Odds and Ends on Identifying Opportunities in Banks

I'm late to the party, but banks are beginning to look interesting - maybe because I'm just beginning to look.    Smaller banks have been smacked around for a variety of reasons.  Competition is pretty fierce.  Some have gobs of shitty loans on their balance sheets.  The market did throw the babies out with the bath water, but now some of the better regional or small saving and loan banks have been repriced to a realistic level.  I find the mutual thrift conversions to be the most interesting area because there are many still coming to market that have strong balance sheets and conservative underwriting standards.

Mutual thrift conversions are a unique transaction that Klarman and Greenblatt highlight in Margin of Safety and You Can Be A Stock Market Genius, respectively.  Basically a thrift issues shares to the market and purchasers end up owning the proceeds of the offering as well as the bank itself since nobody owned the bank prior to the offering.  It's a case of 2+2=5 since the bank doesn't have any shares outstanding, but the bank can't sell shares for nothing.

The typical example is when you can purchase the bank for 50% of tangible book value.  A bank worth $10 has a share offering for proceeds of $10.  The stock trades for $10, but it represents $10 in proceeds and $10 of bank.  What is interesting with some of the small (<$30m) offerings is that interest is so low that some offerings have been below 50% of tangible book value.  While I missed the boat on those, there are still some upcoming.  The nice thing is that even if they are up 20-30%, they still trade at a substantial discount to tangible book value despite having enviously low levels of bad loans, so they are still worth looking at.  Every thrift needs to apply to the OTS to convert.  The OTS is going to be disbanded shortly, but you can find all the application letters here so that you can follow the upcoming conversions.  All their prospectuses are available through EDGAR.  Even though the banks don't have 10 years of information filed with the SEC, they have had to report transparent financial data to the FDIC.  This allows someone to go back in time and see how their loans have performed and what kind of growth the bank has seen.

What first got me interested was this write up of a mutual thrift conversion last month.  I think the level of NPLs at that bank make it less attractive since downside is greater.  There are others that have better loan performance and are overcapitalized.  Their earnings power is low, but the asset quality is strong and are far more valuable than the current market capitalization.  An issue not specific to Wolverine is the liability side comprised of advanced from the Federal Home Loan Bank (FHLB) and deposits.  Advances from the FHLB are a high cost source of funds.  Many of the smaller thrifts have relied on time deposits to attract funds, which are considered lower quality since these tend to flow to wherever is offering the best interest rate.  There are still plenty of banks with core deposits comprised of sticky accounts like checking and savings though.  There is value in these above tangible book value because an acquirer would pay extra for the deposits it would have to pay a lot to acquire through incentives.  That's why you see the megabanks offerings cold hard cash for you to open an account with them.

I haven't really looked at the megabanks, but I have seen some prominent investors tout BofA as cheap.  Jeffrey Gundlach sounded off BofA as a proxy for an echo in the housing bust.  The video is more worthwhile than the article.  He is one articulate guy who backs his ideas up with solid facts.  He makes a very pertinent point about BofA holding tons of subprime loans that are still souring and have worse and worse recoveries.  This opens up the potential that the entire principal on the loan gets written off.  It will be interesting to follow for its broader ramifications on confidence in the rally, but will prove immaterial to the value of many of the thrift conversions since they never wrote poor quality loans.  At the same time, it may push out the timeframe for when the market reprices the banking sector.

An interesting bank stock

Wayne Savings Bancshares is plain vanilla bank with plenty of capital, a good dividend, and a strong deposit base.  Wayne operates through 11 branches in northeast Ohio.  Unlike most banks still working their way through poor loans and repairing their balance sheets, Wayne is healthy with a modest ratio of non-performing loans and strong earnings.  Wayne is well positioned to return more capital to shareholders through buybacks and dividends, and the presence of an activist investor might help unlock this catalyst. 

Wayne trades at 80% of tangible book value and 68% of book value and 11x earnings.  The main problem with valuing a bank is that the numbers are susceptible to manipulation through provisioning and allowances for losses, which fall largely to the discretion of management.  The greatest danger is waking up one day and realizing that the bank is going to take one huge hit on loans that they knew had been souring in prior reporting periods à la Citigroup.

Wayne has $13.6m in total non-performing, impaired assets, and loans past 30 days, which is a wide proxy of things that can go wrong with the balance sheet.  Against $33.7m in tangible capital, $3m in allowances and assuming 25% recoveries on all bad assets, that leaves $26.5m in tangible capital, which would still be above the regulatory definition of “well capitalized” and is marginally higher than the market capitalization.  The bank is earning about $2.8m in pretax pre provision income annualized right now.

Put into the context of the loan book, these broadly defined “bad assets” amount to 5.7% of the loan book and 3.3% of total assets, although some of them are not delinquent (yet?), being renegotiated, or are already in the process of being liquidated to cover the principal.    Non-performing loans were 1.7% as of Dec 2010, which is within reason and about average for peers. 

Funding – the importance of which 2008 really highlighted – is what makes the bank attractive as a potential takeover candidate.  It has a 50/50 split between sticky or low cost deposits with $62m in demand deposits, $101m in savings and money market deposits, and $155m in time deposits (CDs).  The chairman is in his late 70s and the CEO is 65, which makes me wonder if the bank has a greater likelihood of being sold than your average local bank in a similar position.  The presence of Joseph Stilwell, (not to be confused with Vinegar Joe Stillwell, a feisty US general who romped around the Asia-Pacific theater in WW2) an investor – oftentimes activist- who has filed a 13-D in regards to WAYN, might push this process along.  In Item 4, Stilwell lists many of his past investments in small banks.  If you read the summaries of his older investments, many of them sold themselves fairly quickly after his involvement.  In the case of WAYN, it is not his stated purpose, but it seems possible.  The filing states:

“Our purpose in acquiring shares of Common Stock of the Issuer is to profit from the appreciation in the market price of the shares of Common Stock through asserting shareholder rights.  We do not believe the value of the Issuer’s assets is adequately reflected in the current market price of the Issuer’s Common Stock.
 We hope to work with existing management and the board to maximize shareholder value.  We will encourage management and the board to pay dividends to shareholders and repurchase shares of outstanding common stock with excess capital, and will support them if they do so.  We oppose using excess capital to "bulk up" on securities or to rapidly increase the loan portfolio.  We will support only a gradual increase in the branch network.  If the Issuer pursues any action that dilutes tangible book value per share, we will aggressively seek board representation.”

One might read through the lines and think that asserting shareholder rights to have the market price reflect the value could entail an acquisition.  If that were the case, this would be a situation where you could say “heads I win, tails I don’t lose.”

The bank does seem to trade at a discount to what is likely tangible book value when the smoke disappears and it is earning strong returns to justify trading at tangible book value at the minimum.  The TBV is greater than the market price, although not by much.  The upside is only 33% if the reported tangible book value is used.  One might argue it is worth a premium to TBV since the deposits have franchise value.  The problem is that the real attractive upside would be in a buyout scenario, which is feasible considering the consolidation in the industry.  To the extent of publicly available information, such a scenario is entirely predicated on the actions of one individual not directly involved in the company.  As such I’m standing on the sidelines for this, but this its an interesting stock to follow and see how the balance sheet act in the coming quarters.


Disclosure: none

Full House Resorts Update

I’m glad I did an in depth breakdown of my FLL thesis, because there are some things I did that turned out to be grossly wrong.  Luckily, I knew in the back of my head that I wasn’t going to hit the nail on the head so I tried not to overreach on assumptions.  My numbers for the FireKeeper’s contract were way too low, but I missed the boat on the Grand Victoria acquisition almost entirely in terms of deducting the EBITDA or EBIT figures.  While I think the company is less undervalued now that there is more light on the Grand Victoria acquisition, there appears to be less downside risk. 

The bulk of the thesis was that on a sum of the parts, peer, and absolute valuation the company was undervalued.  To redo a back of the envelope SOTP calculation, Stockman’s is worth $14m (7x EBITDA), Grand Victoria is worth $43m (purchase price), and the GEM contract has a NPV of ~$40m ($10m annual payments through August 2016 with a 10% discount rate - management finally broke that out in the most recent earnings announcement) with $21.5m in net debt for a net value of $75.5m.  I think this represents the prices that would be received if the company liquidated tomorrow in an orderly fashion. 

This isn’t a huge discount to the current market price, but that partially hinges on valuing the Grand Victoria acquisition.  Full House purchased the asset for 5x EBITDA, so it would defy rational thought to expect the market to turn around and apply a 7x EBITDA multiple to it.  Recent developments indicate that Grand Victoria’s results might prove more resilient if not stronger relative to the past.  My initial take was that the GV acquisition price implied that management was pricing in a huge drop in revenue and earnings.  This turned out to be wrong.  Hyatt Gaming, part of the Pritzker business empire, has been trying to sell the property for several years not, not just in light of upcoming competition from Cincinnati.  I also totally messed up deriving the EBITDA and earnings of GV.  Grand Victoria generated about $8m in EBITDA in 2010, not $8m in net income as I assumed.  With that disclosure by management though, it also appears that the $8m EBITDA figure is going to be more attainable in the future.  The closer to the $8m figure Full House is able to achieve post 2013, the higher valuation the market will accord to the property (closer 7x+ EBITDA instead of the paid 5x).  The nice thing is that even if this doesn't happen, the price paid might end up being close to 7x normalized EBITDA.

One thing discussed on the conference call was Indiana passing legislation to reduce the required maritime crews on riverboat casinos.  Previously, despite remaining permanently moored, casino riverboats still had to meet regulations for water vessels.  The Indiana Gaming Commission has to approve the casinos actually reducing such staff.  If the staff reductions are approved, starting July 1, 2011, Grand Victoria’s costs will be reduced approximately $1m according to management.  There are tweaks management is making as well, such as converting more hotel rooms into suites.  The 2010 EBITDA of $8m compared to 2010 wins of $100m(IGC figure, doesn’t include hotel, food, or beverage revenue) implies 8% EBITDA margins, which is low.  Assuming a lower market share of 10% of wins (currently 14%) and the $181m drop in casino revenue projected to be taken from the 3 Indiana riverboat casinos from the casino in Cincinnati, the Grand Victoria would still generate $4m in EBITDA or 10.5x its purchase price. 

The downside risk from that scenario coming to fruition is not only limited by the already demonstrated opportunity to lower operating costs, but what now appears to be wrangling over the terms of the Cincinnati casino.  Currently, construction has stopped on the site as the owners and government officials argue over tax rates.  While it will likely just push out the opening date a few months, it gives management more time to maximize unnormalized earnings until either very late 2012 or early 2013.  Indiana is also going to try to keep the casino owners investing in their properties to continue to attract patrons and tax revenues as a result, as evidenced by the maritime crew changes.  This is just gravy, but it will help the business.  

This could just be narrative fluff, but I have considered an additional benefit of the Grand Victoria acquisition that is being ignored.  After talking to a young guy living within the market of the Grand Victoria who enjoys gambling, I realized that the opening of the Cincinnati casino will likely have a disproportionate effect on the revenues of the 2 larger riverboat casinos it competes with – Hollywood and Belterra.  The person I spoke to laughed when I mentioned the Grand Victoria and said that he would never go there.  He and his friends prefer the Hollywood Casino, which is far bigger and glamorous.  That demographic – the ones preferring the glitz and glamor of the casino as a nighttime/weekend outing option over a simple place nearby to gamble after work or during the day – is going to flee the casino that currently suits their taste for the even more glamorous Cincinnati casino.  I can’t quantify this and only time will tell if this translates into stronger revenue and earnings. 

Another tidbit mentioned on the conference call was the potential for additional management contracts.  The FireKeepers management contract has been producing 64% EBITDA margins, which is incredibly high.  This has attracted the attention of casino managements (including bondholders) trying to turn around their operations.  FireKeepers has given Full House a very good piece of proof to tout if approached over a management contract.  This isn’t anything to bank on, but it does present additional upside since it would require little capital and generate a lot of cash flow.  It is also worth noting that FireKeepers has experienced practically no negative effects in light of the opening of the Gun Lake Casino.

One worrisome development was the approval of a motion to increase the number of authorized shares for the company.  Full House did use a stock offering to partially finance its acquisition of Stockman’s, which didn’t result in the share price falling much.  Management stated that they have the capacity to announce another deal by the end of the year, but it wouldn’t be completed until 2012.  They provided some further light on what they would look for in an acquisition, namely a low multiple and management already in place.  While it bears consideration, this risk is mitigated by the intelligent acquisition of Stockman’s and Grand Victoria.  While acquisitive management can be worrisome, management hasn’t done anything stupid in the 5 years it has had an acquisitive stance.  On the face of it dilution would be a negative due to what I perceive as an undervalued stock, but a stock offering to finance acquiring an undervalued property would net out the effect while providing a more diversified earnings stream that would be more highly valued.  The current environment is filled with distressed or heavily indebted casino owners (Harrahs/Ceasers, whatever they call it) and tons of peers have high leverage ratios.  They also have tons of excess cash from the FireKeepers contract including debt service, so there is also the potential that cash will be a large component of future acquisition and either modest additional debt or modest share issuance will finance the remainder.  The combination of Full House's modest leverage, rock bottom interest rates, and a distressed environment increase the likelihood that any acquisition will be a net benefit.

Additionally, here is an interview with the CEO about the company from 2004.  It’s outdated, but gives some nice background on the company if you are interested. 

It might be tenuous to count the FireKeepers contract as traditional EBITDA (although all the proceeds drop through to net income) but Stockman’s and Grand Victoria are generating about $10m in EBITDA right now and FireKeepers is generating at least $10m in FCF.  The stock trades at an EV/EBITDA+FCF of less than 5x compared to the 7-8x range of its peers, many of which have higher leverage ratios.  The core thesis that the uncertainty regarding Grand Victoria is causing the market to ignore the earnings power of the business remains intact, albeit with a slightly lower upside potential.  In addition to upside from business as usual though, newer catalysts that aren’t priced in or crucial have emerged in the potential for additional management contracts or much better Grand Victoria results than expected.  

Disclosure: Long FLL

Exotic ETFs - the innovator, the imitator, the idiot

Warren Buffett has been quoted saying something along the lines of every idea goes through 3 stages; the innovator, the imitator, and the idiot.  The ETF idea went straight from innovator to idiot.  Frankly, ETFs have always been a dumb idea after they created broad based ones that followed broad indices.  The implicit benefit behind the creation of an ETF has always been low cost access to the broad return of the market.  That's simply no longer the case.  A Russell 2000 or S&P 500 tracking ETF is an investing vehicle that intuitively and empirically makes sense.  All of these alternative energy, Brazil this, China that, triple leveraged future gold or oil and all these new derivative ETFs are a fee driven perversion of a simple idea that was beneficial to markets.

This paper by the Financial Stability Board says it all in more diplomatic and eloquent tone as well as warning about all the danger that lies ahead as these products are traded in more volatile markets.  Obviously this will turn into the black swan of 2013 or whatever "oh, shucks" nonsense the media, financial industry, or politicians/"regulators" cook up.  That isn't sarcasm, that's cynicism.

The paper focuses on the increasing innovation in the industry, which I would call blatant idiocy.  The real innovation was creating the plain vanilla funds that broadened access to liquid, tax efficient ways for passive investors to achieve better returns than through handing it to mutual funds.  All the other stuff is just an excuse to take your money.  If you have the capacity to establish X industry is going to do well or is undervalued, why not take the extra step and identify the companies that will really win?  I like what some investors are doing with buying baskets of large cap tech like Microsoft, Cisco, and Dell, but a tech ETF would leave you owning plenty of unsavory names.  If you can't do that work, just stick with the broad based ETFs because you probably couldn't articulate an objective data driven thesis on the industry anyways.  I digress.  The paper is short and filled with fairly easy to digest analysis on where it can all go wrong.

On financial stability risks from exotic ETFs:

Among recent innovations, a specific trend warranting closer scrutiny is the recent acceleration in the growth of synthetic ETFs on  some European and Asian markets. In this type of ETF, the provider (typically a bank’s  asset management arm) sells ETF shares to investors in exchange for cash, which is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return of an index.  Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults.  Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.  

I know I said the analysis was fairly easy to digest and maybe I lied, but I promise most of the paper isn't like that.  The paper continues to note the misaligned interests of banks being in this position.  They note additional fee sources, such as securities lending that are another reason why the creators love these things.  These funds make more money on securities lending than from the management fee on the ETF itself.  The asset management arms of companies use their own parent company trading desks as counterparties for derivatives which is a complete fee-fest.  If this has ignited your interest, I recommend reading the full paper.  It's short and you will be more aware of downside that people will say nobody saw coming whenever this blows up.

There's likely a bunch of money to be made in profiting from this all blowing up.  I don't know enough about the plumbing of the financial system to figure out where it will all go sensationally wrong, but c'mon, how could this not go horribly wrong?  For now, I'm sure the "innovators" are minting money.  The only bet I would make is that in +/-2 years, there will be some Propublica on Magnetar-esque epic documentation of the ETF industry equivalent.  Maybe it will resemble more AIGFP.