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This article describes why I believe a recent decline of over 20% in the stock price of CVB Financial (NASDAQ:CVBF), a California bank, may create an excellent investment opportunity. This article discusses the economics of the business of lending, describes CVB Financial's low cost of loans and conservative lending practices, describes how CVB Financial has been able to maintain profits despite deterioration in its loan portfolio, and explains why CVB Financial may be undervalued. The article goes on to explain the flaws in the short sellers’ arguments, reasons why the SEC subpoena may not lead anywhere, and why the resolution of the SEC subpoena may serve as a catalyst for an increase in the perception of CVB Financial's value.

Economics of the Business of Lending

The two most important factors to a bank's success is the bank's cost of funds and the bank's lending criteria. The cost of funds is important because the bank's profit is a function of the difference between the rate it pays to obtain funds and the rate it pays to lend the funds out. The lower the rate the bank pays to obtain funds, the more potential the bank has to have a larger spread and higher profits. The lower cost of funds also gives the bank the ability to price its loans competitively.

The bank's lending criteria helps reduce loan losses. Conservative lending criteria increases the likelihood that the bank will be paid back on its loans. Conservative lending criteria also minimizes the losses the bank does suffer when defaults do occur, as recoveries from collateral and other security is maximized.

Consequently, banks that have a low cost of funds and conservative lending criteria tend to do well, while those that either have a high cost of funds or lax lending criteria tend to go out of business.

CVB Financial is an Excellent Bank, Having a Low Cost of Funds and Conservative Lending Standards

CVB Financial has a long history of a low cost of funds. Currently, CVB Financial's cost of funds is 1.07%, near the lowest of any bank in the industry. Generally, a low cost of funds results from a high percentage of noninterest bearing accounts, usually checking accounts. 35% of CVB Financial's deposits are noninterest bearing, which is near the highs for any bank. This base portends well for CVB Financial's future cost of funds.

CVB Financial also has a long history of conservative lending standards, resulting in loan losses over its history that total less than 1/10th of 1% of total loans. CVB Financial's borrowers tend to be relatively solid, stable small businessmen. CVB Financial's loans are generally 65% to 75% loan to value. This means that the properties securing the loans can drop 25% to 35% in value and CVB Financial will still only suffer small losses if the loans default. CVB Financial often requires additional security or guarantees, particularly on larger loans.

One consequence of conservative lending practices is that CVB Financial completely avoided subprime loans. That is correct - CVB Financial did not make any subprime loans, not a single one. Additionally, CVB Financial made very few residential construction loans, another type of loan sustaining large loan losses. CVB Financial's loans of this type total less than 1% of its total loans.

CVB Financial has a long history of low cost funds and conservative lending standards, resulting in: (1) over 130 consecutive quarters of profit and 84 consecutive quarters of dividends (the dividend is currently 4.5%); (2) deposit growth in the past decade of almost 300%, from $1 billion to $3.9 billion; and (3) loan growth of almost 400%, from $1 billion to $3.9 billion. For the past 30 years, the Findley Report has ranked CVB Financial as a Super Premier Performing Bank for 19 years and a Premier Performing Bank for 11 years.

Despite Deterioration in Its Loan Portfolio, CVB Financial Has Been Able to Maintain Its Profits, Repay TARP, and Acquire another Bank, Resulting in Recognition by Industry Experts

CVB Financial has managed to maintain its profits during the downturn and repay TARP Funds. Although down from its record net profit of $70 million in 2006, CVB Financial still managed to record net profits of $60 million, $63 million and $52 million in 2007, 2008, and 2009, respectively. As a result, CVB Financial was able to quickly repay the TARP funds in 2009 that it received in 2008. Furthermore, in 2010, CVB Financial is on pace to record net profit of $70 million, matching its record high in 2006.

These profits have been maintained despite CVB Financial also reporting deteriorations in its loan portfolio due to the difficult economic environment. In the 3rd quarter, CVB Financial expects to report nonperforming loans of $142 million on $3.6 billion worth of loans, charge-offs exceeding $34 million, and loan loss reserves of $106 million. However, these numbers are still very low compared to industry averages. Also, these are record or near record highs for CVB Financial because CVB Financial has had little to no nonperforming loans, loan losses and loan reserves in previous years.

CVB Financial's loan deterioration has been offset by its record low cost of funds and its acquisition of another bank on favorable terms. As discussed earlier, cost of funds is the most important factor in a banks’ potential for success and CVB Financial has a very low cost of funds, currently 1.07%. CVB Financial's low cost of funds has always been relatively low due to having a high percentage of noninterest bearing deposits, currently at 35%. However, the cost of remaining funds, comprised of interest bearing deposits and loans to CVB Financial, has steadily dropped the past several years due to the steadily dropping interest rates.

CVB Financial's profits for 2010 are also aided by an FDIC assisted acquisition of a bank in late 2009 under favorable terms. CVB Financial acquired $540 million in deposits, $489.1 million in loans, $124 million in borrowings, and $25.3 million in investment securities. After an initial loss of $26.7 million, the FDIC has agreed to absorb 80% of the losses up to $144 million and 95% of the losses in excess of $144 million for 5, 8 or 10 years, depending on the type of loan.

This outstanding performance by CVB Financials in recent years has been recognized by industry analysts. Forbes recently ranked CVB Financial as the 6th best bank in America. Bank Direct recently ranked CVB Financial 9th. BauerFinancial Reports’ last rating for CVB Financial gave it a 5 star rating for 2009.

CVB Financial Currently Appears Undervalued

As a result of the drop in its stock price after the SEC subpoena, CVB Financial appears to be undervalued. Currently, the stock price of CVB Financial is about $7.85. A reasonable estimate for the stock price is $10.30 to $11.80, based on a valuation of between $1.1 billion and $1.26 billion, which would provide a return between 30% and 50%. This valuation would be based on applying a P/E multiply of 15 to a reasonable estimate of 2011 net profits of $74 million to $84 million. The 2011 net profits are based on an estimated pre-provision, pre-tax net income of between $120 and $140 million, discounted by an estimate of 10% for losses and subtracting 33% for taxes. Furthermore, the stock price of CVB Financial will be worth over $14.00 based on a P/E multiple of 15 if net profits are approximately $100 million, as this author believes is possible within the next several years. If this estimate is current, CVB Financial has upside potential of nearly 80% over the next several years.

Positive Resolution of the SEC Subpoena May Be a Catalyst for Increasing Valuations of CVB Financial

Since the stock price of CVB Financial dropped over 25% after the announcement of the SEC subpoena in August of this year, the resolution of the SEC subpoena may be a catalyst for a return to the prior valuation of CVB Financial. As the prior stock price was $10.30, this would be over 30% increase from the current price of approximately $7.85.

The SEC subpoena requests information regarding CVB Financials loan underwriting guidelines, and loan loss calculations, as well as presentations given by the bank at conferences. It is unlikely that the SEC will find much, if anything, wrong with CVB Financial's activities in these matters. As described above, CVB Financial has conservative lending practices and has historically had very low loan losses.

Furthermore, CVB Financial seems to have survived 3 recent inspections by the FDIC fairly well. The FDIC examined CVB Financial in connection with providing it with TARP Funds, found it satisfactory enough to provide TARP funds to it, which CVB Financial repaid quickly. The FDIC also examined CVB Financial in connection with its’ acquisition of San Joaquin bank in late 2009. The FDIC found CVB Financial satisfactory to assist in the acquisition and agree to a substantial loss sharing provision. Finally, the FDIC recently completed its annual inspection of CVB Financial. If there were problems, revisions in CVB Financials’ subsequent financial reports would be expected and there were no such revisions.

It is unlikely that the SEC will discover something that the FDIC missed in these inspections, particularly considering CVB Financials’ long history of excellent performance.

Short Sellers’ Arguments Appear Flawed and the SEC Subpoena Will Likely Not Lead Anywhere

Short Sellers have been targeting CVB Financial for well over a year. The results had been disastrous, with the short sellers watching the stock price steadily rise. However, the short sellers’ fortunes recently changed as the stock price has dropped about 23% since the announcement of the SEC subpoena in August. Indeed, the belief is that the SEC subpoena was a result of vociferous complaints by short sellers to the SEC.

Short sellers contend that CVB Financial must be greatly understating the deterioration in its loans as CVB Financials’ reported deterioration is not nearly as severe as industry averages despite being located in one of the hardest hit areas, the Inland Empire in Southern California. Short sellers can’t believe that CVB Financial can be performing as well as reported when two of its largest competitors in the region, Vineyard Bank and Temecula Bank, both declared bankruptcy in 2009. Short sellers contend that CVB Financial has lax loan standards and point to problems with the loans of CVB Financial's largest borrower, the Garret Group, as an example of problems that it believes are endemic to CVB Financial's loan portfolio.

However, short sellers seem to have ignored the differences that could account for CVB Financial's superior performance. Short sellers seem to have ignored the fact that CVB Financial avoided any exposure to the worst type of loans, the subprime loans. Short sellers seem to have ignored that CVB Financial limited its exposure to another type of loan suffering extensive losses, real estate construction loans. Short sellers seem to have ignored that CVB Financials’ loans usually require 65% to 75% loan to value.

Short sellers argue that CVB Financial's reported nonperforming loans are too low to be true considering the difficult economic circumstances. However, short sellers seem to ignore that CVB Financial has historically had very low nonperforming loans compared to industry averages. Short sellers seem to ignore that CVB Financial's current nonperforming loans appear to reflect the current difficult environment because they are very high in comparison to CVB Financial's own historical averages.

Short sellers may be right that there will be further deterioration in CVB Financial's loan portfolio. However, short sellers seem to ignore CVB Financial's ability to absorb further loan losses as a result of its large cash position and its’ earning power. Short sellers also appear to overestimate the potential loan losses by underestimating the value of the collateral. For example, short sellers have called the Garret Group loans worthless, when current bidders are offering 50% to 60% for the loans and CVB Financial has additional security and guarantees on the loans to cover losses. As a result, CVB Financial's charging off of $34 million on a total of $82 million in total loans appears very reasonable.

This Short Seller Attack Appears Similar to the One against Fairfax Financial and May End Similarly

Several years ago, short sellers targeted Fairfax Financial for over a year with poor results, watching the stock price rise. Anonymous websites appeared criticizing Fairfax Financial (OTCQB:FRFHF), as has happened with CVB Financial. Writers Gretchen Morgenson of the New York Times and Peter Eavis of the Wall Street Journal both wrote articles questioning the company’s performance through innuendo but without many facts, as they have concerning CVB Financial. The SEC then served several subpoenas on Fairfax Financial, after which the stock price plummeted nearly 50%, similar to CVB Financial's being served with an SEC subpoena and then seeing its stock price plummet.

While short sellers tend to do very good analysis and are often right, they appear to have been mistaken with regards to Fairfax Financial. Since its stock price dropped after receiving the SEC subpoenas in 2004, Fair fax Financial continued to perform well, increasing its revenue and net income year after year. As a result, Fairfax Financial has seen its’ share price rise 800% from the lows after receiving the SEC subpoenas. The SEC finally dropped its investigation into Fairfax Financial in 2009, without filing any charges.

While it is unlikely that CVB Financials share price will rise quite as dramatically as Fairfax Financial's has, it is likely that short sellers are also mistaken with regards to CVB Financial. It is expected that CVB Financial will continue to perform well over the long term and will increase its’ revenues and net profits over time. If CVB Financial is able to deliver this performance, it may ultimately be recognized in its share price.

Disclosure: Long CVBF

Source: CVB Financial: A Business You Can Bank On