Unnoticed and undervalued, over the last two years Baylake Corp. (NASDAQ:BYLK) has streamlined operations, solidified its balance sheet, and is now positioned for robust growth. If Baylake stays independent, I expect a 30% to 50% increase in the stock price over the next year. But I don't think that will happen because Baylake is attracting the attention of banks interested in making regional acquisitions. A number of banks -- including Associated Banc-Corp (NASDAQ:ASBC) and First Source Bank (NASDAQ:SRCE) -- are looking to add deposits and loans in their footprint, and Baylake fits perfectly. On the national level, U.S. Bancorp (NYSE:USB) is an active acquirer and is very interested in banks with the balance sheet and growth prospects of Baylake.
Baylake is a $1.0 billion bank headquartered in Sturgeon Bay, Wis. I recently had lunch with CEO Rob Cera, and he is very impressive. Cera is quickly and quietly building shareholder value. He has cut expenses, improved credit, and increased capitalization. He is creating an efficient, well-balanced bank with multiple sources of income that will generate exceptional growth and earnings going forward.
Credit at Baylake is better than it has been in 40 years. Cera has instituted a professional credit process over the last couple of years, and the metrics prove it. Provision for loan losses was $600,000 in Q1 2013 vs. $900,000 expected and $1.75 million in Q1 2012. Non-performing assets (NPAs) declined 30.9% to $17.22 million in Q1 2013, compared with $24.92 million at year-end 2012 and $37.3 million in Q1 2012. Non-performing loans (NPLs) to total loans declined sharply to 1.5% in Q1 2013 compared with 3.5% in Q1 2012. The loan loss reserve to non-performing loan ratio was 96.2% in Q1 2013 compared with 50.1% in Q1 2012, representing much stronger coverage against NPLs.
Cera is not afraid to cut expenses when an area is not performing. Baylake is closing and selling branches that are not performing or don't fit its long-term strategy. Over the last six months, it has sold four branches and closed one. Non-interest expense for Q1 2013 was $6.81 million, compared with $7.83 million for Q1 2012, a 13.1% reduction. The improvement compared with first-quarter 2012 was highlighted by a 66.6% decline in expenses related to operating foreclosed properties, a 5.5% reduction in salaries and employee benefits, a 47.2% decline in FDIC insurance costs due to the company's improved financial condition, and a 54.8% decline in loan and collection expenses that reflects the company's improved asset quality. The company's efficiency ratio improved to 67.1% for first-quarter 2013, compared with 71.6% for first-quarter 2012.
Interest expense declined 35.3% to $1.29 million compared with $2.0 million in first-quarter 2012. Baylake's strategy to reduce wholesale borrowings has contributed to reduced interest expense. The company expects further reductions in higher-cost wholesale borrowings to occur in the second and third quarters of 2013. All of this has contributed to improved profitability. Baylake reported Q1 2013 EPS of $0.19 vs. the consensus estimate of $0.16. Return on average assets (ROAA) has improved to 0.73% in Q1 2013 compared with 0.50% in Q1 2012. Return on average equity (ROAE) increased to 7.60% in Q1 2013 compared to 6.23% in Q1 2012.
As a result of Baylake's financial performance, capitalization is strong. The company's total risk-based capital ratio increased to 16.42% in Q1 2013 compared with 13.77% in Q1 2012. Tangible Common Equity Ratio (TCE) has improved to 9.23% and Tier 1 Capital Ratio is 13.79%. The company is considered "well capitalized" by all regulatory standards. Baylake does not hold any TARP-preferred securities.
But profitability is only one element of Baylake's shareholder focus. Baylake recently initiated a $.04 per share quarterly dividend, and then promptly increased it to $0.05 for a 2.1% annual yield. At a modest 25% payout ratio, it will allow plenty enough retained capital to continue to grow the business. In addition, the board just approved a common stock buyback program where Baylake can buy up to 400,000 shares on the open market over the next year.
Cera understands the need for building a balanced franchise. Wealth management, data processing, and diversified lending all provide revenue and income. From the Q1 2013 earnings release:
We are seeing continued strength in our mortgage lending business, and non-interest income derived from the sale of loans in the secondary market increased 64% compared with first-quarter 2012, primarily from residential mortgages. We also reported a 51% increase from the prior year first quarter in income generated from our asset management and wealth services which demonstrates a growing contribution from our efforts in this important operating division. We expect to see continuing gains in coming quarters as we expand these business lines.
We believe Cera will prove correct. With the balance sheet firmed up, he has turned his full focus to diversified, high-quality growth. He will continue to raise non-interest income, including fees from commercial banking and asset management. Cera is building a full-service bank, with a complete offering of business banking services and solutions as well as asset management and financial planning capabilities. This will give Baylake a competitive edge over other banks in their markets, allowing it to leverage its service and technology infrastructure to cross-sell current customers and to win new ones.
Q1 2013 book value is 11.85, up from 10.89 in Q1 2012. Q1 2013 tangible book value is 11.01, up from 10.05 in Q1 2012. At a recent price of 9.40, P/BV = 0.79 and P/TBV = 0.85. With a 2014 earnings estimate of $0.98 per share, forward P/E is 9.4. Now, how many banks have the balance sheet, capitalization, and growth prospects of Baylake but trade at 85% of tangible book and 9.4x forward earnings? In my opinion, Baylake will not remain an independent bank for very long.