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We take pride in our track record of identifying threats and business model risks that other investors may be missing. A handful of stocks that we have analyzed on Seeking Alpha have experienced significant declines (PCBC down 82%, HUSA down 36%, and JTX down 70%). We have chosen our profiles carefully, focusing on companies that are severely mispriced and possess risks that have gone unnoticed. We believe we have identified another stock that is not what it seems.

City Holding Company (NASDAQ: CHCO) of West Virginia is a bank that is perhaps the most egregious perpetrator of a nasty trick being played on US retail depositors. We do not believe it is an exaggeration to describe CHCO as a glorified payday lender operating under the umbrella of a bank charter. We believe the stock will face significant earnings and multiple compression, and believe current investors face greater than 40% downside from current levels. It is our hope that by highlighting our concerns, other investors can make better informed decisions as it relates to an investment or short position in CHCO.

Overdraft Background
Bank overdraft and insufficient fund fees (which we will refer to as “overdraft”) penalize customers for taking a greater amount of money out of their account than their account balance. It is not uncommon for a single overdraft to have annual percentage rates [APR] that exceeds 1,500%. Unsavory overdraft practices are currently in the cross hairs of regulators and politicians. We expect a new Federal Reserve rule that becomes effective in July to be the first step in reducing and eliminating these fees. Overdraft is practically a 100% margin revenue item for banks, and the banks that earn a disproportionate amount of income from these fees are going to face significant headwinds.

It is our opinion that allowing customers to overdraft their account until their next paycheck is deposited, and then charging them a very steep fee for this privilege, is no different than controversial payday loans. While payday lenders have long been attacked for their APRs, banks typically charge dramatically higher interest rates than payday lenders. Payday lenders typically charge 300-350% APRs for a relatively high-risk loan. A bank that charges a $32 fee to a customer that overdrafts his account by $100 for one week earns a 1664% APR for a very low-risk loan. If the $100 in overdraft was generated by more than one transaction, the fees and implied interest rate multiply.

The policies of most banks are even more insidious than what we just described. Many banks have set up their software so that if multiple checks, debit card, or ATM transactions occur in a single day, the transactions are processed in the order of the highest dollar amount to the lowest. Management teams have argued that they process the largest transactions first because they assume these are the most important transactions for their customers. This argument is completely specious because banks are not actually denying any transactions. They are clearing all of the transactions so that they can charge multiple overdraft fees to a single customer on a single day. The fact is that the order in which most banks process transactions is in place for one purpose… to maximize fees charged to their customers.

City Holding Company (CHCO)
To determine which banks are most reliant on these fees, and who is the most aggressive with overdraft, we screened deposit fees as a percentage of revenues and deposit fees as a percentage of non-CD deposits (transaction accounts). Most banks do not disclose specific overdraft fees, but it is reasonable to assume that in the era of “free checking,” the majority of deposit fees represent overdraft charges.
CHCO not only tops the lists of overdraft fee generators, but does so by a wide margin. By our estimate, City Holdings generates 60% to 70% of earnings from overdraft (see table 2 below). Shockingly, CHCO is currently generating a 6% yield on its retail deposits and a 4% yield on its transaction accounts (see table below). Said another way, CHCO is currently generating a higher yield on their deposits (a liability!) than their assets. We researched 140 banks and discovered that the service fee to average transaction account balance was less than 1%. We found two other banks that generated roughly 3% of fees, while no other bank was over 2%. CHCO was a startling outlier and appears much more reliant on deposit fees than any other bank in the country.
Table 1
200720082009
CHCO service fees$44,416$45,995$45,013
Average checking accounts727,852715,413752,409
Service fees % average checking accounts6.1%6.4%6.0%
Average non-CD deposits1,063,6931,068,1941,119,833
Service fees % average non-CD deposits4.2%4.3%4.0%
Average non-CD deposits - all banks 0.94%
Source: Company Filings

Given the huge amount of fees relative to other banks, we can only assume that CHCO is using the most aggressive and potentially deceptive tactics in the industry to promote overdraft. Our industry research suggests such unsavory practices could include: high per incidence fees, an unlimited number of fees per day or month, ordering of transactions from highest to lowest, and overstating account balances due to bounce or overdraft “protection.” CHCO’s depositor base also plays a significant factor (a point that seems to be front and center with new regulations). Banks located in lower income geographies typically have a higher than average proportion of low balance checking accounts that have a much higher propensity to overdraft.

In the Crosshairs of Regulators and Legislatures
So why will these abuses change? First, starting on July 1,2010, a new Federal Reserve regulation (known as Reg E) goes into effect that significantly alters overdraft fees. The new rules require customers to positively opt-in to an overdraft program in order for banks to charge them fees. We believe banks will have little success convincing the right customers to opt-in. The type of bank customer that regularly racks up multiple overdraft and insufficient funds fees is not the type of customer that religiously opens and balances their bank statement. The prospect of these customers proactively reading and signing a piece of paper “opting-in” before dutifully mailing the signed form back to the bank so that they can continue to charge the high fees is very low.

The new Fed rules are likely to have a material effect on this high margin revenue item, but we believe the new rules are just the tip of the iceberg. The sweeping financial regulatory reform currently being debated in Congress could be signed into law within the next month. Following the creation of a consumer finance protection agency [CFPA], we believe the curbs in overdraft will become even more severe. Overdraft and order checking is the type of behavior that the CFPA will likely target. Regulators and legislators have aggressively targeted payday loans, and we believe overdraft fees are significantly more usurious. While overdraft could be banned entirely, at the very least we believe restrictions on the number of charges a customer can incur, a cap in per incident charges, and a change in transaction process ordering policies are very likely. It is hard to imagine this area of future policy receiving much opposition.

Some banks are proactively changing their overdraft policies. In March 2010, Bank of America (NYSE:BAC) announced it was eliminating overdraft fees. On a conference call in mid April, Bank of America implied that changes in their overdraft policy and Reg E will cost the bank $3 billion in fees annually. JP Morgan (NYSE:JPM) has also adjusted their overdraft policies and expects to lose $500 million “after-tax” in fees. While these lost revenue sums are massive, they do not represent material sums for each bank’s overall income statement. The same cannot be said for CHCO.

Impact on CHCO

We believe CHCO’s overvalued stock could unravel for two reasons. These two risks, lower earnings [E] and multiple contraction (P/E), could occur in tandem, which would lead to a much lower “P”. First, we see significant earnings risk that investors have ignored, so far. Analysts and investors appear to be assuming that future monthly maintenance fees will offset the gaping hole that would be created from the reduced overdraft fees. We believe this will be very difficult for CHCO to implement because overdraft fees are primarily generated by a very small percentage of depositors (14% according the FED).
Complicating any plans for deposit fees is the fact that CHCO operates in a very competitive environment for deposits. In West Virginia, BB&T (NYSE:BBT) has the highest deposit share, while CHCO is a distant fifth. Competing banks, including JP Morgan and BB&T, would aggressively market to CHCO’s disgruntled customers should they start charging their “good” depositors to try and offset the loss of revenue from serial overdrafters. If we are correct and new regulations change the rules on overdraft, the hit to CHCO’s earnings could be dramatic.
Under the draconian scenario, we assume that overdraft is banned and CHCO’s earnings from overdraft fall to zero. Under this scenario, CHCO’s earnings power falls below $1.00 per share, a level that may only support an $11 to $13 stock price. In the second scenario, we assume CHCO is able to generate service fee revenues of 1% of transaction accounts. This level is inline with the average bank today (although regulations should pressure this level going forward) and assumes maintenance fees without deposit share loss (so a conservative estimate). Under this scenario, earnings would have been 40% to 85% lower the past three years (see Table 2). On a go forward basis, earnings power at the bank falls below $1.50 per share.
Surprisingly, current analyst estimates expect earnings to accelerate in the second half of 2010 and continue higher in 2011. While deposit fees are not the only component of earnings, they are certainly one of the most important drivers for CHCO. With upcoming changes to overdraft, we believe CHCO’s future earnings will be significantly lower than investors and analysts expect.
Table 2
200720082009
CHCO Today
CHCO service fees$44,416$45,995$45,013
CHCO pretax earnings76,81237,59663,178
% margin on service fees **assumption**92%92%92%
Earnings from service fees40,86342,31541,412
% pretax from service fees53%113%66%
EPS$3.01$1.74$2.68
P/E10.8x18.7x12.1x
CHCO - Service Fees at Industry Average
Service fees 1% of transaction accounts$10,637$10,682$11,198
% margin on service fees **assumption**92%92%92%
New pretax earnings45,7355,10832,069
EPS adjusted$1.79$0.24$1.36
New P/E18.1x137.6x23.9x
% earnings decline-40%-86%-49%
Source: Company filings and assumptions

The second driver for the lower stock price will be multiple contraction. As investors begin to understand the risk to CHCO’s primary income driver, the multiple on these destabilizing earnings stream will also contract. CHCO trades at 200% of its tangible book value of $16.11, which is one of the highest multiples of all US banks. A better comp group for CHCO’s multiple would be the payday lenders, given their similarities. There is a reason that payday lenders trade at 4-5x earnings. While payday is a highly profitable business, it operates under the constant threat of regulatory and legislative changes that could severely alter the profit model with little notice.
We know for a fact that Reg E will go into effect on July 1st for banks and can only assume that Congress and the CFPA will follow-up with additional restrictions. It seems logical that CHCO should trade at a multiple that better reflects the looming threat to its profit model. However, investors appear to lack an understanding of the true drivers of their profit model – a fact that we hope to clarify. Even if CHCO maintains its current earnings multiple, at 12 times our scenario two earnings estimate of $1.50, the stock could fall 45% from current levels. CHCO should be commended for maintaining solid capital and credit through a difficult banking cycle. However, we believe it is a business model that faces future impairment and uncertainty. As a result of future earnings revisions and multiple contraction, we believe shares could face at least 45% downside from current levels. And as we have seen in financial services stocks over the last two years, it is better to be out early before earnings risks materialize and stocks face massive selling pressure.

Disclosure: Short CHCO

Source: Glorified Payday Lender City Holdings: A Wolf in Sheep's Clothing