As you may recall, friend and fellow value investor DTEJD1997 did a guest write-up a while ago on a company called Rurban Financial, here is his follow up. Please note the disclaimer at the bottom - he owns shares and I don't. Regardless, it is a neat bank that has been fun to follow. He has also done analysis on Nevada Gold (UWN), a company which I have owned shares of for a few years and written up several times (though, I was a bit early with my thesis beginning to play out, but that is a story for another time). Additionally, we have worked on a few other investments together, the most public of which was Calloway's Nursery (OTCPK:CLWY).
Without further ado:
This is DTEJD1997, and I wanted to revisit Rurban Financial and give an update as to what has happened and what Rurban's future prospects are.
NOTE: Rurban is going to be announcing earnings on Tuesday, January 21st 2014. It will very interesting to see what they report.
In the past couple of years, Rurban has accomplished quite a bit. The most notable thing is that they have changed their name and ticker symbol. Rurban is now known as State Bank Financial Group, ticker symbol: (SBFG).
Since my first article, SBFG has turned around their operations and are now solidly profitable. They took charges for bad loans. They also took a lot of write downs in the data processing division. A lot of people were let go in this division. It is a fraction of it's former size and it appears that most of the problems there have been solved. After these write downs, REO was sold and the loan book and capital base has improved. As a result, reported earnings are now well over $1/share. Actual earnings are somewhat higher than reported earnings!
Regulatory capital levels have improved and SBFG is now well capitalized. They are no longer under increased FDIC scrutiny. And perhaps most importantly of all, SBFG started a dividend and raised it once already.
Well DTEJD1997, that sounds all well and good, what has happened to the share price? I am pleased to report that it has gone up, tremendously so. Recent trades have been around $8/share. However, when you look at the underlying financial metrics and likely future earnings, SBFG is STILL undervalued and has room to run! Let me explain my thinking:
I'll start with the easiest and move to more difficult things:
Insiders are purchasing shares.
Insiders have been steadily purchasing them ever since I wrote the first article. Some of the shares purchased have been at prices HIGHER than what SBFG is trading at today. These aren't huge purchases, but they are several hundred shares at a time. These are frequently DIRECT purchases using their own money, not just option exercising. The trend is strong, continual purchases.
THERE HAVE BEEN NO INSIDER SALES. This is an EXTREMELY bullish sign. Actual earnings are higher than reported $1.13/share
Earnings of $1.13/share is giving SBFG a P/E ratio of just over 7. Flip the equation, owner's earnings are reported as about 14%. HOWEVER, this is NOT ENTIRELY ACCURATE! Why? SBFG bought out a couple of very small local banks a few years ago. There was some goodwill and intangibles associated with the takeovers. SBFG has steadily been writing this amount down. This is a non-cash expense. Thus, true cash earnings (owner's earnings) are actually in the realm of $1.28/share. This brings the P/E down to about 6, and the true earnings yield jumps to close to 17%.
As earnings have increased, so has the Return on Equity (ROE)
This critical measure of management's skill has increased to just over 10%. While this is not a tremendous return, it is certainly very respectable. It is even more respectable when you can buy SBFG at a healthy discount to book value! I think it is highly likely that ROE will increase in the near future. The rate of gain will start to slow from past rates, but if ROE can get to 10.5%, 11.5% or even 12%, shareholders will be in a good position. I will further suggest that shareholders are going to be in an even better position when the market realizes that SBFG should be trading for about book value.
There is simply no reason that a stock earning over 10% ROE on a normalized basis should be trading for significantly LESS than book value. I am confident that SBFG will be re-rated higher. The only question is how long it takes ...
*NOTE ON BOOK VALUE* SBFG has a good amount of "intangibles" on the balance sheet from past acquisitions. Thus there are TWO measurements of book value. Shareholders have "regular" book value, which includes intangibles, and then there is "tangible book value", which excludes intangibles. Obviously "tangible book value" is a more conservative measure. A sharp purchaser can still get SBFG at a slight discount to tangible book if they time their purchase correctly!
Regulatory capital levels have improved to “well capitalized”
Of course, the FDIC required capital levels are rather low for my tastes, but they are a good starting point. As per management of SBFG:
"Capital ratios continue to improve, however it still remains a primary focus of management. The Tangible equity ratio improved by 65 basis points over the past twelve months, and now stands at 6.20 percent. All bank regulatory ratios remain in excess of "well-capitalized" levels. At September 30th, 2013, State Bank's Total Risk-based Capital was estimated to be $60.0 million, $21.6 million above the well-capitalized level. The Total Risk-based Capital Ratio is estimated at 12.6 percent."
In the intervening quarter, the equity ratios have further improved with Tangible Equity/Tangible Assets further improving to 6.18 and Tier 1 capital improving to 10.53.
Asset quality is rapidly improving
Asset quality is improving with SBFG reporting nonperforming assets of $8.8 million for the current quarter, lower by $0.6 million, or 6.7 percent, than the prior-year third quarter. From the latest quarterly report:
“Net charge-offs of $0.3 million were just 25 basis points for the quarter and up slightly from the prior-year third quarter. Delinquency levels have declined, with the 30-89 day category totaling $0.4 million at the end of the 2013 third quarter, compared to $0.7 million for the prior-year third quarter. Mr. Klein continued, "All of our asset quality measures, especially delinquency, have shown improvement. We have continued to add to our loan loss reserve, resisting thus far in 2013 to release loan loss reserves to impact our earnings."
So SBFG's loan book is well reserved against future losses. SBFG will continue to grow it's loan book in the future. Small additional incremental earning improvements will continue to come from improving asset quality.
If the economy continues to improve, the loan reserve ratio may prove to be over reserved. Thus, there is a possibility that future earnings will be "juiced" by releasing funds from the loan loss reserves. The other possible way to increase earnings is to LOWER the future contribution to the loan loss reserve, as it is already more than adequately reserved
Problems at the data processing division have largely been solved.
Losses were incurred, massive write downs taken, and people were let go. The data processing division is now a relatively small part of SBFG. Gross revenue was only $700k for the quarter. Win, lose or draw, the data division is now a relatively small part of the company. I believe it is a small operation and won't make much of a difference either way going forward.
So it is clear that SBFG has made tremendous progress and has turned the business around. What about the future?
I strongly suspect SBFG is going to expand their loan book in the upcoming year. I think the expansion will be relatively large, as management has done two interesting things:
The first interesting item is that they filed a S-3 "Shelf Registration" statement with the SEC. They are taking the first step towards raising $30MM in future equity. As CEO, Mark Klein stated:
"Our performance has benefited from the strategic initiatives we implemented across our organization over the past three years. We reduced our problem assets early on, and have since maintained a consistently strong and stable portfolio of quality loans. Revenue growth has been derived from both loan growth and fee income; in particular, our geographic expansion of residential mortgage banking activities has been well-timed to enhance corporate profitability and attract new households for continued enterprise growth. Additional capital can enable us to pursue future banking opportunities that will contribute to the continued growth of the Company, while preserving the capital levels of SB Financial Group and State Bank, which are both currently in excess of well-capitalized requirements."
Raising capital will allow SBFG to greatly increase the size of their loan book. This is going to be a major expansion.
The second interesting item is that SBFG has retained Lambert, Edwards & Associates of Grand Rapids Michigan to head investor relations and to conduct outreach to potential shareholders.
"We are excited to partner with LE&A. Their team of investor relations and financial communications experts will help SB Financial leverage its recent re-branding initiatives, enhance our strategic communications, target and engage the investment community, and build-out our shareholder base,"
Mark Klein, president and CEO of SB Financial Group.
In addition to everything Mr. Klein stated, I think the OTHER reason the public relations company was hired is to get the share price up. The share price needs to be raised BEFORE issuing more equity to prevent dilution to existing shareholders.
As a shareholder, I do NOT want more equity issued at $8/share. That is below book value! Book value is $11.41, with tangible book being about $8. If equity could be issued at a price higher than tangible book, yet lower than stated book, I think most current shareholders would be OK with that.
If shares are issued around $10/share, that probably would be OK if management has a good place to put that capital to work. it appears that the S.E. Michigan and N.W. Ohio real estate markets are strong and are continuing to be improve.
Issuing $20 or $30 million in new equity would allow SBFG to enter new geographic areas and increase the loan book tremendously.
I am going to guess that management is planning a major expansion into the Columbus Ohio area. Another possible area is expanding operations in Indiana.
The success of the future expansion comes down to whether management can earn MORE on the additional raised capital than it is on the existing capital. If so, the expansion will be accretive to existing shareholders and thus a success. There is a very good chance that it will be. Management knows which areas are ripe for growth. They already have a lot of infrastructure in place to handle new growth, as evidenced by the steadily improving efficiency ratio . Insiders have also been steadily purchasing shares indicating they think the bank is undervalued.
If you have read this far, you may be thinking "Well DTEJD1997, that is all fine and good, but what of the risks"?
The main risk is that management is too anxious to grow the business and issues equity that dilutes existing shareholders too much. As a shareholder, I want my position strengthened, not weakened or diluted. It is not entirely clear at exactly what price management intends to issue shares, so this may be a misplaced concern.
Assuming that new equity is not sold too cheaply, there is execution risk in growing the loan book. Management will have to be judicious in putting the new money to work. I think they can do it, but there is some risk.
There is also risk from rising interest rates. I do not think that will be too much of a risk in the near future, but it could be a larger problem a few years from now.
Of course there is a risk that the economy as a whole, or in Ohio and Indiana, will weaken substantially. There is not much management can do about that.
And finally, this bank was driven into the ditch once before, and it very well might be at some future point. It is generally NOT prudent to buy banks and then hold them indefinitely. Banks trade in long term cycles. In my investing career I saw the tail end of the S&L crisis, the Internet boom & bust, the housing bubble, and the Great Recession. Buying banks when there is trouble and panic, holding them for a while, and then selling them when things are exceptionally good is a much better strategy than buy and hold. There are a few banks that are exceptions, but these are a rarity. Witness how many times Citibank (C) and Bank America (BAC) have boomed and bust. These cycles last YEARS, sometimes almost a decade. So we may have many years left before it is time to sell.
The end result is this, SBFG is still one of the best values in small banks out there. The P/E ratio is unreasonably low at a level below 7. They are trading at a significant discount to book value. SBFG has insider buying, with NO selling. There have a dividend that is growing. Take any financial metric that you want, and SBFG is demonstrably cheap, low P/E, low P/B, growing dividend, etc.
At some point, the market is going to re-rate SBFG at higher valuation levels. SBFG will probably never be a huge growth stock, nor will they be a top tier bank. THEY DON'T HAVE TO BE. As investors, we are capable of getting a superior return as the market is selling SBFG at too great a discount. Superior returns will be realized as SBFG gets rated higher. Will SBFG ever sell at market rates? Maybe not, but it does not have to. Go from a 7 P/E to a 10 P/E and you have over a 50% gain when you factor in dividends and organic growth!
*Please do your own research and due diligence. Don't take my word for it, verify it for yourself. I own shares of SBFG and may trade it at any point without advance notice.
Disclosure: Jeff has no position in SBFG, but certainly thinks it is a neat little company.