Mutual thrift misdirection

I have some other ideas for specific applications of SJG’sideas to analyzing stocks, which may or may not just boil down to common sense.  Mutual thrift conversions are a category of stocks I can look back on in a different light after some reflection.  The quality of the bank is a distraction from capacity to return excess capital.  The quality of the bank is relevant in as much as it gives one confidence to purchase the shares and wait for the excess capital to be returned.  These aren’t growth stories, these aren’t quaint narratives of local firms doing “better banking”, and most of the qualitative appeal simply isn’t there with the crop from the past 2 years. 

The first thing I would look at is the quality of the bank.  It would be difficult to buy a bank on the thesis of excess capital being returned to shareholders without establishing that excess capital will exist in coming quarters.  If it doesn’t exist due to growth, I wouldn’t jump to a negative conclusion, but the growth would have to be qualified on the historical record.  But none of this is where you make money.  This is where you avoid losing money.

I just uploaded this write up of SPBC to scribd, which is more in depth than my post on it several months ago.  As is my hope with every stock I buy, it’s cheap at 65% TBV and slightly underleveraged for a bank at 11% tangible equity/assets.  They’re located in Plano, a solid economy for a bank to be exposed.  Now that the stock is publicly traded, the thinking is there should be incentives to properly manage the company to peer profitability. 

I don’t think this is how you make money though.  It should be returning what is excess capital and post conversion that can almost be the entire market cap.  So say a bank should ideally have a 9% leverage ratio, SPBC has 2% of its assets that can be returned to shareholders and the bank will still operate fine.  That’s about $6m in this case against a market cap of $20m, so a cool 30% gain and the bank still trades at 77% TBV.  If SPBC had a leverage ratio of 16%+ and traded at 65% of TBV, it would be a lot more interesting from this perspective.

The problem is that the world is not perfect.  I shouldn’t expect a $6m check in the mail any time soon.  This is a slim amount of excess capital.  This isn’t a very sound thesis.  SPBC may initiate a dividend and distribute some of the excess capital as they are allowed, but not to the degree that really provides a nice return in a short time frame. 

Abstractly, there are certain thrifts I stayed away from that never met the qualitative requirements, like Naugatuck Valley Financial, which I spoke about a while back.  In hindsight, they also stated a desire to expand, a de facto statement that I wasn't going to see any of that excess capital.  It’s only been several months, so it’s not like I can this based on an outcome, but the ones I bought were bought cheap and of decent quality.  It’s pretty hard to lose money with balance sheet by and large clean at a large discount to TBV.  They've held up well against the recent market swoons.

So like the dome and the spandrel, a quality bank is what holds up the possibility of gobs of excess capital being returned.  Will this always be the case?  No, but it’s more likely than not the proper aspect to be focusing on if you want to make money.  There’s nothing wrong with owning a quality bank at a cheap price, but there is no excess capital being returned which really creates the reward in the aftermath of thrift conversions. 

A banking franchise within a franchiser

Share Plus Bancorp (SPBC) is a well-positioned bank that is trading at a large discount to tangible book value. It has tons of capital, good loan growth prospects, a manageable number of problem loans, and a strong deposit base.  It's former sponsor companies are a mix of Pepsi-related companies including YUM! Brands subsidiaries such as KFC, Taco Bell, and Pizza Hut, which has created a strong customer base.

The bank converted to a public thrift because it needed capital in late 2010. After taking its lumps in 2008-2010, the bank had a tangible common equity ratio of 7.4% pre-conversion. As a mutual thrift, it wasn’t positioned to earn back its capital cushion since mutuals are run with a focus on offering cheap banking services to its depositors. As a public company with an incentivized management team (direct ownership and options), the company is well positioned to exploit its unique customer franchise to generate profits, while the conversion has provided the bank with a strong capital cushion.

SPBC trades at 65% of TBV, while a healthy bank with a nice deposit mix should trade for at least 100% of TBV, with the additional upside of a premium to TBV in the case of a buyout. If management proves especially adept at lowering their efficiency ratio and writing conservative loans, earnings power should receive a boost that will attract a premium to TBV by the market. Even if the bank doesn’t really grow earnings from its current level, it has excess capital from the conversion that it could return $1m/year to shareholders through dividends and buybacks, a 5% yield at current prices.

The bank is going to have a depressed return on equity over the next several quarters as it just increased its capital by 50% in the conversion. In the quarters up to the conversion, the bank was earning a ROE above 5%, but it has since dropped to 3%. If the bank can revert back to earning a 5% ROE, it would represent a 7.5% return at current prices. While this is not a mouthwatering return, the price has a number of catalysts to benefit from. A dividend would draw attention. Continued growth in TBV would exert upwards pressure on the share price even if still trades at 65% of TBV. Banks are pretty much hated right now and any shift from shunned to merely tolerated would boost the psychology behind banks.  Danvers Bancorp, which converted in Jan. 2008 received a bid in January 2011 for the company, which is evidence that these conversions are watched by acquisitive banks looking for access to low cost deposits in areas with loan growth.  SPBC is positioned in a similar fashion, so there is potential for them to be acquired if they do not achieve reasonable returns.

SPBC started out in 1958 as the credit union for Frito employees. Over the years due to Frito-Lay merging then being bought out by Pepsi, who also owned YUM! Brands at one point, SPBC now has branches in the corporate offices of Frito-Lay, YUM!, Taco Bell, KFC, and Pizza Hut. On top of these 6 locations, it has 2 branches, one in the Oak Lawn neighborhood of Dallas and Plano. This footprint has lead to a good deposit mix that has franchise value. Only 38% of the bank’s funding is in CDs of FHLB advances. The rest is in sticky traditional deposits. Interestingly, the bank only owns 1 of its 8 locations, but has a leasing expense of $1.1m in 2010. The corporations that it has locations in likely view it as a benefit to offer their employees and not as a source of rental income. There are switching costs to kicking SPBC out though as all the employees would be inconvenienced with changing their bank.

The bank has been proactive in restructuring debt and so the reported NPL ratios are higher than reality. For instance, on a $200m loan book, they had restructured 3 commercial real estate loans totaling $5.1m in the most recent quarter. The loans had extended maturities and lower interest rates in exchange for the borrowers paying back 5% of the principal. In the accounting, this is considered a troubled debt restructuring. All the loans are current. This caused the reported NPL to be over 4%, which reflects poorly on the bank when subjected to a cursory look.

Another curious feature is that the bank has branches in Louisville, KY (2), Irvine, CA (1), and then 5 in the Dallas-Fort Worth metro area. Louisville and Irvine are much less attractive demographically and economically, but the bank only lends to employees of the corporations in which it has locations (Taco Bell and KFC). The area in Texas where the bulk of its lending is focused has a much healthier economy and its freestanding branches are located in affluent areas. Overlaying macroeconomic data on the Louisville or Irvine regions on the banks creditworthiness is a possible reason why the bank remains undervalued.

SPBC looks like a market neutral stock that has a basic undervaluation due to its size and the traditional technical reasons that make mutual thrift conversions cheap.  While the returns aren't thrilling, there is downside protection in the valuation as well as the pretty efficient market for acquiring banks.  The bank is not close to distressed territory to warrant the current valuation, which has catalysts to move higher in the form of the ending on restrictions on buybacks and being acquired in 1 year and 3 years respectively post conversion.