Heritage Oaks (NASDAQ:HEOP) is a local bank that operates in the central coast of California. The company has 12 branches and employs 250 employees. The bank has posted strong results in the last 5 years and its market value increased greatly; however, the share price has been trailing the market because the bank issued a lot of new shares during the great recession, which caused a dilution. Now that the bank is in a much better shape than it was during the recession (and ready to pay-off its TARP bill), the bank should outperform greatly.
As I mentioned before, all of the bank's branches are located in the central coast of California. While the bank has a strong history in San Luis Obispo and Santa Barbara counties, it recently expanded into Ventura county for new growth opportunities. In San Luis Obispo, Heritage Oaks is the largest community bank and in Santa Barbara, it is the 3rd largest community bank. The bank is mostly focused on certain industries that are dominant in the central coast of California, such as hospitality, agriculture and technology. Also, keep in mind that the average household income in Central California is 25% above the average household income in the US, which means that the bank is located at a high-income area where there are a lot of opportunities.
Last year was a great year for Heritage Oaks. The bank passed not only its performance of the previous year, but also its performance before the great recession by a large margin. The figures shown in the chart below are adjusted for the bank's deferred tax valuation allowance. In 2012, the bank's total net income was $13 million which is an all-time high for the bank.
The bank's loan production has been very strong, as it achieved an 86% year-to-year growth in this metric in the last quarter. The economy in Central California recovered at a much faster rate than many different parts of the country and the bank should continue its strong performance unless another recession hits the country which is not likely at the moment.
Even though the company is mainly focused on a few dominant industries in the local market, its loan portfolio is pretty diversified. For example, if we look at the loan distribution by customer type, we see that the distribution looks a lot like the market distribution in the area. More than half of the loans were originated to service and hospitality customers, which represent more than half of the economic activity in Central California. Also, it is important to note that more than half of the loans (54% to be exact) issued by the bank were backed by commercial real estate.
Even though the loans of the bank have been increasing at a rapid rate, its loans-to-deposits ratio is still a healthy 79%, which allows for plenty of room for further loan growth. Just a couple of years ago, the bank's loan-to-deposits ratio was 85%. Since the fourth quarter of 2011, the bank's loan portfolio has been growing consistently while the loan-to-deposits ratio has been coming down.
Of course, these results were a consequence of constant deposit growth achieved by the bank. As the economy in the area improves, the local people and businesses have more money to put in their savings accounts. Keep in mind that the amount of deposits would have been a lot higher if it wasn't for the ultra-low interest rates. People are less likely to put their money in savings accounts if they don't believe that their money will grow in these accounts.
In 2011, the cost of deposits was low to begin with, but in 2012, they became even lower as the Fed is committed to keep interest rates as low as possible in order to stimulate the overall economy and the real estate market. The current rates of the deposit costs are near all-time low. Currently, the total cost of deposits is 0.36% down from 0.56% in 2011.
As the bank's assets are increasing in quantity, they are also increasing in quality. The amount of low-quality assets in the bank's portfolio has been consistently falling. As of the end of last year, the bank's low-quality assets represented 35.4% of Tier I Capital + ALLL which used to be at nearly 70% 2 years ago.
The amount of non-performing assets, as well as the rate of non-performing assets to all assets was also on the decline recently for Heritage Oaks. In the fourth quarter of 2010, the amount of non-performing assets totaled $40 million whereas the number is as low as $17 million as of the last quarter. Again, in the fourth quarter of 2010, the rate of non-performing assets to all assets was 4.0% which is around 1.5% today. The less non-performing assets a company has, the more extra money it will have in its reserves, which can be passed to the investors in shape of dividends and buybacks over time.
The company's current liquidity is very strong and impressive. The current rate of liquidity at Heritage Oaks is 36%. This represents the rate of liquid assets to deposits and short-term liabilities. The current rate also represents an all-time high for the company. The bank isn't likely to have any liquidity problems for the foreseeable future regardless of the Fed's short-term policies.
The bank's investment portfolio is highly diversified in composition but not much diversified in terms of quality. As you can see in the charts below, a large majority of the bank's investments are in top rated items. Currently, AAA rated agencies represent 66% of the company's investment portfolio and those rated between AA+ to A represent another 32%. The bank's investment in junk bonds is very minimal at 0.11%.
Regardless of whether we exclude or include the deferred tax allowances for the bank, its return on assets ratio has been increasing in the last year. As the bank's total assets jumped from $980 million to $1.08 billion in the last 2 years, its return on assets ratio jumped from 0.25% to 1.17%.
Similarly, the bank's book value has been increasing every quarter in the last 2 years. During this period, the bank's book value per share jumped from $3.33 to $4.27 while its return on equity jumped from near 0% to 11%.
The bank's institutional ownership rate is 74% and the top 11 institutional holders account for 68% of its outstanding shares. This represents a lot of institutional support for the company.
In conclusion, the bank's desirable geographical location, strong liquidity and cash position, ever-improving book value, improving quality of assets and increasing return on assets makes it a strong "buy" candidate. As the bank expands into Ventura county and possibly new locations, its position will improve further.
Keep in mind that the banking industry is risky by nature and small cap stocks tend to carry more volatility and risk than larger companies. Investors should do their homework and learn about the companies they are investing in great detail. Investors should also assess their risk appetites to determine how much risk they can tolerate in their portfolios. Remember, there is no such thing as safe investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.