I first covered Parke Bancorp in a perfectly timed article back in January 2013. At that time I first recommended to buy Parke at a bottom price of $5.00 per share. Since then the share price has soared an impressive 150% (including a stock dividend of 10%). In the article I correctly pointed out that the market was worried about the company's asset quality, in particular its rapidly increasing non-performing assets. I also suggested a turnaround of asset quality was luring behind the corner. I anticipated this turnaround based on following observations:
- General economic recovery of the US
- Recovery of the US real estate market
- Declining number of bankruptcies on a national level
- Parke Bancorp was lagging its peers
I did overlook the fact that small business bankruptcies were actually increasing in the metropolitan areas of New York and New Jersey (Parke's operating region). So looking back on it, I must admit I was quite lucky with my timing. Nonetheless, the turnaround took place and was first notable in Q4 results of 2012 quickly after publishing my first article. Subsequently I posted this comment on my own article:
In this article I discuss recent events, asset quality data and profitability. I also give an outlook on what to expect from 2014 and provide a SWOT-analysis of the company.
Parke Bancorp (NASDAQ:PKBK) is a community bank, with an emphasis on providing personal and business financial services to individuals and small-sized businesses primarily in Gloucester, Atlantic and Cape May counties in New Jersey and Philadelphia and surrounding counties in Pennsylvania. Community banks play an important role in the economy as they provide oxygen to small businesses trough SBA-loans. The biggest disadvantage of community banking is that big banks have cheaper funding (as they are considered 'too big to fail').
3. Asset Quality Data
3.1 Non Performing loans: Borrowers that cannot redeem debt are very costly to any financial institution, such as community banks. Faulty borrowers result in a loss of interest payments and capital payments. Secondly when defaulting, financial institutions have to write down the loans. Prior to charging off loans, they are first classified as non-performing loans. The exact definition of a non-performing loan (NPL) is when a borrower has failed to make interest or principal payments for 90 days. A lead indicator for the increase of NPL's is the total of accrual loans with payments past due 30 - 89 days. For Parke, past due payments peaked at the end of 2010 and Q1 of 2012.
3.2 Other Real Estate Owned: When a loan is mortgage backed, a default will result in the confiscation of the property by the bank. The real estate property will appear in the balance sheet of the bank under the term "other real estate owned" (OREO). OREO peaked in the third quarter of 2012 and has now stabilized around the peak value.
OREOs also result in a loss of interests, because the property does not yield any income. In addition, OREOs also result in costly lawsuits as foreclosure is not so easily justified in the eyes of Uncle Sam. In the case of Parke Bancorp, OREO expenses are rapidly increasing as shown in the graph below.
In summary both OREOs and NPLs are comprised under the term 'non-performing assets' (NPA). To keep the balance sheet clean a bank must keep its proportion of NPA's under a controllable level as these assets are considered to be toxic. Toxic does not necessarily mean that these assets are worthless. It means there is no longer a functioning market, so that such assets cannot be sold at a price satisfactory to the holder and assets have to be disposed of at a price way below its value on the balance sheet. This presents a level of uncertainty in the value of these balance items and is considered a risk. The potential gap between balance items and price in case of liquidation presents a challenge for investors to assess the value of shareholders equity. It will be of no surprise that share price will move closer to the equity value as the risks on the loan portfolio are reduced. This is true for the reason that investors demand higher returns (in terms of a lower P/E, P/B) for higher risk taking. During the last financial crisis the Fed played an important role in maintaining the liquidity of toxic assets by purchasing mortgage bonds. With this stimulus the Fed successfully unfroze the market for these illiquid assets.
3.3 Allowance for loan losses: So how does a bank manage the risks on defaults? First of all it searches for the lowest risk-to-profit loans. Secondly, a bank builds a financial buffer, called an allowance for loan and lease losses (referred to as ALLL). Allowance for loan losses is no more than a saving jar for possible defaults. On the balance sheet it appears as a contra-asset account (negative asset) as an offset to loans receivable. It is an account with a running balance of the allowances for loan losses established to report loans receivable at their net realizable value. The allowances are filled by booking provisions as an expense in the income statements. Parke generally keeps the allowance at 2-3 % of total loans.
In 2013 substantially less provisions were necessary to keep allowances at stable levels. This was the sole driver for achieving record earnings.
3.4 Texas Ratio: Equity reserves serve as a buffer in rainy days when banks are reporting losses. All financial institutions have a high leverage (debt/equity) to offset low return on assets (~ 0.5 - 1.5 % ) and to achieve reasonable returns on equity (~ 7 - 15 %). The downside is the risk of levering up. It means that banks do not need a lot of setbacks to tip over the balance sheet. During a financial crisis reported losses can be so large that equity quickly becomes negative. At this time depositors will massively storm the bank to recuperate their hard earned savings in what is called a 'bank run'. Subsequently the institution will find itself in a cash crunch leading up to bankruptcy. In summary, when equity becomes negative the bank goes bankrupt or becomes a zombie bank. As explained earlier NPA's contain potential unrealized loss. Consequently if the amount of NPA's surpasses the amount of buffer (equity + ALLL) the bank is at risk. Texas ratio quickly captures that risk.
In other words, if Texas ratio is higher than 100% the capital cushion is no longer sufficient to absorb potential losses from troubled assets. Subsequently the bank has a high risk for collapse.
Yet, this does not necessary imply that a bank is not viable. There are plenty of banks with a Texas ratio well above 100%. The situation for Parke Bancorp is presented in the graph below.
The company's Texas ratio was increasing rapidly after 2009 in response to the financial crisis but has recently started trending down again. Texas ratio was 58% at the end of the year, down 24% compared to a peak value of 82% in the third quarter of 2012. The ratio is now at a comparable level as the first/second quarter of 2011. As a result Price to Tangible Book Value is also comparable with the first/second quarter of 2011 (see graph below).
Note the negative correlation between Texas ratio and P/B-ratio. This proves that Mr. Market's primary concern has been Parke's asset quality data. Still Texas ratio of Parke is still way above national average.
3.5 Expectations for 2014: It is the author's belief that the total of NPA's keeps trending down at a slow pace. More precisely OREO will be stable throughout 2014 with a likelihood of negative surprises. On the other hand NPL's will shrink at a comfortable pace and will offset any negative surprise in OREO's. This prediction is based on the following observations:
1. U.S. economy is still recovering
2. The number of bankruptcy filings is still trending down.
3. House prices are still going up. Keep in mind that a large chunk of Parke's loan portfolio is still in construction loans.
Y-axis: U.S. real estate prices (% change over a year)
Money markets dried up in the wake of the 2008 financial crisis and small businesses were finding it hard to get credit. Therefore, the U.S. Treasury launched the Small Business Administration (SBA) 7(a) Securities Purchase Program to help small businesses. Parke responded to the program and sold $16.3M in preferred stock (TARP) to the government in 2009. This eventually saved the bank. Since Treasury launched its program, the SBA 7(a) market has recovered and new SBA 7(a) loan volumes have returned to pre-crisis levels. This also implicates that competition is increasing and SBA loans are becoming less and less profitable.
Treasury started to wind down the program and sold Parke's TARP-equity to private investors. During the fourth quarter of 2013 the company's TARP equity was repurchased at a discount. A positive development since interest payments on TARP were sky high (9%). Parke financed the deal by completing a new private placement of $20M in convertible preferred stock with a 6% annual interest payment. This deal has a positive effect on both profitability and shareholders' equity.
A downside of this financing is a lurking dilution of common equity as the preferred equity can be converted into common stock at $10.64 per share. It is important to note that this private placement still needs to be approved. It is the author's opinion that Parke should have taken the risk of repurchasing TARP without the help of a private placement. Its Tier 1 capital ratio is around 15% and in my opinion large enough to absorb the capital decrease. On the other hand its cash balance was too low at the point of repurchase. Another way to finance the deal was to attract new depositors with slightly higher interest rates and usage of this cash. It shows that management is very conservative and prefers to sit on a comfortable balance sheet.
5. Income statement
The company announced record earnings for 2013. Top line results were down 2.5%. A decrease in profitability of SBA loans was partially offset by an increase of total loans vs. total assets (thus a decrease in cash). I expect that the top line results will further decrease in 2014 as a result of increased competition in the SBA market. Increasing competition is directly related to the strong confidence in U.S. economy and the Fed's quantitative easing program. Parke needs some cash on the balance sheet to buffer fluctuations in deposits.
The main catalyst for record earnings was without doubt the sharp decrease in provisions for loan losses. I expect these to decrease further in 2014.
Non-interest income was down 21.5% as a result of a decrease on gains from sales of SBA loans.
Non-interest costs have increased sharply (25%) mainly caused by an increase in wages/staffing. Parke Bancorp's cost structure is now less efficient then its peers. In 2014 I don't see an improvement, but I also don't expect a sharp increase.
- High ROE (9%) as a result of a very high ROA (1.1%)
- High Tier 1 capital ratio (15%)
- Cheap funding: low interest rate on deposits (0.5 - 1.5%)
- High management stake (24%)
- Dynamic management
- Improving asset quality
- Above average risk of loan portfolio
- High non-interest expenses (high efficiency ratio)
- Rapidly increasing OREO-expenses
- High amount of OREO (3.6 % of total assets)
- Net interest margin increase triggered by higher interest rates
- Further improvement of asset quality allows levering up and increasing ROE
- SBA-loans are vulnerable for economic set backs
- Extremely slow disposal of OREO in New Jersey (up to 900 days)
One year later Parke Bancorp is still undervalued. As asset quality improves, this stock will eventually reach a P/NAV ratio of 1. Before the crisis the stock even traded at an average P/NAV of 1.5. There is still a 30% upward potential remaining. On the other hand the stock also remains cheap in respect to its earnings power (P/E 2014 = 9.7). This is still a long term buy.