3 million, or $0.12 per share, in the prior year six-month period. This improvement is largely attributable to higher net interest income. The net interest margin expanded by 13 basis points, reaching 1.89% for the current six-month period, up from 1.76% in the prior year. This expansion was primarily fueled by higher yields earned on the loan portfolio, a direct result of the ongoing shift towards higher-yielding commercial loans, which outpaced the increase in deposit costs. It's worth noting that the prior year period's results were significantly impacted by a $13.3 million pre-tax net loss from the securities strategy initiated in October 2023. Excluding this non-recurring item, the prior year EPS would have been $0.20, still indicating a solid improvement in core earnings in the current period.

Looking at the more recent quarter ended March 31, 2025, net income held steady at $15.4 million, or $0.12 per share, compared to the preceding quarter ended December 31, 2024. The net interest margin continued its upward trend, increasing by six basis points to 1.92%, primarily due to a decrease in the cost of deposits, particularly retail certificates of deposit. While net interest income after the provision for credit losses improved quarter-over-quarter, this gain was nearly offset by an increase in non-interest expense.

Analyzing the components of interest income, interest on loans receivable saw a slight decrease quarter-over-quarter, reflecting a lower average balance as the commercial loan growth did not fully compensate for the decrease in the one-to-four-family portfolio during that specific period. However, the year-over-year comparison for the six-month period shows a $10.2 million increase in loan interest income, underscoring the positive impact of the portfolio remix. Interest income from MBS increased significantly year-over-year ($8.6 million), driven by a higher average balance and yield resulting from the reinvestment of proceeds from the securities strategy. Interest income from cash and cash equivalents increased quarter-over-quarter due to higher balances held for liquidity needs but decreased year-over-year due to lower average balances in the earlier part of the current fiscal year.

On the expense side, interest expense on deposits increased year-over-year ($7.3 million) due to higher weighted average rates paid, particularly on retail certificates of deposit and the high yield savings product. Quarter-over-quarter, deposit interest expense decreased, mainly due to lower rates on retail CDs and money market accounts. Interest expense on borrowings decreased year-over-year ($1.7 million) due to a lower average balance, partially offset by higher rates on renewed borrowings.

Non-interest income saw a substantial increase in the current six-month period compared to the prior year, primarily because the prior period included the $13.3 million net loss from securities transactions. Excluding this, non-interest income saw modest increases in deposit service fees and insurance commissions. Quarter-over-quarter, non-interest income increased due to higher insurance commissions (including annual contingent commissions) and other income (including BOLI death benefits).

Non-interest expense increased year-over-year ($3.3 million in salaries and employee benefits) due to raises, increased headcount, and higher incentive compensation accruals. Information technology expense decreased year-over-year due to lower third-party services and depreciation. Federal insurance premiums decreased significantly year-over-year due to a lower FDIC assessment rate. Advertising and promotional expenses also decreased year-over-year. Quarter-over-quarter, non-interest expense saw increases across several categories, including salaries, IT, regulatory services, and deposit/loan transaction costs, contributing to the slight dip in quarterly profitability despite NIM expansion.

The efficiency ratio, a key measure of operational cost relative to revenue, improved significantly to 59.23% for the current six-month period, down from 74.29% in the prior year (or 63.28% excluding the securities loss). This improvement reflects the higher net interest income generated. The operating expense ratio remained stable year-over-year at 1.18%. Quarter-over-quarter, the efficiency ratio slightly increased to 60.54%, and the operating expense ratio rose to 1.23%, reflecting the higher non-interest expenses in the most recent quarter.

Financial Strength and Managing Risk

CFFN's balance sheet reflects the ongoing strategic adjustments. Total assets increased by $190.6 million from September 30, 2024, driven by increases in cash and cash equivalents and securities, partially offset by a decrease in the overall loan portfolio balance. The one-to-four-family loan portfolio decreased by $186.9 million in the six months ended March 31, 2025, while commercial loans grew by $159.3 million, primarily in CRE. This portfolio remix is central to the strategy.

Deposit growth has been a notable positive, with total deposits increasing by $242.6 million since September 30, 2024. This growth was primarily fueled by the success of the high yield savings account offering and retail checking accounts, offsetting decreases in retail certificates of deposit. Management is actively focused on leveraging these products to retain and grow the deposit base, which is crucial for funding future loan growth and managing interest expense.

Total borrowings decreased by $36.6 million, mainly due to principal payments on amortizing FHLB advances. The Bank maintains significant liquidity, estimated at $2.96 billion at March 31, 2025, through its FHLB collateral agreement and unencumbered securities. This provides flexibility to meet funding needs and manage interest rate risk.

Asset quality remains a key strength for CFFN, with historically low levels of loan delinquency and charge-offs. At March 31, 2025, loans 30-89 days delinquent were 0.18% of total loans, and loans 90+ days delinquent or in foreclosure were 0.12%. Net charge-offs were minimal at $107 thousand for the six months ended March 31, 2025. The Allowance for Credit Losses (ACL) stood at $24.0 million at March 31, 2025, with a reserve for off-balance sheet exposures totaling $5.6 million. The ACL methodology incorporates economic forecasts and qualitative factors for risks not fully captured by the model, such as large dollar commercial loan concentrations and potential market value risk in newer one-to-four-family loans. While the overall asset quality metrics are strong, management specifically highlighted a $39 million participation loan related to a Texas hotel classified as substandard due to slower-than-projected stabilization and a debt service coverage covenant violation. This underscores the inherent risks in commercial lending, although the loan had a low LTV of 47% and was not delinquent at quarter-end. CFFN's commercial real estate ACL ratios are noted as being higher than peer averages, suggesting a potentially more conservative reserving approach.

Stockholders' equity increased slightly by $4.8 million from September 30, 2024, totaling $1.04 billion. The Bank's capital ratios comfortably exceed the well-capitalized requirements, with a CBLR of 9.50% at March 31, 2025. The company paid regular quarterly cash dividends totaling $0.17 per share in the six months ended March 31, 2025, and announced a $0.09 dividend payable in May 2025. A key consideration for investors is the limitation on capital distributions from the Bank to the holding company due to the pre-1988 bad debt recapture tax. Management intends to avoid distributions from the Bank in fiscal year 2025 to allow the Bank's taxable income to replenish accumulated earnings and profits, potentially enabling distributions without the recapture tax in fiscal year 2026. This tax consideration also impacts the timing of potential share repurchases under the existing $75 million authorization, which are not expected until the holding company's cash balance is rebuilt, likely not before fiscal year 2026.

Market risk, particularly interest rate risk, remains a significant factor. CFFN's balance sheet shows a cumulative one-year gap where interest-earning assets projected to reprice exceed interest-bearing liabilities by $1.11 billion, or 11.40% of total assets, at March 31, 2025. This suggests a slight asset sensitivity in the near term. Management models the impact of hypothetical rate changes on net interest income and market value of portfolio equity (MVPE), noting that the Bank exceeded internal policy thresholds for interest rate sensitivity at March 31, 2025. While NII is projected to increase in decreasing rate scenarios and decrease in increasing rate scenarios over a 12-month horizon, the MVPE analysis shows a decrease in value as rates rise, reflecting the longer duration of assets compared to liabilities.

CFFN is also involved in a putative class action lawsuit regarding overdraft fees, which is currently on appeal to the Kansas Supreme Court. While management believes the outcome is unlikely to have a material adverse effect, it represents an ongoing legal risk.

Outlook and Key Considerations

Management anticipates that the Bank's net interest margin will continue to improve for the remainder of fiscal year 2025, assuming deposit costs continue to decrease and loan portfolio yields increase. The one-to-four-family originated loan portfolio is expected to continue its decline due to housing affordability challenges and limited supply. Commercial loan growth is expected to be driven by new and existing relationships, with a significant portion of existing commitments ($136.5 million) related to hotel loans expected to fund in the upcoming quarter. While the Bank will continue lending to existing hotel relationships, it is not seeking new ones to manage concentration risk.

The intention for fiscal year 2025 is to pay regular quarterly cash dividends totaling $0.34 per share. Additional dividends may be considered if earnings exceed this level. The ability to resume capital distributions from the Bank to the holding company, and consequently, potential share repurchases, is tied to the Bank's tax earnings and profits and is currently projected to potentially occur in fiscal year 2026.

For investors, the core investment thesis hinges on CFFN's ability to successfully execute its strategic pivot to commercial banking, leveraging its regional strengths and technological investments to drive sustainable earnings growth and margin expansion. The improving net interest margin and core profitability trends are positive indicators. However, investors must weigh this against the competitive pressures from larger, more technologically advanced institutions and fintechs, the inherent risks in commercial lending (as highlighted by the specific substandard hotel loan), and the limitations on capital return to shareholders in the near term due to tax considerations. The outcome of the ongoing litigation also warrants monitoring.

Conclusion

Capitol Federal Financial is navigating a pivotal transition, leveraging its deep regional roots and investing in technology to shift its business model towards higher-yielding commercial banking. Recent financial results demonstrate tangible progress, with expanding net interest margins and improving core profitability driven by the changing loan portfolio mix and deposit cost management. While the company benefits from strong asset quality and robust capital levels, it faces competitive challenges from larger, more agile peers and must successfully execute its digital strategy to maintain relevance. The near-term outlook points to continued margin improvement, but the pace of commercial loan growth and the effective management of associated credit risks will be critical. Furthermore, investors should be mindful of the current constraints on capital distributions and the potential impact of ongoing litigation. CFFN presents a case of a traditional institution adapting to a changing market, with the success of its strategic pivot and technological integration being key determinants of its long-term value creation.