Salisbury Bancorp: Trading Under Book, This Multi-State Regional With A Healthy Dividend Merits Attention

Jan.10.14 | About: Salisbury Bancorp, (SAL)

Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Bargain Shopping

Regional banking represents an ideal hunting ground for investors. The sector is vast and many of the banks are small entities, providing individual investors and those managing smaller funds significant opportunities to hunt for bargains without competition. Larger entities such as hedge funds are largely prevented from investing in the sector due to liquidity constraints and the "law of large numbers." Individual investors on the other hand benefit from this neglect and are able to profit from the lack of attention paid to the sector.

I have long been a fan of regional banking because of the fact that the companies operating in this sector retain significant advantages over their larger counterparts. The management of regional banks often hails from the locations in which they operate, providing an important degree of insight that helps regional banks make prudent loans. Management often owns a significant amount of stock in the company and thus their interests are more closely aligned with minority shareholders. Regional banks are also simpler operations than their gigantic counterparts and are thus able to escape the bad press and the tremendous risks that come with exotic financial products, reducing the potential for any catastrophic events and increasing the ability to respond to the specific needs of their local markets. A regional bank also has intimate experience in both its market and nearby geography, opening up the possibility for moderate and prudent expansion.

One regional bank which has recently come to my attention is Salisbury Bancorp (NYSEMKT:SAL). While the bank has been in operation in some form for a long period, it has only been listed on the Nasdaq stock exchange for a little more than a year. The bank currently trades under book value, pays a dividend over 4% and operates in three states on the east coast of the United States.

What Salisbury Does

Salisbury is engaged in residential, commercial lending and wealth and trust management services in Massachusetts, Connecticut and New York. Tracing its lineage to the Salisbury Savings Society of 1848, the company has existed in its present form since 1998. Over the years the company has expanded outwards from its primary operating location in Connecticut to serve locations in New York and Massachusetts which are primarily composed of small towns and rural communities.

The communities within which Salisbury operates are predominately rural and consist of small towns. The company's operations in Connecticut, its home state, indicate the strength of the bank's competitive position in the small communities where it chooses to do business, with Salisbury retaining a significant and in some cases overwhelming majority of the deposit share.

City SAL 2013 Total Market Share (%) Population
Canaan, CT 78.57% 1081
Sharon, CT 54.46% 2782
Salisbury, CT 52.12% 3977
Lakeville, CT (Main Office) 90.32% 928
Click to enlarge

Tri-State Exposure

Salisbury also enjoys a unique geographic advantage in my mind, as the company is located in the border region between three states: Connecticut, Massachussets and New York. This location provides the company with the ability to expand outward in a discretionary manner, evidenced by its recent expansion into Great Barrington, MA. By virtue of the company's small size, it also has plenty of room to grow its deposit share.

County Deposit Share Rank
Litchfield, CT 8.68% #5
Berkshire, MA 1.47% #10
Dutchess, NY 2.06% #14
Click to enlarge

The Numbers on Salisbury

With a market capitalization of $45 million, the company is a tiny one. Currently priced at $25.90 against $32.65 of book value, the company is offered at a significant discount to its assets on the books. Insider ownership in the company stands at slightly over 11%. While this level of insider ownership is significant it is not as high as many other regional banks that I have examined however when one considers the long operational history of the company (stretching back into the 19th century) it becomes more understandable.

The company also pays a dividend currently yielding over 4.2%. In the years since the financial crisis, the company has also posted a steady improvement in earnings per share. The company's payout ratio is also improving, dropping from .52 in 2011 to .49 in 2012. A lower payout ratio and a stable or increasing dividend is something that I look for, as it indicates the bank is able to retain and internally compound more of its earnings going forward. Due to the fact that many banks are struggling with this low interest rate environment due to declining net interest margins. In response, several regional banks that I follow have reduced their dividend payments in anticipation for higher capital requirements.

Turning The Corner: Improving Metrics Indicate Slow and Steady Progress

For 2012, the company's Return on Assets (RoA) stood at .67%, below my preferred threshold of 1% which I use as a litmus test for "best of breed" banks. Despite this fact, when viewed in conjunction with the discount to book value and robust dividend, I believe that Salisbury falls into the "turnaround story" category for regional banking and is attractive because of the lack of risk involved, with the company's tangible book value (common equity less goodwill and other intangibles) standing at $26.17 for the third quarter of 2013, indicating that the company is currently being offered at a discount to liquidation value.

The company has also been posting improving capital ratios since the financial crisis, a key indicator about the health of the bank. In addition to the improving earning power of the company and also paid back TARP obligations in 2010.

2012 FY 2011 FY 2010 FY
Tier 1 Capital 15.46 14.88 12.84
Tangible Equity / Tangible Assets 10.49 8.47 8.39
Click to enlarge

While the market does remain challenging, Salisbury has been able to both increase its earnings and book value since the financial crisis every year in a healthy manner while maintaining its generous dividend, as this table taken from the company's most recent 10-K indicates.

Year EPS Dividends - Cash Tangible BV
2012 $2.28 1.12 26.85
2011 $2.12 1.12 23.69
2010 $1.9 1.12 20.81
2009 $1.25 1.12 19
2008 $0.66 1.12 16.58
Click to enlarge

I believe that investors will continue to see Salisbury perform well in the future as its capital ratios, earning power and tangible book value increase over time. The company will also be favorably positioned to benefit from rising interest rates, increasing the bank's Net-Interest Margin (the difference between interest earned and interest paid), helping contribute to the company's RoA.

In the "Sweet Spot" For Regional Growth and Consolidation

With the advent of Dodd-Frank regulations, regional banking has witnessed a large amount of deal activity. There is definite impetus for banks to acquire smaller competitors or to sell out to larger entities to help offset the burden of regulatory costs. I believe that Salisbury is well situated by virtue of its geography, as it currently conducts operations in three states and thus has significant outlets for growth or expansion. Another part of the company which I find appealing is the fact that many of the communities it serves are small towns or rural areas that number no more than several thousand individuals and thus the company is well situated to absorb smaller family-run banks, thrifts and S&L operations that are experiencing both regulatory and demographic pressure. As I have mentioned in previous articles about other regional banks, I also believe that there is significant potential for companies of this size (under $50 million market capitalization) to be acquired and I believe that this outcome provides shareholders with considerable benefits.

The company's expansion further into Massachusetts through a recent branch opening indicates the pursuit of organic growth and I am optimistic about the company's footprint continuing to expand in an organic fashion over the longer term. Examining the company's non-Connecticut operations, it becomes apparent that the company is focusing on developing its Massachusetts line of business as evidenced by a recent branch opening, where it retains the smallest amount of deposit share and thus the highest potential for growth.

Locations Deposits
Millerton, NY $60.209 M
Dover Plains, NY $34.126 M
Sheffield, MA $28.074 M
South Egremont, MA $17.376 M
Click to enlarge

Salisbury's location in three states also makes the company an attractive target for larger regionals with an eye towards expanding their presence quickly and provides the bank as a standalone entity with numerous options to pursue organic expansion in attractive markets. From an inverted perspective, the company is also well positioned to absorb branches from other regional banks or larger national banks as these banks divest non-core assets, sell themselves or are wound up. While larger banks may find it unprofitable to operate in small towns and rural areas, Salisbury makes a business of it.

While I would not recommend purchasing shares in any company on the speculation of an acquisition, I believe that regional banks located in the New England and East Coast area with market capitalizations between $300 and $600 million could easily perform a "bolt on" style acquisition of Salisbury, representing a one-time windfall for shareholders.

A Quantitative Valuation of Salisbury Using the Graham Number

In situations where a company is trading below book value yet continues to operate profitably, I find it useful to utilize the Graham Number and to reference insider purchases (if there are any) to arrive at an acceptable entry point and a target stock price.

The Graham Number, developed by Ben Graham, is a metric utilized to arrive at the theoretical "fair value" of the company's assets (or the "correct" stock price) to a private purchaser. Purchasing below the Graham Number (Typically at a 20% or more discount) provides investors with a significant margin of safety, a reasonable forecast of the company's stock price and a very healthy return. The Graham Number, expressed as the square root of (Book ValuexEPSx22.5), provides investors with a price target for the company's fair value on the market and has been successfully used by Value Investors practicing the "cigar butt" investing strategy for many decades.

When I use the Graham Number to value companies, I also typically look for insider purchases as a reference point to help me to decide upon a potential entry point because insiders only buy stock in their own company for one reason: to make money. When examining recent insider activity with Salisbury, there has been no insider selling in the past 52 weeks. In addition, one insider has purchased shares over the past 52 weeks between $28.50 and $29, higher than current market prices.

Using tangible book value, the most conservative measure of the company's book value, Salisbury Bancorp's Graham Number can be calculated as the square root of ($26.17x$2.06x22.5) or $34.82 per share, a number which is over 30% higher than the price of the company currently and very close to the book value of the company. This means that using this metric, the company is currently undervalued by over 30% at its current market price.

A Qualitative Example of Salisbury's Regional Advantage

After examining scores of regional banks, one notices the "little things" or pieces of qualitative data that set regional banks apart from their larger counterparts. While these data points are often not reflected on the balance sheet, they demonstrate the ability of management to tailor their operations to the needs of the local market and adapt to changing conditions and emerging opportunities.

In a previous article I discussed a bank operating in a wine producing region with a robust hospitality economy. The management of this bank cultivated relationships with local of wine producers and bottlers to create value. In this case, Salisbury has developed an operating segment that caters to Equestrians and Equine businesses. The ownership of horses is something that requires both a significant financial and time commitment and evidences the willingness of the bank to tailor its services to a specialized customer demographic, providing clear evidence of the ability of management to anticipate and respond to needs of the local community.

Specially designed services represent a key element of differentiation from larger banks for regionals and often function as important value-added services for local customers. While it may be difficult to quantify the profitability of these services (as often, many are not particularly profitable), the benefits are experienced indirectly through increased deposit share retention caused by increased customer satisfaction.

Risks

Like any regional bank, the fortunes of Salisbury are tied to the communities within which it operates. This is especially important for investors to make note of in this case due to the fact that the bank operates over a geographic area that comprises more than one state and the fact that the regions it operates in are predominately rural areas and small towns with low populations. Investors must be appraised of the long-term demographic challenges facing rural areas and the potential for a decline in local economies.

Another risk over the long term that has the potential to adversely affect the operating performance of the bank is the significant compliance costs related to Dodd-Frank regulation. While these regulatory costs are insignificant for large banks, excess regulatory costs can potentially burden the Salisbury going forward if it were to remain an independent entity and not conduct acquisitions or itself be acquired to increase its asset base and thus the ability to absorb increased compliance costs.

As with any equity of this size, a major structural factor investors need to be apprised of is liquidity risk. Many small regionals are often very illiquid and thus subject to periods of volatility which are disconnected from the underlying fundamentals of the company. Salisbury is no different and its average volume has recently been under 3,000 shares traded daily. In order to reduce the effects of liquidity constraints I would recommend that investors employ dollar cost averaging and stagger their purchases. Given the proximity of the company's price to tangible book value, one must be very careful.

Final Thoughts: Opportunity In The Lack of Risk

While Salisbury Bancorp has not increased its dividend over the past five years and does not pass the 1% RoA hurdle, I believe that this company remains a compelling investment as it has been posting slow and steady improvement in its earnings and capital assets in addition to opening a new branch.

The company trades at a very cheap valuation (slightly under tangible book and well under book value), making it a compelling candidate for a "cigar butt" type of investment, particularly given the discount of the company's share price to the Graham Number.

I believe that the operating metrics of the company company will continue to gradually improve and as such investors at current prices will enjoy a high degree of safety given the cheap valuation and that it is paying investors a dividend of over 4%.

The company has also demonstrated its capacity to adapt to the needs of the market it serves with uniquely tailored programs to differentiate itself and to increase its value proposition which help to both increase and retain the company's deposit share and thus provide a larger base of assets with which to conduct profitable lending practices.

Investors who are patient and able to make use of limit orders can also exploit the low liquidity of the stock to purchase the company on a bout of exogenous volatility, which could allow for investors to make purchases further below tangible book value and thus obtain quite the bargain.

As a standalone entity I believe that Salisbury is an attractive purchase, particularly when contrasted against the Graham Number for the company. As the company's operating metrics improve, I believe that the market will find this company increasingly attractive will lead to an upward revision of the company's stock price closer to its stated book value of $32.65 - a 26% difference from current prices and over a 30% total return should this event occur in one year if one were to include dividends. Given the company's steep discount to stated book value and the current regulatory environment, this company also represents in my mind an attractive acquisition target for larger banks in the New England region, providing investors with an embedded call option and any merger activity should it occur.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SAL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.