Xenith Bankshares Update

The other day, Xenith released a lot of details on the figures related to its recent assumption of VBB and its purchase of Paragon’s Richmond loans and deposits.  My rough guestimates outlined in my write up the other month were accurate and a shade below reality.  While the proforma balance sheet puts Xenith very close to break even, it will be interesting to see what progress has been made organically over the past quarter as well.

The details on the Paragon acquisition are positive.  Xenith is getting $23m in non-interest bearing deposits from Paragon, which is great.  Only $4m/78m in deposits are time deposits.  Almost all the loans associated with Paragon are C&I or CRE lending.  There are no credit metrics on the loan portfolio, but the lack of construction or development loans is one signal that the loan portfolio is solid, as is Xenith only acquiring performing loans.  The combination of C&I lending and non-interest deposits indicates that Xenith actually purchased a decent commercial lending franchise that has profitable relationships.

Not only is Xenith acquiring an already profitable division, it can be incorporated into an existing infrastructure.  Xenith’s cost calculated as the difference between the loan adjustment and core deposit intangible is $647k.  The assets and liabilities earned that much in the first six months of 2011.  This deal arose because Paragon wanted to leave the Richmond and focus on its North Carolina operations.  There was nothing fundamentally wrong with Paragon's Richmond related balance sheet and Xenith got a good deal.  They also took out what appears to have been a successful competitor.

The Virginia Business Bank (VBB) transaction doesn’t extend Xenith’s franchise, but it contributes $5.7m of equity to Xenith.  Xenith got a pretty steep discount on VBB’s assets and the opportunity to take out a competitor for good.  VBB’s deposits are almost exclusively jumbo time deposits.  These will likely prove very transient, but the pro forma loan to deposit ratio is 83%.  Xenith has some flexibility to secure additional deposits to cover the gap between VBB’s assets and liabilities if it emerges.

VBB’s loan portfolio is mostly C&I and CRE lending.  The acquisition is being done with a built in $9.4m discount to the performing loans.  This is not part of the initial gain recognized for assuming more assets than liabilities in the initial transactions of $5.7m.  I don’t think it’s intellectually honest to think this way, but if you drop this $9.4m fully taxed through the income statement right now, TBV goes from $57m to $63m - it isn't going to happen like that. The discount will likely just accrete through interest income, which will somewhat mask any projected improvement in NIMs from the failed bank.  Xenith is also not profitable currently, so clearly immediately recognizing the gain would be offset by some losses.  I’m less concerned about when the bank becomes profitable only because it’s current losses stem from being a de novo bank and not from lax lending standards coming to roost.  This reserve certainly lowers the hurdle even more. 

Xenith issued preferred shares worth $8.3m to a government program for funding small businesses.  Xenith is paying a 1% dividend, which is really a 1.53% yield since preferred dividends are taken out of aftertax earnings and I consider this a liability akin to a deposit.  It’s a longer-term source of funding than the time deposits and its cheaper than debt.  Initially I thought this issuance stemmed from Xenith encountering more loan demand than it could satisfy out of deposits, although this was sadly Panglossian.  Now I believe that it is related to the need to maintain liquidity that might be hampered by a failure to rollover enough of VBB’s time deposits.  This isn’t a static situation though and Xenith has shown discipline in restraining lending until deposits allow it.  It isn't severe since Xenith also has plenty of cash to match any time deposits that don't get rolled over.  The weighted average interest was 1.03% though, so Xenith won't exactly have to break the bank in offering a rate that will keep the deposit at the bank.

Xenith earned a 4.35% net interest margin in the last quarter on $263m of interest earning assets.  Now they have pro forma interest earning assets of $356m in addition to the $74m in cash now on the balance sheet (clearly excessive amount).  Annualized noninterest expenses are $14m based on the past 6 months and a 4.35% NIM would result in $15.5m in net interest income.  This is contingent on a lot of things, so I wouldn't bank on this number, but clearly the threshold of profitability is very close to being crossed.

Xenith has done a great job at executing so far, but there is clearly a ways to go towards full profitability.  They have wide NIMs, attracted quality deposits since late 2009, and taken advantage of some great opportunities.  They are only halfway there.  Proforma tangible book value and assets are $57m and $461m respectively, which results in a 12.3% leverage ratio.  If Xenith grows over the next 2 years to have a 9% leverage ratio, its assets will be $633m, a 37% increase in assets.  If the bank achieves a 1% ROA, which I believe is achievable, it would earn $6.3m.  I’m less enamored by that than the fact that at 55% of TBV, a lot can go wrong before I lose money. 

Xenith has proven they can grow the balance sheet already and their overall strategy is clearly focused on taking business from lenders currently providing subpar lending relationships to businesses.  My confidence in management’s ability to execute this strategy well in the future stems from their historical record of already having done so and the presence of what I believe is a long term large shareholder.  I haven’t seen anyone else talk about Xenith and management isn’t too chatty, so somewhat fortuitously I don’t believe I have an excessive bias in my assessment. 

As it pertains to Xenith and my write up on State Bank & Trust (STBZ), these FDIC assisted transactions are very interesting.  I need to rewrite my STBZ write up since it’s admittedly not the pinnacle of clarity, but they have since participated in 2 more FDIC assisted transactions, which I will try to post about this week.  STBZ is well positioned regardless of the economy.  If the economy worsens, they have the capital to assume more failed banks.  If it improves, they will be well positioned to grow their balance sheet to a normalized size.

Some resources on FDIC assisted transactions that are useful (an offshoot of my post on scuttlebutt):

1.     3 Grant Thornton white papers on: 1) accounting and tax considerations of acquiring a whole bank 2) accounting for FDIC assisted acquisitions of loans and ASC 310-30 and 3) what you need to know about FDIC-assisted transactions:

http://www.grantthornton.com/portal/site/gtcom/menuitem.91c078ed5c0ef4ca80cd8710033841ca/?vgnextoid=391c35d703776210VgnVCM1000003a8314acRCRD

2.      FBR Capital Markets primer on FDIC assisted transactions:

http://www.slideshare.net/equidebt/primer-on-fdic-assisted-transactions-by-fbr

3.     Powerpoint on opportunities in failed bank acquisitions:

http://www.austinassociates.com/publications/2010AOBA.pdf

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. 

It's peachy at State Bank & Trust, y'all.

Scribbified for my formatting ease.  State Bank & Trust (STBZ) is a messy looking Georgia bank that's cheap and and has nice prospects for which I need not pay at current prices.

State Bank & Trust (STBZ) Write Up

Long STBZ

A low point in Xenith Bankshares' valuation

Xenith Bankshares is an interesting bank that trades at a pretty steep discount to TBV despite a bright future that is getting brighter.  I put my analysis on scribd because I'm not tech savvy enough to format tables in blogger.  You can read it via this link or embedded below: XBKS Write Up

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

Has Trinity Bank found the holy grail of banking?

Trinity Bank is a bank in Fort Worth, Texas and it blows my mind.  It is a real gem of a bank run by a real gem of a CEO.  The bank is actually focused on customer service, maximizing efficiency, and sound lending.  Unlike just about every other bank that claims to do this, Trinity Bank actually does show evidence of this when you look at the results.

I would normally expect a small bank to have a generally higher efficiency ratio than a large bank due to economies of scale, but this is a dumb assumption on my part.  Their efficiency ratio is at 45%, which isn't the lowest in the world, but is still low.  They also aren't operating at full capacity either (revenue should pick up if the economy improves without much additional staffing) so a normalized efficiency ratio might turn out to be lower.  The bank opened in 2003 with capital raised by Jeff Harp, the current CEO.  After a few years of losing money as the bank ramped up, the bank has been steadily profitable and growing to this day.  They haven't lost money on a loan in their history (a handful were nonperforming, but all balances were recovered) and achieved a ROA and ROE of 1.42% and 12.90% respectively in the most recent quarter.  It trades at 1.7x book value, which isn't cheap, but it's not overpriced and the bank's quality indicates it deserves a premium to book.  The numbers are excellent and seemingly for all the right reasons.

The bank is hopelessly illiquid, even by the standards of...anyone.  The stock hasn't traded since June 21st.  Maybe it's a Munger moment where I could just invest and then sit on my ass, but then I'd have nothing to do.  I wonder why anyone would sell their shares at this point.  The reason for celebration though is that the CEO includes a letter to shareholders with each quarter's results written in the same vein as Buffett's.  Everything is pretty straightforward and simple, which is too complex of a concept for many CEO's to execute.  The letters focus mainly on the 3 key traits of an outstanding bank: efficiency, good loans, and working with customers.  There's nothing novel or profound about any of this, but the same could be said for Berkshire letters.  There is minimal non-banking commentary and I would characterize the banking commentary in the same way that Buffett comments on insurance.  It's possibly too simple and doesn't equip you with the tools to go invest in banks (although this is not the point of the letters) but it puts you in the proper mindset.  The CEO offers some macro commentary, but it's intentionally vague with healthy confessions of ignorance.  Some choice quotes for the bank investor (the letters are all worth reading):

“It has been brought to our attention by our outside accounting firm that Trinity Bank cannot justify, based upon loss history (none) and the current level of problem loans, the amount of money we have set aside in our Allowance for Loan Losses. Therefore, you will notice that the bank did not make a provision for loan losses in the first quarter of 2011. And we probably will not be able to add any more to the Loan Loss Reserve this year unless loans start to increase.” (This is by far my favorite from an operational and irony standpoint.)

"The key is not to have zero problem loans. If that is the case, a bank is not taking any risk and is not serving its customers (and ultimately, will not prosper). The key is how much money do you get back when you make a mistake. We will make some mistakes, but we will protect the bank while working to help good people through bad times." (Pithy, but the essence of sound loan underwriting)

“All things considered, Trinity continues to perform well. However, our performance reminds me of the swimmer that won the Olympic gold medal in a very slow time – because everyone else drowned. To really meet our long-term investment objectives, we must increase the returns on your investment to the 15-20% level (Return on Equity). It is difficult to do that in a soft economic environment without taking on a lot of risk. We are trying to be patient and avoid the “vulture” tendency. The vulture tendency is an old joke about two emaciated vultures sitting on a tree limb. One of them says to the others, “Patience hell! I’m going to kill something”. He was tired of waiting around for something to do so he could get a meal. He decided to make something happen.”

“The down side to the increase in loan demand is that it is mostly from people buying assets at reduced prices. Believe me, we think these are good loans and we are finally able to obtain good equity and decent rates. But these loans typically are not putting people back to work. I would much rather be financing business expansion, i.e. new equipment purchases, working capital requirements from growth in sales, new buildings, hiring more people, etc.” (Note this is not altruistic. The bank piggybacks on the growth of its customers, which is blindingly obvious but not the focus of many banks who instead try to pitch credit cards and HELOCs - see previous quote.)

“I wish I knew what to do. Obviously, I don’t or I would be selling advice instead of trying to run a bank.”

Anyone know of any other good bank shareholder letters?  I know they exist, but most are usually just corporate garbage and thin.  Yes yes, I know that MTB and JPM have good letters.

The narrative fallacy of thrift conversions and their deposits

I was going to focus on other aspects like loan quality, but I think looking at the deposit mix of some of the recent thrift conversions is enough to prove my point.  I might be making this up, but I sense that people make the assumption that thrifts by virtue of being local have these great local relationships and strong deposit bases.  This is plainly false to hold as a rule and its easy to prove/disprove by looking at the types of deposits the bank attracts.  Just because Peter Lynch and Seth Klarman have singled out thrift conversions as a fertile hunting ground for investments doesn't mean that all conversions are brimming with investment potential.  It's kind of easy to determine that they are cheap with huge discounts to TBV, but you still need to consider whether or not the business is any good.  Deposits are very important to banks, so it stands that examining them in greater detail is worthwhile in judging the bank's overall attractiveness.

I'd also caution people that because it's difficult (not impossible) for an amateur investor that isn't less than incredibly enterprising to get in on the initial offering, purchase prices are higher so you need to pick out the overcapitalized conversions that have the most potential.  If you do participate in the offering, you really are getting a dollar for 50 cents and the markets generally boost the price a cool 10-15% once they list on the exchange.  If the deposits give the bank some additional franchise value, it can still be had for 50 cents on the dollar without trading at 50% of TBV.

I've seen a narrative floating around that these thrift conversions have been happening due to regulator shopping.  This is dumb.  This reeks of sloppiness.  I'd call it intellectually irresponsible, but I don't want to taint the idea of intellect with this notion.  An awful credit bubble occurred over the past decade, banks have lost money, mutual thrifts weren't in a position to earn their way out of their reduced capital and now they need to go to markets to raise funds.  This isn't rocket science and even if I put forth this reasoning solely out of stubbornness and knee jerk contrarianism, it reduces my risk of making a mistake (although possibly at the expense of return).  

It reflects a political bias because the inverse is that different regulators need to justify their existence and therefore would not act in an egregious manner to justify their constituents abandoning their regulatory structure for another.  This is equally plausible under the same set of assumptions.  The entire discussion of regulators neglects the fact that plenty of mutual banks still exist and don't look like changing.

The investment opportunity lies not in the idea that management is being so kind offering us these amazing banks to avoid regulatory uncertainty, but in the fact that these banks end up raising more capital than they need (it was the only way they could) and now are incentivized to generate greater profits on that capital.  To even entertain this regulator shopping idea is just to distract people from the fact that many of these banks are not worth considering post-offering.  I wouldn't pay something like 70 cents on the dollar for a bank that has enormous interest rate risk from a poor deposit mix and loads of 30 year mortgages unless the bank is very efficient, demonstrates conservative underwriting standards, and has generated a nice ROE preconversion (see Versailles Financial).

A recent thrift conversion demonstrates my point well in that it is totally unexciting and a pass.  Naugatuck Valley Financial Corporation (NVSL) recently completed its second step conversion and trades at the offering price.  Second steps aren't quite as profitable historically from an investment standpoint since the bank raises equity for 75-80 cents on the dollar instead of 50 cents on the dollar.  It still does result in a discount to TBV which is generally unwarranted.  It can be plenty rewarding if the bank is capable of double digit ROE's and now has even more capital to do that with, but this hasn't been the case over the past 2 years.  NVSL trades at about 70% of book value post offering, although their NPLs are a good measure above their allowances so the denominator in that equation might fall in coming quarters (they could also have no problems, but I'm a pessimist).

NVSL does mention regulatory uncertainty in is prospectus as one of the top reasons for converting.  While this may be fairly plausible since they were half public, half mutual, the reality is that they have a depleting capital cushion.  If you adjust their allowances to be 100% of NPLs, instead of the current 35%, this becomes clear.  Instead of lacking a profit motive though like most straight mutual conversions, the bank really just lacks profit.  I attribute this a good part due to deposits, which is what I want to focus on.

It has a poor funding mix.  The bank is dependent on CDs and FHLB advances for 80% of its funding.  What is really absurd about this is how much they pay for them.  The part that really sticks out about this is that they pay very similar interest rates for both: ~2.60%.  CDs account for $238m out of $409m of deposits with FHLB advances totaling $88m out of a total of $497m in total interest bearing liabilities.  They are starved for funding in an environment where there it is cheap and plentiful.

One reason I will put forth is that they only give their customers 0.07% on their checking accounts, which is insultingly low.  They clearly face competition for local deposits, but have adopted a strategy that is not going to lead to a high return business.  They are paying above average rates for unattractive deposits and below average rates for attractive ones, which explains why the deposits are what they are.  They are just desperate and short term oriented.  Since I can't frequent their branches to verify this, I interpret this as a sign of poor customer service and poor banking in general.

I realize it might sound ludicrous to say a bank shouldn't be paying as little as possible for funding.  The reality is so much more complicated than that.  A small bank that seeks to differentiate itself should be paying a nice rate on its core deposits (non-CDs).  While not a perfect proxy, it does indicate a management's focus on the consumer first rather than the bottom line, which will follow.  There will be different scenarios that call for different approaches, but in the case of small thrifts I think my assertion is correct.  From my limited to non existent knowledge of banking, a superior consumer experience is a key part of what really generates strong profits over an entire cycle.  That's how a small bank can differentiate itself from a behemoth bailed out bank and get people to turn to them for loans and repay them to the best of their ability in hard times.

There are plenty of customers who are actively pursuing higher interest rates on their money and are called rate shoppers.  They aren't attractive customers.  That doesn't mean that an ordinary customer can't expect a decent yield on all their deposits.  While people generally remain passive about rate shopping, if you schtup them hard enough, they will leave and never come back.  Then you are left with what it is the banking equivalent of what Keynes called hot money.  These depositors are gone when the next new best thing comes around in the form of a high rate CD.  This is not an absolute truth of banking, but this fairly consistently applies to a vanilla S&L type bank.  A company like Bank of Internet or Beal Bank (neat little bank) has different advantages such as low costs or high yielding assets .  I'd also like to point out that BofI was paying 2.30% on their CDs as of last quarter, which is less than NVSL, although still high (and they specifically target rate shoppers).  Their ROE is about 7x that of NVSL though, so clearly deposits are not the only thing that matter.  

First Connecticut Bancorp (FBNK), which converted a day after NVSL, is a much more interesting bank that fits the mold of thrift conversion worthy of further investigation.  Just looking at the deposit mix, they manage to have about 15% of their deposits with no interest, which is different than offering an interest bearing deposit with an insultingly low rate (the bigger this balance the better - while not potentially better than free money like insurance float, banks don't have tail risk from catastrophes - since it it is free money they get to lend out).  For instance, there is no limit on deposit insurance for these accounts, which is a clear trade off between risk and reward.  While First Connecticut pays a 4x higher interest rate on checking accounts (0.30%), they pay less than half the interest rate that NVSL does on CDs (1.18%).  The same idea holds true for their other deposit products.  They still have a good amount of CDs in their funding mix, but not nearly to the same overwhelming degree or at the same expense as NVSL.

This isn't a paradox, it's just better banking.  It's a pretty quantifiable way of figuring out how a bank treats their customers, although not a surefire trick.  Clearly if the bank has little to none CDs on its balance sheet, the bank is doing something right.  If you have a better idea for how someone in Kenya can assess the customer service of a bank in Idaho though, I'd be interested in hearing it.

While I am interested in turnarounds of companies that are simply adapting their formula within reasonable parameters, I have a hard time considering thrift conversions turnaround candidates.  I would differentiate between an improvement in operations from which many conversions benefit and a turnaround which implies that operations suffered from past mismanagement.  A bank can be a turnaround in the sense that the economy turns around so reasonable loan growth can resume and NPLs go down since most banks are priced for a continually stinky economy.  There are far too many moving parts that are not easily identifiable for a bank to turnaround its fundamental approach to lending or deposit gathering in a way that I could identify and profit from.  I can try the new fries at Wendy's (meh, but I never was a fan of potato sprinkled sodium) and get an idea of how store remodeling and traffic is coming along, but I can't figure out if a bank has lowered its costs or has started to insist on and receive higher down payments on loans.  By the time this comes through in the numbers, the stock price would likely respond faster than I would notice.

For NVSL to be attractive, they would really need to alter their fundamental model.  Joe Stilwell, an activist investor involved in another bank I've mentioned, filed a 13-D on NVSL that seems to pushing for such.  The CEO had stated a desire to use proceeds from the conversion to expand.  While I've just passed on this opportunity to invest into an expanding empire of high cost deposits, Stilwell is capable of rattling the cage for change.  Stilwell is very against potential expansion if you couldn't tell by him stating:

"If the Issuer opens even a single branch while non-performing assets remain above 2% or return-on-equity remains below 8%, or if the Issuer pursues any action that dilutes tangible book value per share, we will aggressively seek board representation."

While this is possible, I would question their basic ability to earn an 8% ROE since their funding costs are going to be persistently high and their underwriting and efficiency don't compensate for this.   There isn't a newfound incentive post-second step.  Management had a share price to be interested in well before that.  Maybe I'm not brimming creativity or I'm overly fixated on the deposit base, but I have a hard time fathoming how a bank goes about fundamentally altering its approach to deposit gathering.  I wouldn't expect it to happen in a year, but even on a longer timeline a bank faces constant competition to make an improvement in deposit gathering difficult.  Deposits are just one factor that can make a bank a great investment or an easy pass.

Thoughts on bank stocks

I'm beginning to get really interested in bank stocks.  I wanted to articulate what I'm thinking about when I look at bank stocks.  The quality of a bank stock is easier to quantify*, although this ease can still cause mispricings since Mr. Market's recency bias cause him to sour on a bank's prospects beyond reason.  It also helps that the pendulum of public opinion is swinging very hard to extreme dislike for all banks.  In reality, a great bank is a really great business to own at the right price.

I recently finished The Most Important Thing by Howard Marks, which easily pushed its way to top of the list of my favorite books so far this year.  One of the overarching themes is that of the cycle.  Assets tend to become out of favor in their down cycles - homebuilders, banks, oil, chemicals - as a result of the pendulum really swinging to the negative extreme.  People tend to extrapolate current events into the future, so they think that the down cycle will continue and the relevant firms will continue to do poorly.  This is what creates a buying opportunity since the revulsion usually causes a bunch of selling which only encourages more selling, etc.  I don't think banks are the buy of the century right now, but I think they are a fertile ground to look for value as they are in a down cycle with poor outlooks.  I've been kicking around some ideas over the past week or two here and here, mainly focusing on mutual thrift conversion that have happened in the past few months.

David Tepper bought bank stocks at the brink, which turned out to be a phenomenal call.  He has since sold them and moved into homebuilders, probably not multibaggers in a matter of months like the banks were in 2009, but definitely an area where people are revolted and maybe not giving the stocks their fair value.  Bruce Berkowitz loaded up on financials about this time last year, although they seem to be around the same price +/- 15% depending on the name.  His reasoning:

We bought at prices reflecting pessimism in the economy. I do not believe that we are going to lose money at the prices we paid. If the economy just sputters along, we’ll do fine. If the economy recovers, we should do reasonably well. Absent a severe double-dip recession, I don’t see how our shareholders can get hurt.

When you buy something this out of favor, even the slightest bit of not bad news can be good news.  He is also focusing on the price, not nitpicking over credit card fee legislation.  This is a sensible outlook.  At least in my head, the cyclical forces that drive the banking business are very clear since it tends to mirror the broader economic cycle of the geography it serves.  Banks possess some identifiable characteristics that make for interesting investments in their own right.

1.  Essential service - Banks provide an essential service that will be difficult to change in the grand scheme.  Any type of financing allows people to purchase goods that would otherwise require huge upfront cash payments that don't match an individuals cash flow.  This is an essential service for people looking to own homes, cars, or for businesses wanting to expand faster without dilution.  Compared to other financing vehicles, banks are the low cost providers since their cost of funding is very low.  Even with financing consisting mostly of certificates of deposit, a bank's interest payments still fall below an equivalent financing vehicle without the same funding options.  This obviously changes in a credit bubble and banks can get sloppy as the lending environment becomes more competitive.

2.  Commodity business - There is no real superiority of a 6% plain vanilla loan from Bank A versus Bank B or even a nonbank financing entity.  For an investor though, behind the loan will be a difference in cost structure (efficiency ratio, net interest margin) as well as managerial competence (loan to value, non-performing loans, capital allocation) that are for the most part easily quantifiable.  Buffett's favorite bank, Wells Fargo, combines a low cost structure with managerial competence.  Its price goes down in bad times, but the bank never loses its enduring competitive advantage or normalized profitability.  This is no different from broad investing principles, but I find it easier to quantify these characteristics in a bank.  Banks are more susceptible to the depressive episodes of Mr. Market since a bad economy depresses loan growth and causes loans to sour.  The recency bias causes Mr. Market to really extrapolate out the bad times, but a calm investor can identify the cyclicality and wait for an attractive price (Berkowitz style).

3. Compounding machines - A good bank is compounding machine.  If a bank has a low cost structure and managerial competence, an investor can earn a lot of money if they purchase at the right price.  If you buy a bank that earns a normalized 12% ROE at 80% of book value, then you can earn a 15% return. The bank can either reinvest the profits in its loan book to continue to grow profits at a 12% ROE or it can return it to shareholders via dividends and share repurchases.  This can happen year after year if the bank has the right management at the helm.  The market for banking services is so huge that opportunities for reinvestment are a lot greater than say home builders or oil companies.

I think the ability to compound is what makes banks so interesting.  Most banks can't do it and the ones that have in the past are easily identified and rewarded with high multiples most of the time.  The smaller banks though are victims of the same inefficiencies  of small cap stocks in general though, so it makes for an interesting space to look.  A small bank beyond a minimum threshold is better suited to compounding too simply due to the law of large numbers.  Geographic concentration can expose you to specific risks, but it can also allow you to apply local knowledge if you live in the area.  You can also coattail on a better local economy (Dallas vs. Detroit) so it works both ways.

*It is easy, but still requires work.  It's certainly easier than figuring out the competitive advantage of a semiconductor company.  I like that I can go on the FDIC website and pull tons of figures and metrics into excel on an annual and quarterly basis and really dig into how the business has looked over a 10 year period.  You can overlay this with economic data to get a good feel on the performance of the bank, which is a lot easier than devoting hours to understand the product cycle of PC makers or really industry specific trends.  These posts on Value Uncovered do a good job in highlighting the specific investment process here and here and are well worth the time.