- We view the small-cap bank sector as a secular growth story.
- Despite a strong capital position and attractive credit metrics, PBIP trades below 80% of tangible book value.
- A number of shareholder-friendly catalysts exist; expect a share repurchase announcement in Q4 2014.
Community Banks Are Long-Term winners
The Hemlock team remains extremely bullish on community banks. We believe the entire sector has and will continue to benefit from four key trends over the next several years -- improving credit, loan growth, higher interest rates, and consolidation. However, we prefer the neighborhood banks vs. the national players for two reasons.
First, generally speaking, the smaller firms maintain relatively straightforward balance sheets, avoiding many of the elaborate, hard-to-assess assets and liabilities that are typically present at the national institutions. In essence, we believe the community banks are more transparent; and therefore, provide us greater confidence in the reported book value, and ultimately, are easier to value.
Second, when evaluating real estate, we believe there is significant value in local market knowledge and only the community banks can consistently provide this level of expertise. As loan growth increases across the sector, we are betting on the local operators to select the best performing investments.
To ensure we are able to capitalize on this secular growth story, the Hemlock team follows 47 of the most attractive community banks in the United States. We have developed a proprietary system to rank each bank stock based on its five-year appreciation potential. As we mentioned in our March article ("Sell SWS Group, Better Opportunities Abound"), one of our favorites is Prudential Bancorp (NASDAQ:PBIP).
With a market cap of $100 million and $525 million in assets, PBIP operates as the holding company for Prudential Savings Bank. Founded in 1886, the bank serves the Philadelphia region via seven local branches. The business model consists of taking deposits from the general public and investing those funds primarily in single-family residential mortgages.
Over the last 12 months, PBIP's asset quality has approved dramatically and now is at elite levels. The non-performing assets to total assets ratio totaled 1.3% in the most recent quarter vs. 3.0% a year ago. In October, the bank completed its second-step conversion, making it a fully public institution. The demutualization process raised plenty of capital, which creates both near- and long-term catalysts.
With a tangible equity to asset (TE/A) ratio of 25%, PBIP is overcapitalized relative to our coverage universe (average TE/A ratio of 14%). The substantial liquidity is critical to driving shareholder value as it provides the wherewithal to pay dividends, repurchase shares, and ramp loan growth. Trading at 78% of tangible book value, we expect PBIP to begin repurchasing shares in the fourth quarter of 2014. By law, the company must wait one year from completion of the demutualization to begin to buy back shares.
At the current valuation, every share repurchased will be immediately accretive. As we inch closer to year end, the multiple will increase as the market anticipates a stock buyback announcement. The combination of actual repurchases and the multiple boost should provide a double-digit return over the next six to eight months.
With a multi-year investment horizon, the return potential looks even better. We expect PBIP to follow the path of so many other shareholder-friendly demutualized banks. The company will continue to repurchase shares as long as they trade well-below tangible book value.
Subsequently, PBIP is likely to issue a dividend, attracting a whole new group of investors willing to award the bank a healthier valuation multiple. The combination of dividends, stock repurchases, and multiple expansion is quite likely to please long-term equity holders who purchase shares at current levels.
Two to three years down the road, we view the acquisition of PBIP as a very realistic possibility. As we mentioned in February ("Here Comes the Sun (Bancorp)"), the banking community is in the midst of a challenging situation. Despite a low net interest margin environment, there are limited organic growth opportunities available. Furthermore, rising compliance costs are encouraging banks to increase assets, thereby spreading the expense over a larger base. As banks look to expand, the most logical approach is to acquire smaller peers.
For an acquirer, PBIP offers tremendous excess capital and a high-quality portfolio in the robust Philadelphia market.
PBIP is one of the most attractive banks in our coverage universe. Despite a strong capital position and attractive credit metrics, the company trades at just 78% of tangible book value. Due to its small market capitalization, PBIP is anonymous to most investors and therefore perfect for the value-centric individual investor.
Disclosure: I am long PBIP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.