I already own a pair of thrift conversions in my Special Situations portfolio, and I'm back to add another one in the form of Waterstone Financial (NASDAQ:WSBF). The bank is about to complete its second-step conversion to become a fully public institution, and it should initially trade for about 81% of tangible book value, according to the prospectus. That combined with massive excess capital should allow the stock to outperform.

The business
Waterstone provides banking via WaterStone Bank in the Milwaukee, Washington, and Waukesha counties of Wisconsin. Its primary lending activities consist of originating one- to four-family and over-four-family residential real estate, which it retains in its portfolio. The former category comprises nearly 41% of its loan portfolio, while the latter makes up 45%. So, heavy concentration in these two areas.

The bank also owns Waterstone Mortgage, which originates residential real estate loans that are then sold into the secondary market. The company had the sixth-largest market share in its metro area, with 1.7% of all deposits. The company does not offer and has never offered residential mortgage loans specifically for sub-prime and borrowers.

Credit metrics are miserable but improving. Non-performing assets (as a percent of total assets) flirted with 8% for all of 2010 and 2011, before sliding to 6.7% last year and 5% over the last four quarters. Excess capital has also improved since mid-2012. Equity/assets has grown from 10.2% to 13.1%, while Tier 1 capital has climbed from 13.8% to 20.3%, so the balance sheet has strengthened.

The lousy credit performance led to consent orders from the FDIC and the Office of Thrift Supervision in 2009 and forced the company to maintain specific levels of capital, among other things. The FDIC's consent order was replaced last year with a memorandum of understanding that specifies minimum levels of 8% Tier 1 capital and 12% risk-based capital. The MOU also prohibits dividends without prior approval.

In July, Waterstone surmounted the OTS consent order, with no further issue.

The special situation
In June, the company announced that it intended to fully convert from a partially private company to a fully public institution. It will sell the 73.5% of its shares that are held by its mutual holding company. At the maximum, the sale is expected to auction off 25.3 million shares at $10 a share, raising an estimated net $243 million for Waterstone.

Following the transaction at the high end, tangible book value should come to somewhere around $13.47 per share on a share count of 34.4 million. That translates into a price/tangible book value around 81%. Because of the mechanics of the demutualization, most public finance sites misreport the current price to tangible book value as around 1.6 times.

As part of the demutualization, the company announced it will begin a $0.20 annual dividend, paid quarterly. That should attract some investors to the stock. In addition, the company can begin buying stock after one year. That's a typical value-creating move for recently demutualized companies. If Waterstone remains priced below book value, I expect to see the company buy back shares. It will be a mark against them if they don't.

One of the more significant risks facing Waterstone is its reliance on CDs as a huge part of its financing. At year-end 2012, CDs comprised more than 78% of its deposits. This is worrisome because CD owners are rate shoppers typically, shuffling cash to the bank that pays the highest rates when the CD matures. It's preferable to see the bank with more checking and savings accounts, which are "stickier" and whose owners maintain banking relationships for years.

Of course, another significant risk for the company is the ongoing memorandum of understanding with regulators. So the company needs to keep writing better business. But with all that capital soon to be on its books, staying afloat is no longer an issue.

Acquisitions could be a concern. Waterstone has said it is looking for acquisition candidates. This would be fine, if done well. That would mean investing in a bank trading substantially below tangible book value, perhaps even buying a bank out of bankruptcy. I hear the FDIC has some available for sale.

Foolish bottom line
So my Special Situations portfolio will adding $2,000 in this soon-to-convert thrift. I think we'll see outperformance from the stock over the next couple years.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.