The first signs are there that bank lending is rising again, a shift that could bode well for the economy in general. We think it could also be beneficial for community banks in the United States. More than five years after the financial crisis appeared and banks began booking massive losses, they are approving more loans to businesses that are seeking to grow.
Some evidence is already occurring, including:
- Banks nationwide had $287.6 billion in outstanding loans to small businesses as of Dec. 31, up 1.4 percent from a year earlier, according to the Federal Deposit Insurance Corp.
- A February survey by Pepperdine University's Graziadio School of Business and Management found that 39 percent of small-business owners who applied for bank loans in the previous three months were successful, up from 34 percent in a survey taken in October and November.
I ran a screener and after some initial research, we decided to buy shares of Premier Financial Bancorp (NASDAQ:PFBI) for our fund, RJT Capital. The investment thesis for this community bank is plain and simple: Premier is undervalued and is in the process of completing the purchase of Bank of Gassaway, which will be accretive to earnings.
More about Premier later on. First, I want to talk about why we think community banks should be part of a diversified portfolio.
The most exciting factor to invest in community banks is the big chance of a consolidation trend over the next few years. The U.S. seems to be overbanked and overbranched if you compare it, for example, with my country The Netherlands. There are 7,100 banks and almost 100,000 bank branches in the U.S., and more than 90% of those banks have under $1 billion of assets. Banks under $1 billion in assets, which is almost all of the banks in the country, are under a lot of cost and margin pressure. Most are not earning their cost of capital and have little prospect of doing so. So banks under $1 billion have higher expense ratios and lower profitability than those above $1 billion. And the only way out of it is through M&A activity, where the buyer gets cost efficiencies and greater market share.
According to a report of KPMG, M&A activity remains a powerful tool for growth and is likely to increase in the years to come.
The mergers and acquisitions "wave" that was widely expected to rush through the banking industry over the past several years amounted to something more like a ripple. There were 162 bank mergers in the United States through the first nine months of 2013, up from 111 in the first three quarters of 2011.
The chance that a community (regional) bank is snapped up by a competitor for 2x book value bodes well for your portfolio, that's why we think some exposure into this banking sector is not bad at all.
From the first 10-K filed in 1997, investors can get a great view of the history of the bank.
Premier Financial Bancorp, Inc. (the Company) was incorporated in 1991 under the laws of Kentucky and is registered under the Bank Holding Company Act of 1956, as amended. The Company only conducts business through the Banks and other direct or indirect subsidiaries. The Company was organized in connection with the reorganization of Citizens Deposit Bank and Trust Company, Vanceburg, Kentucky (the "Vanceburg Bank") into a holding company structure. The Vanceburg Bank is a banking corporation organized under the laws of Kentucky, resulting from the merger in 1930 of Deposit Bank, chartered in 1894, with Citizens Bank, chartered in 1903. In 1992, the Company acquired Bank of Germantown, Germantown, Kentucky (the "Germantown Bank"), a banking corporation organized under the laws of Kentucky in 1900. The Company in March, 1995 acquired Georgetown Bank and Trust Company, Georgetown, Kentucky (the "Georgetown Bank"), a banking corporation organized under the laws of Kentucky in 1988, and in October, 1995, Citizens Bank, Sharpsburg, Kentucky (the Sharpsburg Bank"), a banking corporation organized under the laws of Kentucky in 1903. On July 1, 1996, the company acquired Farmers Deposit Bancorp, Eminence, Kentucky ("Eminence") and indirectly, its commercial bank subsidiary, Farmers Deposit Bank, (the "Eminence Bank"), pursuant to an Agreement and Plan of Share Exchange dated March 4, 1996. At December 31, 1996, the Company had consolidated total assets of $292.6 million, total deposits of $235.6 million and shareholders' equity of $39.9 million. The Vanceburg Bank, the Germantown Bank, the Georgetown Bank, the Sharpsburg Bank and the Eminence Bank are herein referred to individually as a "Bank" and collectively as the "Banks".
Right now, Premier Financial Bancorp, Inc. is a multi-bank holding company that operates eight banking offices in Kentucky, five in Ohio, fourteen in West Virginia, four in Washington DC, two in Maryland and two in Virginia. At December 31, 2013, Premier had total consolidated assets of $1,100.2 million, total consolidated deposits of $924.0 million and total consolidated shareholders' equity of $146.9 million. The banking subsidiaries consist of Citizens Deposit Bank & Trust and Premier Bank.
Through the Banks, Premier Financial Bancorp is focused on providing community banking services to individuals and small-to-medium sized businesses. By looking to provide such banking services in non-urban areas, PFBI believes that it can minimize the competitive effect of larger financial institutions that typically are focused on large metropolitan areas.
Bank holding companies, such as PFBI, currently are required to maintain Tier I and total capital (the sum of Tier I and Tier II capital) equal to at least 4% and 8% of total risk-weighted assets, respectively. At December 31, 2013, Premier had a Tier I of 16.9% and total capital of 18.2%.
In addition, the Federal Reserve requires bank holding companies to maintain a minimum "leverage ratio" (Tier I capital to adjusted total assets) of 3%, if the holding company has the highest regulatory ratings for risk-based capital purposes. All other bank holding companies are required to maintain a leverage ratio of 3% plus at least 100 to 200 basis points. At December 31, 2013, Premier's leverage ratio was 11%.
Premier realized a net income of $13,229,000 ($1.49 per diluted share) during the year ending December 31, 2013, a 28.2% increase from the $10,323,000 ($1.24 per diluted share) reported for the year ending December 31, 2012.
The increase in net income in 2013 was largely due to a decrease in the provision for loan losses and a decrease in operating expenses when compared to 2012 results. These items more than offset a decrease in interest income and non-interest income.
Net interest income for the year ending December 31, 2013 totaled $43.695 million, compared to $43.999 million of net interest income earned during 2012, a decrease of $304,000, or 0.7%.
Total interest income in 2013 decreased by $1.965 million, or 3.9%, when compared to 2012, largely due to a $1.044 million, or 14.6%, decrease in interest income on investments and a $931,000, or 2.2%, decrease in interest income on loans. The decrease in total interest income was substantially offset by a $1.661 million, or 25.8%, decrease in total interest expense. The decrease in total interest expense was largely due to a $1.465 million, or 26.4%, decrease in interest expense on deposits as well as a $39,000 decrease in interest expense on FHLB advances at the subsidiary banks, a $53,000 decrease in interest expense on federal funds purchased and repurchase agreements, and a $104,000 decrease in interest expense on other borrowings at the parent company.
During 2013, Premier recorded a $375,000 negative provision for loan losses compared to $4.260 million of provision for loan losses recorded during 2012, which had the effect of adding $4.635 million to income before income taxes. During 2013, Premier received substantial principal payments and payoffs on loans classified as impaired which resulted in the direct reduction of the estimated required allowance on impaired loans. These reductions exceeded the estimated additional provision for loan losses needed to provide for the loan growth realized in 2013.
Net overhead costs (non-interest expenses less non-interest income) for the calendar year 2013 totaled $24.850 million compared to $26.751 million in the year 2012. The $1.901 million decrease in net overhead costs when compared to 2012 is largely attributable to a decrease in operating expenses partially offset by a decrease in non-interest income.
Non-interest income decreased by $202,000, or 3.1%, in 2013 when compared to 2012 as an $186,000, or 5.3%, decrease in service charges on deposit accounts and a $55,000, or 17.7%, decrease in income from selling mortgages in the secondary market was partially offset by a $38,000, or 5.8%, increase in other sources of non-interest income. More than offsetting the decrease in non-interest income, non-interest expenses decreased by $2.103 million, or 6.3%, in 2013 compared to 2012, largely due to a $661,000, or 26.3%, decrease in expenses related to foreclosed properties (other real estate owned "OREO"), a $769,000, or 65.1%, decrease in loan collection costs, and a $281,000, or 23.8%, decrease in professional fees. Other decreases in operating expenses include a $215,000, or 4.7% decrease in occupancy and equipment expenses, a $76,000, or 0.5%, decrease in staff costs, a $72,000, or 10.7%, decrease in intangible asset amortization and a $46,000, or 10.7%, decrease in supplies expense. These expense decreases were partially offset by a $19,000, or 2.8%, increase in taxes not on income and a $26,000, or 3.2%, increase in FDIC insurance expense.
Not included in net overhead costs, but certainly improving the net income for each year, Premier also realized $1.413 million of gains on early calls and sales of investment securities in 2013 compared to $545,000 in gains on the early call of two investment securities during 2012. Premier also recognized a $2.463 million gain on the sale of a loan on non-accrual status during 2012.
Total assets as of December 31, 2013 decreased by $20.6 million, or 1.8%, from the 1.121 billion of total assets at year-end 2012. The decrease in total assets since year-end 2012 is largely due to a $65.9 million decrease in investment securities that helped Premier to fund the $36.1 million, or 5.1%, of loan growth in 2013, the $6.6 million, or 0.7%, decrease in total deposits, the $14.8 million decrease in repurchase agreements and the $2.2 million, or 14.0%, decrease in outstanding borrowings at the parent company in 2013.
Total deposits decreased by $6.6 million in 2013 as an $18.7 million, or 2.5%, decrease in interest-bearing deposits was partially offset by a $12.1 million, or 6.1%, increase in noninterest-bearing deposits.
On the asset side of the balance sheet, liquid assets, such as cash, bank balances and federal funds sold, increased by $6.5 million, or 9.3%, as proceeds from maturing investments were temporarily held in liquid assets in anticipation of future loan growth.
Total loans outstanding increased by $36.1 million, or 5.1%, since year-end 2012. Beginning with the second half of 2012, Premier has experienced an increase in loan demand, particularly in the more resilient economic areas that Premier serves such as north central West Virginia and the Washington D.C. metro area.
Stockholders' equity of $146.9 million equaled 13.4% of total assets at December 31, 2013, which compares to stockholders' equity of $144.3 million, or 12.9% of total assets at December 31, 2012. The increase in stockholders' equity is largely due to the $13.2 million of reported net income during 2013, which was substantially offset by a $7.2 million, net of tax, decrease in the fair value of the investment portfolio available for sale. Premier also paid $3.5 million of common stock dividends and $600,000 of preferred stock dividends during 2013.
Premier's loan portfolio grew for the second year in a row, this year by over $36.1 million or 5.1% compared to December 31, 2012. At the same time, non-accrual loans decreased by $9.2 million, or 35.5%, to $16.6 million at December 31, 2013 following a $16.5 million decrease in non-accrual loans during 2012. At the same time, loans charged-off decreased from $3.2 million in 2012 to $909,000 during 2013 while recoveries of loans charged-off increased from $586,000 in 2012 to $823,000 during 2013.
Additionally, net operating cost improved as a result of carrying a lower level of problem assets. Non-interest expenses decreased by $2.1 million in 2013 when compared to 2012 results, largely due to a $661,000, or 26.3% decrease in expenses related to foreclosed properties and a $769,000, or 65.1%, decrease in loan collection costs.
Important Profitability Ratios: ROA and Net Interest Margin
Return on Assets (ROA): Net Income as a percentage of assets
ROA is a good measure of overall profitability for a bank because it removes the effect of leverage. The typical community bank generates an ROA of around 1.00%.
Premier's ROA in 2013 increased from 0.90% to 1.13%.
Premier's net interest margin for 2013 remained above peer level at 4.26% compared to 4.25% in 2012. The Net Interest Margin ("NIM") is net interest income as a percentage of average interest earning assets (annualized).
The NIM is the key to profitability for most community banks, and the primary driver of the NIM is a low-cost deposit base. Obviously, the higher the NIM the more profitable Premier will be, unless Premier gives too much of it back in the form of loan losses and excessive operating expenses. The size and the stability of the NIM are determined by several factors, including:
- The bank's mix of earning assets;
- Its sources of funds;
- Pricing competition;
- Its sensitivity to change in interest rates;
- The slope of the increasing NIM.
Given Premier's current mix of assets and liabilities, a rising interest rate environment would have a positive effect on the bank's results of operations, because it has more interest bearing assets than interest bearing liabilities. As you can see below.
A Devoted Acquirer
As mentioned in the investment thesis, Premier was in the midst of acquiring The Bank of Gassaway as announced in November 19, 2013. This week they finally completed the acquisition of the $172 million single bank holding company for $20.25 million in cash.
If we go back in history, we can see that Premier in late 2007 resumed a strategy of franchise expansion by acquiring and owning community banks. Premier's acquisition philosophy is to seek community bank candidates in primarily non-urban areas that can become a part of Premier on a non-dilutive basis within a two-year time frame. In evaluating acquisition opportunities, Premier conducts a due diligence review to determine both risks and earnings potential. Desirable candidates have an established base of community involvement, strong local directors, a history of earnings and readily identifiable asset risks. Acquisition transactions are structured to make a fair return on investment while meeting the needs of the shareholders of banks joining Premier.
Here are some of their acquisitions.
- October 24, 2007 - Citizens First Bank, Inc. - $60 million assets for $11,700,000 in stock and cash
- November 27, 2007 - Traders Bankshares - $108 million assets for $18,140,000 in stock and cash
- December 31, 2008 - Abigail Adams National Bancorp, Inc. - $436 million assets for $10.8 million in stock
All these acquisitions have been good for Premier's total asset expansion and has accordingly led to an increase in book value.
The only thing that lags behind is the share price, despite the fact that Premier's stock price has increased from $10.83 at the end of 2012 to $14.22 now.
Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, did a great job of presenting a list of current multiples in the banking sector. He used a combination of data from Morningstar, Bloomberg and Capital IQ.
More of his work can be seen here.
I used also a dataset from Reuters Eikon and made a comparison with the major banks.
I made also a comparison with regional banks in the same area and the same market capitalization range. For this dataset, I used Finviz.
One of the conclusions comparing all the gathered data is that Premier Financial Bancorp, Inc. is undervalued and could easily trade above its book value ($16.79). With an average of 1.3x book value for regional banks, Premier should be valued at $21.83.
Before I switch to my conclusion, I have a few additional thoughts on investing in community banks.
The U.S. banking industry can no longer cut its way to profit growth. After half a decade focused on managing risk, cutting costs, and meeting regulatory requirements, the banking industry must focus on growing revenues. One way to meet this goal will be through mergers, acquisitions, or joint ventures.
Patience is an Asset
Investing in community bank stocks often requires a great deal of patience. The valuation argument alone can take a long time. A catalyst of some sort is often required to get a bank's stock running towards fair value.
Premier Financial Bancorp is undervalued and has plenty of room to grow their franchise going forward. The purchase of the Bank of Gassaway will grow their franchise and will become immediately accretive to Premier this quarter. We expect more M&A activity from Premier at the end of this year or in the year 2015.
While Premier is not a near-term acquisition candidate, it could become one several years from now.
The pick-up in loan demand will bode well for Premier. In 2013, average loans already increased by 4.8% or $33.1 million, mainly in the D.C. Metro and Virginia market areas. We expect also a further decrease in the provision for loan losses that will lead to an increase in net income in 2014.
With a stock price of $14.22, Premier trades below their book value and offers investors a dividend yield of more than 3%. A conservative taxation of earnings per share of $1.60 for this year, gives the stock a P/E ratio of 8.89.
Interest rate risk: Premier's earnings and stock price could decline if the yield curve were to flatten for an extended period of time.
Economic risk: Premier's common shares would likely suffer if there were a meaningful economic slowdown in the areas where Premier's franchises are located.
Integration risk: Premier's stock could fall if it faces difficulties integrating The Bank of Gassaway.
Acquisition risk: Premier's stock could decline in value if it makes future acquisitions that are deemed by a majority of investors to be overpriced.
Analyzing and Investing in Community Bank Stocks, David B. Moore
Banking Outlook 2014: An Industry at a Pivot Point
Company's press releases
Dataset Damodaron, Stern School of Business at New York University
FDIC: Statistics on Banking
Disclosure: I am long PFBI. 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.
Additional disclosure: Dutch Trader is managing partner of RJT Capital, a Dutch-based investment fund in US-listed equities. RJT Capital is long Premier Financial Bancorp (PFBI).