Peapack-Gladstone Financial

Peapack-Gladstone Financial Corporation (NASDAQ: PGC)

Current Price: $11.00
Shares Outstanding: 8,825,882
Market Capitalization: $97,084,702
TTM Common Net Income: $6,651,000
Tangible Common Book Value: $101,311,000

Overview
Peapack-Gladstone Financial Corporation is the parent company of Peapack-Gladstone Bank, a community bank in New Jersey with $1.5bn in assets. The bank has 23 branches, all from organic growth with the exception of 2 branches acquired in 2000 and 4 Trust & Estate offices. The bank sits atop the three pillars of a strong community banking franchise: growth, profitability, and quality. With the exception of trust-preferred securities held for investment, which blew up in 2008, the bank has performed well and is close to repaying TARP funds. The bank has a demonstrated long term ability to prudently grow in a profitable manner without diluting the quality of its loans or deposits. The current bear market in banks has created an opportunity to acquire this fundamentally strong banking franchise at a cheap price.

There is downside protection due to the low valuation (1x book, 4.5x PPPT income) relative to the normalized earnings power of the business (>1% ROA, historically 1.3%). As the bank finishes repaying TARP funds in the next 18 months, market interest should renew as the bank has less negative overhang. The bank has continued to prudently grow its business through the recession, which includes a trust division that generates fee income that will remain unaffected by increasing regulation. Even with a continued weak economy, the stock price doesn’t reflect the value of the business.

Valuation
There are two approaches to value PGC. The first is to look at the returns of the business and attach a multiple to its normalized earnings power. The second is a sum of the parts analysis that treats the earnings streams of the core banking business and trust division as two distinct businesses.

#1 The bank historically earned a 1.3% ROA over 1997-2007. As loan loss provisions decrease and increased regulation takes hold, the bank can earn a 1% ROA as a base case. With assets of $1.5bn, the normalized earnings power of the bank is $15m or $1.69/share. Currently at 6.8x normalized base earnings, an average market multiple of 14x earnings would present a double.

Once the bank pays off its remaining TARP preferred stock, it can begin to build up its capital to continue growing its loan book and increasing earnings. An improvement in the economy to where the bank can earn a 1.3% ROA with its current balance sheet would imply normalized earnings of $19.5m or $2.21/share. At 5.2x normalized bull earnings, an average market multiple of 14x earnings would present a triple.

The bank is earning a run rate $21m in pre-provision pre-tax income annually against run rate provisions of $8m annually. If charge offs were to remain about 1% of loans, provisions would have to remain at $9.3m, which still leaves the bank in a position to continue rebuilding capital and repaying TARP funds. Looking at the business on a normalized earnings basis is an appropriate approach to valuing the business because its current earnings power remains ample to get it through a soft economy.

The other side of the earnings valuation would be a multiple of book value, which would reflect the earnings power of the franchise the bank has in excess of tangible assets. As will be discussed in the following section, the bank has a high quality deposit base that is growing. It has been able to profitably exploit it in the past, and should it continue to do so in the future, above average returns on assets should be attainable and an above average multiple of book value would be assigned. The bank currently trades at just under 1x tangible common book value, so no premium on the deposit franchise exists. This implies a low valuation for an investor as well as an acquisitive bank.

#2 The bank has a traditional bank business as well as a trust division that generates fee income in addition to the more traditional fee income generated by loan origination or overdraft fees. The trust division has a symbiotic relation with the core bank by making deposits at the bank stickier while driving customers to the trust division and helping that business generate earnings. The businesses could not exist separately, but they do possess distinct earnings streams. The trust division is more predictable than the core banking business. A sum of the parts valuation can show the market disconnect about the true value of the bank.

Core Division: Currently the bank is doing poorly with the economy and only started provisioning heavily in late 2009 as they were well provisioned going into the downturn. The company’s assets and equity are all in the bank, which is currently earning subpar returns. If these subpar returns of 0.5% return on assets continue, a discount to the book value is necessary. If the bank trades at .75x book, it is worth $76m. If the bank can return to earning 0.75-1% ROA, it would deserve a valuation of at least 1x common book value or $101m. This will receive a boost from repayment of TARP funds as well.

Trust Division: The trust division fluctuates in terms of market value of assets, but the fee income has been fairly consistent. Earnings fall in the $3-4m range. The company opened up an additional trust office in Bethlehem, PA to expand into the Lehigh Valley region in 2009. This division should continue to grow and requires only $1.5m in assets to run overall. This earnings stream is very valuable as a result and is worth around 15x earnings or $45m.

Even if the core division continues to underperform, the business is worth $121m, although the underperformance is clearly transient and tied to higher loan loss provisions. The bank is adequately reserved for loan losses, which should allow them to report higher returns in the core business. The most recent quarter indicated a subsiding in credit issues and a partial repayment of TARP. If the core division continues its improvement, the entire bank’s common equity is worth $146m on a sum of the parts basis. This does not include potential growth in the trust business.

Quality
The balance sheet is clean since the bank took a huge write down on its trust preferred security portfolio of $56m in 2008. The bank took $28m in TARP funds as the loss was $36m after tax and the bank earned $11m that year helping to cushion the blow. The bank’s earnings have declined in recent years as the loan book has shrunk and provisioning for non-performing loans has increased.

While the bank’s common equity ratio is 6.7%, the equity ratio is 7.6% due to the preferred stock. The bank has been repaying TARP funds with earnings. It is on track to finish repaying TARP in 18 months if provisions remain at this level, although lower provisioning in recent quarters opens up the possibility that TARP is repaid before then, as does additional income from loan growth.

The loan book is primarily composed of residential (45%) and commercial (32%) mortgages and commercial loans (13%). The bank is focused on its local geography and there is a senior officer at every branch. This has appeared to lead to solid and conservative underwriting. The bank’s commercial relationships are with small businesses and professionals so no single loan dominates the portfolio. Over the past 4 years, nonperforming loans and REO peaked at 2.22% of assets in June 2010. The bank’s current nonperforming loans, OREO, and troubled debt restructurings total 1.85% of assets as of June 30, 2011. The ratio of allowances to nonperforming loans is at 91.54%, so the bank is more or less caught up with provisioning and has the pre provision earnings to continue adding.

The loan book has shrunk from a peak of $1.05bn in 2008 to $965m as of June 30, 2011. The loan book has become more conservative than just a $100m decrease suggests. Construction loans have decreased from $66m as of December 31, 2008 to $15m as of June 30, 2011 with $8m getting charged off along the way. The bank has let their residential mortgage loans get paid off instead of refinancing or seeking new borrowers in order to reduce interest rate risk. The bank has historically sold 30-year mortgages to minimize risk, but keeps shorter duration mortgages on its balance sheet.

The loan book shrinking is appropriate since the leverage ratio also won’t support a large expansion in the loan book at this time. The bank has been able to accomplish this while maintaining its earnings power by letting time deposits roll off and be replaced with stickier and lower cost deposits. Time deposits are only 15% of deposits and the bank only makes minimal use of FHLB advances for funding, which are under 2% of funding. The ratio of loans to deposits excluding time deposits is 84%, so the bank has ample access to funding once the capital position improves. The bank has continued year over year increases in deposits going back over 15 years. The bank has a very attractive deposit franchise, with 17% and 22% being non-interest bearing and checking respectively, with both seeing consistent growth over the past decade.

The combination of the quality of the deposit franchise and the success of the trust division are solid indicators that the bank actual achieves that mythical quality customer service that many banks try to ascribe to themselves. The management letter included in the 10-K does mention that quality customer service is an aim of theirs, but more importantly the financials back up the assertion. Additionally, in their 10-K is a list of officers at every bank branch, indicating that an empowered individual is present at all bank locations to be responsive and nimble to customer needs.

To look at credit quality indicators, the bank breaks down its loans into pass, special mention, substandard, and doubtful. The bank doesn’t disclose underwriting criteria, but the resilience of the loan book over the past years indicates that they don’t just talk the talk about conservative underwriting. Out of a $965m loan book, $883m pass, $30m special mention, and $51m substandard. If the economy worsens and all the special mention and substandard loans default with 85% recoveries, the bank would lose $12.1m, which is fully covered by pre-provision pretax earnings in conjunction with the current run rate of provisioning. The leverage ratio would drop to 6.7% and common equity leverage would be 5.8%, but the bank would still be standing and a share offering would be dilutive but not wipe out current equity holders. This doesn’t acknowledge the dynamic nature of banking which gives the bank the ability to earn back its capital. The historical results don’t indicate poor underwriting that would result in such extreme losses, but it is worth examining the potential losses in such a scenario.

Profitability
The bank has remained profitable throughout the recession with the exception of the loss on the trust-preferred securities. From 2005 to 2007 as the yield curve flattened and inverted, the bank’s profits decreased. In this period the ROA dropped from 1.30% in 2004 to 0.90% in 2007, with a low of 0.79% in 2006. In the years prior to 1997, the ROA never dropped below 1.30%, and averaged 1.30% over the next decade (1997-2007). While normalized earnings might be closer to 1.30%, the uncertainty of the interest rate and regulatory environment make 1.00% appear a more conservative case to base earnings on. Even in a poor economy with credit losses, the bank has earned a 0.50% ROA, which allows it to repay TARP funds

The efficiency ratio currently stands at 66.8%, although was in the 55% range for many years +/- 200 basis points prior to 2005. The same management has been in charge since 1997 with little drift from a disciplined approach. The “decrease” in efficiency is coming from lower revenues rather than expenses getting out of control.

The bank has opened 4 branches since 2007 when noninterest expenses started to creep up as measured by a percentage of assets. The bank had consistently expanded over the past decade, but banking was a much easier business prior to 2007. The bank moved headquarters and upgraded the system used in the trust division during 2010. The bank expanded its trust division, which has 4 total offices, into Bethlehem, Pennsylvania in 2009.

All of these expenses have yet to produce the necessary revenue and asset growth to bring the efficiency ratio in line. The bank has closed branches it has opened in its expansion plans in the past, consolidating them into a close branch or turning two into one. If newer expansion initiatives don’t generate enough earnings, the bank’s past actions indicate they know when to stop wasting money.

Growth
The company has been a steady grower. The bank started 2000 with 13 branches, $423m in assets, $380m in deposits and the value of assets under administration in the trust division was $651m. As of June 30, 2011, the bank has 23 branches, $1,510m in assets, $1,361 in deposits, and the value of assets under administration in the trust division is $2,010m. There is operating leveraging in the branch network as the bank has expanded into commercial lending over the past 7 years with its larger balance sheet. The bank’s more recent branch openings in Morristown and Summit give the bank access to broader commercial lending opportunities. Assets and deposits grew at a rate of 12% annualized from December, 31, 1999 through June 30, 2011. The value of assets under administration in the trust division grew at a rate of 11% annually. Even without continued long-term growth, the bank is undervalued. If the bank can continue this growth rate, there is additional upside.

Management
The role of management at a bank is crucial because there is a lot of leeway that can lead to impropriety. In the early 90s, management decided to start prudently expanding the business while still offering quality customer service. The CEO until 1997, Leonard Hill, was a commendable steward of the bank who grew it from a much smaller footprint starting in the late 1980’s. The bank has a deep management team that Hill consciously cultivated.. There has never been high turnover in the senior management. Compensation is fair and there is a meaningful level of inside ownership relative to compensation.

When Hill retired, he had three senior officers ready to take on varying roles. Frank Kissel, now 60, became CEO and chairman. He owns 82,568 shares outright, worth just under $1m compared to a salary $687,000 in 2010. His financial stake is higher when including shares in the profit sharing plan and restricted stock.

Robert Rogers, now 52, became President and COO. Craig Spengeman, now 55, became President and CIO. They were appointed to these positions when Kissel became CEO. Their ownership stakes are not as large relative to annual compensation as Kissel, but they do own shares valued around one times their annual salary in addition to options. Senior management was granted a new slug of options in 2010 after their 2007 option plan. Their older options have strike prices at pre-TARP prices of $28/share or higher. The scale is not egregious and bank executives should not have incentives for them attempting to double the share price on a short timeline.

The Chief Loan Officer, Vincent Spero, joined in 2009 from Lakeland Bank, a well performing New Jersey community bank. He was the leader of the commercial loan team, an area that PGC has been slowly expanding into over the past decade. He owns shares, including restricted stock, about equal to his compensation excluding the 2010 options issuance. Even though he has only been there for 2 years, he already owns at least $100,000 worth of stock outright.

Frank Kissel became CEO in 1997, but had been a director since 1989. A brother of his, John Kissel, is on the board. He has been on the board since 1987 though, so there is little indication that there is any form of mutual corruption. The last time a new member joined the board was when the CIO and COO joined in 2002. This isn’t as much of a concern as it would be at other companies because board members do own shares in the company and the company has remained prudently run.

Anthony Consi, a board member since 2000, represents James Weichert. Weichert owns a 9.54% stake in the company due to its acquisition of Chatham Savings Bank in 2000. In 2007, Weichert filed a 13-D stating he had sent a letter to management demanding they seek an appropriate buyer and that he would take it upon himself to find a suitable buyer if the company failed to do so. The bank discloses as well that Weichert owns a mortgage originator from who the bank might purchases mortgages. It has not done so since 2005, when they purchased $191.8m in mortgage loans. There has been no indication that those mortgages have been of lower quality than the rest of the loan portfolio. The residential mortgage portfolio has performed well and was never polluted with alt-A or subprime loans.

Consi and Weichert provide some upside optionality if they decide to push for a sale again, as well as downside protection in a watchful, incentivized eye on management. Consi sits on the compensation committee, although there are no hard facts to support that management would go crazy if not for his presence.

Geography
The bank is in an affluent and economically resilient geography. The bank is located in New Jersey in towns that mostly fall between Route 78 and Route 80. Hunterdon, Morris, and Somerset counties where the bank has 4, 6, and 10 branches (out of 23 total), are the 4th, 8th, and 9th richest counties in the US based on median household income.

There are numerous corporate campuses and headquarters in this area. The bank does not serve these large corporations, but the small businesses and residents that in one way or another benefit from their presence. In this specific region include Bell Labs (Alcatel-Lucent), Chubb, Merck, Honeywell, and Quest Diagnostics. Some companies that are headquartered right outside the immediate geography, but with employees that live near bank branches include Johnson & Johnson, ADP, Bed Bath & Beyond, Prudential, and Avis. AT&T, Pfizer, Exxon, Novartis, and BASF have major offices in the area as well. The area is also a convenient commute for people working in New York City. The area is economically diverse, robust, and services oriented in defensive industries.

Conclusion
Peapack-Gladstone Bank has been a consistently well-run community bank in New Jersey that was not flawless over the past few years. The core value of the business remains and the bank has steadily worked its way through rebuilding its capital and managing its loans. As the bank finishes repaying TARP funds, the market should recognize the underlying strength. The business is undervalued even if the economy continues to muddle along, while it has the earnings power to absorb further loan losses.

Long PGC