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I've been exploring regional banking for investment opportunities for a portfolio with a long time horizon. In two recent articles I've written, on National Bankshares (NASDAQ:NKSH) here and on Camden National (NASDAQ:CAC) here, a Vermont-based bank came up in the comments. I thought it was high time that I took a serious look at this bank: Merchants Bancshares Inc. (NASDAQ:MBVT).

Background

Merchants Bank is the only independent statewide community bank in Vermont. It operates 33 community branches and 40 ATMs. In addition to traditional banking activities such as taking in deposits and making loans, the bank has a division, Merchants Trust Company, focused on financial planning, trust and other wealth management services.

The market capitalization of MBVT is about $174 million. It pays a quarterly dividend of $.28 / share, which works out to approximately a 4.03% dividend yield at the current price near $27.75. The dividend was maintained through the financial crisis; however, it has been frozen at the current distribution since 2006.

I originally became interested in MBVT for two reasons: first because it was pointed out in comments to previous articles and second because it is one of approximately 15 regional banks that maintained Returns on Equity greater than 10% for each of the past 10 years. In this case, the Returns on Equity have been greater than 13% for each of the past 10 years, which is great; although, they are currently under pressure due in part to the lack of consumer appetite for debt and the low-interest rate environment we all live in.

Qualitative Notes

Reading through the past several years' of annual reports, I was left with a feeling that management is running a sound operation that should reward shareholders over time. There is a fairly consistent focus on reducing costs and on growing organically through sound lending.

I think it's very important to note that Merchants has been the sole statewide independent bank in Vermont since 2007. Writing in the 2008 shareholders' letter, management notes:

Today, the community bank model is being held up as the lone bright spot in the banking business. The opportunity to pick up market share by demonstrating the value of our company to the markets we serve has never been better. Many of our competitors are now branches of larger out-of-state and foreign-owned competitors that are not nearly as connected to our markets as is Merchants Bank. Now more than ever Merchants Bank can stand out as the sole statewide independent bank in Vermont.

At present, consumers are not excited to be taking on more debt, which makes it difficult to make more loans. The bank has responded by seeking to grow its customer base so that there are more people it can offer services to. In addition, it has started to focus on small business customers. Over time, I think the expanded relationships will be very beneficial and will drive strong results in the future. In 2011, the bank had 10.11% of the market, and in 2012, that number was 10.61%, so we see this strategy playing out in the numbers.

As one example of past action by management, the bank took several concrete steps in 2006 to combat margin compression. Here are two quotes from the shareholders' letter:

In addition to repositioning the balance sheet we will also look to additional opportunities in noninterest income and expense. This past year we were able to hold noninterest expense levels very close to 2005 levels. We have undertaken additional efforts to reduce expenses in 2007. This included a review of all of our employee benefit programs. One step we have taken as a result of this review is a reduction in the match in our 401(k) program that should save over $400 thousand in 2007. This was a very difficult decision, but we felt it was necessary under the current circumstances. Our benefit programs are still very competitive in the local marketplace and we appreciate the support and understanding of our employees with this change.

It is very possible that although net interest margin may stop eroding and start to improve, we may never again see margins at historical levels. If this is the case we need to position ourselves to earn acceptable returns for our shareholders, invest in our franchise and enhance our products with smaller margins. The scale of our business will be a major determining factor in our ability to succeed in this environment. At reduced margins we need to drive more revenue over relatively fixed cost base to produce the necessary returns to remain competitive and reward shareholders.

As a final thought, I will leave you with a quote from the 2011 annual report. It highlights both the robustness of Vermont as a region as well as Merchant's commitment to sound lending:

This is the reality of the market and we are prepared to meet the challenge by continuing to do exactly what we did in 2011: grow our company. The best way to meet the pressure of reduced net interest margin is to grow our earning asset base. At the same time, we will also look to increase fee income and control costs, but our success will be driven in large part by the net interest income line. Our market remains relatively healthy. Vermont has fared significantly better than many areas of the country over the past few years. The combination of a healthy market together with our own dedication to thorough underwriting and sound risk management have produced some of the best asset quality measures of any bank in America. Rest assured we will not sacrifice our commitment to strong asset quality in order to achieve our growth objectives.

Historical Data

Below, I give some graphs highlighting Merchant Bancshares' historical performance.

First is a graph of earnings per share, dividends per share, and the payout ratio for the past 10 years and the trailing 10 months. Note that there was a special dividend of $4.5 / share in 2004.

(click to enlarge)

Next is the Returns on Equity (RoE), Returns on Assets (RoA), and the net interest margin. The consistently high, particularly through the financial crisis, Returns on Equity are one of the reasons I was initially attracted to the stock. The Returns on Assets have hovered near 1%, dipping a bit below, recently, which is a number I would like to see be higher.

(click to enlarge)

The next graph highlights the balances of Deposits, Loans, Assets and gives the ratio of Loans to Deposits (one way to see the extent to which the deposits are being converted into loans that ideally return more than the cost of deposits).

(click to enlarge)

Finally, the book value per share.

(click to enlarge)

Peer Comparisons of Bank Specific Metrics

Merchants Bancshares defines its peer group as: Bancorp-Rhode Island, Inc. (NASDAQ:BARI), Bar Harbor Bankshares (NYSEMKT:BHB), Century Bancorp, Inc. (NASDAQ:CNBKA), Enterprise Bancorp, Inc. (NASDAQ:EBTC), First Bancorp, Inc. (NASDAQ:FNLC), Northeast Bancorp (NASDAQ:NBN), Northway Financial, Inc. (OTCQB:NWYF), Patriot National Bancorp, Inc. (NASDAQ:PNBK), and Wainwright Bank & Trust Company (WAIN). In the Investor Relations section of Merchants' website, it gives the following comparisons of 9/30/2012 data against this peer group:

Performance Ratios (%)
MBVT

Peer

Median

Peer

Mean

Return on

Average Assets

.93 .65 .66
Return on Average Equity 13.55 8.10 7.58
Net Interest Margin 3.32 3.23 3.39
Efficiency Ratio 66.53 69.37 73.62
Loans / Deposits 85.63 92.09 90.31
Asset Quality Ratios (%)
MBVT

Peer

Median

Peer

Mean

NPAs / Assets

.16 1.91 2.28

NCOs / Avg Loans

(0.00) .23 .39

Reserves / Loans

1.07 1.58 1.38
Reserves / NPAs 417.66 56.80 70.20

The ratios of Non-performing assets to assets and of net-chargeoffs to average loans are astonishing and a great sign indicating a high-quality loan portfolio.

Capital Ratios (%)
MBVT

Peer

Median

Peer

Mean

Tier 1 Capital 14.62 14.24 15.88
Tangible Equity / Tangible Assets 7.00 8.21 9.11
Total Equity / Total Assets 7.00 8.80 9.67

The capitalization ratios are important to check since a low capitalization ratio would suggest a future decrease in Return on Equity as the bank raises additional capital in response to Basel III regulation. The tangible equity / tangible asset ratio is lower than its peers but should be taken in context with the superior performance on the asset quality ratios.

Market Ratios
MBVT

Peer

Median

Peer

Mean

Price / Earnings (NYSE:X) 11.50 13.69 17.71
Price / Book (%) 139.86 100.72 97.13
Dividend Yield (%) 4.04 2.9

Valuation

In valuing a financial services firm, I follow Damodaran's thoughts in "The Little Book of Valuation." I look at the Price / Book ratio as a relative measure and then a Dividend Discount Model.

Merchant Bancshares Price / Book ratio is 1.47 (Price / Tangible Book is 1.5). This is above-average for a regional bank but is justifiable by the above average and consistent Returns on Equity. Morningstar reports the 5-year average P/B ratio for MBVT to be 1.5. By this metric, MBVT is currently fairly valued.

Next I work through a Dividend Discount Model to get a rough intrinsic valuation. To do so, I must make several assumptions about the future. Those assumptions are:

  • The RoE for the next 5 years will be roughly 13%. This is slightly lower than the TTM figure of 13.3%, but I felt it justified by the downward trend.
  • The dividend payout ratio of the next 5 years will be roughly 47%, which is in line with the current payout ratio.
  • The cost of equity (discount rate) for the next 5 years is about 7%.
  • The RoE in the long-term for computing the terminal value after 5 years will drop to 8%.
  • The long-term earnings growth rate will be 3%, which when combined with an RoE of 8% gives a payout ratio of 62.5%.
  • The cost of equity after 5 years will rise to 8%.

Putting this together and using a TTM EPS figure of 2.41 gives:

Dividend Discount Model for Merchants Bancshares
Year EPS

Predicted

EPS

Growth

Payout Ratio RoE

Div /

Share

Discount

Rate

Present

Value

TTM 2.41 47% 1.13 1.13
1 2.58 7.05% 47% 13% 1.21 7% 1.13
2 2.76 7.05% 47% 13% 1.30 7% 1.13
3 2.96 7.05% 47% 13% 1.39 7% 1.13
4 3.16 7.05% 47% 13% 1.49 7% 1.13
5 3.39 7.05% 47% 13% 1.59 7% 1.14
Terminal 3% 62.5% 8% 8% 27.49

Adding up the present value of the forecast cashflows gives an estimate of intrinsic value of $34.29 per share. At the current market close (1/8/13) of $27.72, this gives a margin of safety of about 19%. Given the low discount rate, I conclude that MBVT is currently at the low end of being fairly valued.

My Takeaway

Readers of my article on Camden National know that I was not ready to invest in part due to the non-increasing dividend. I have those same reservations about Merchants, but I believe they are compensated for by a higher dividend yield (just over 4%) and Merchants' position as the sole statewide independent bank operating in Vermont. Merchants' also has a low debt/equity ratio of .2, which I believe makes it safer. I've placed a limit order with my broker and hope to be a shareholder in the near future.

Source: Merchants Bancshares Inc.: The Only Statewide Independent Bank In Vermont Yields More Than 4%

Additional disclosure: I may initiate a long position in MBVT in the near future depending upon price movements. All data sourced in this article is from annual reports, Merchant Bancshares' investor relations website, or 10-ks.