We recently pointed out
our belief that a speculative bubble had formed in small cap E&P stocks. We now believe the same speculative capital is chasing small cap distressed banks.
Examples can be seen with the stocks of Dearborn Bancorp (NASDAQ:DEAR
), Banner (NASDAQ:BANR
), and Preferred Bank (NASDAQ:PFBC
). Possibly the most mind boggling example is Pacific Capital (NASDAQ:PCBC
). Pacific Capital is up over 400% year-to-date and is the best performing stock in the Russell 3000. The stock has been up 18 of the last 19 trading trades and is up over 225% since their auditors issued a “going concern” qualification in their 10-K a little over a month ago.
Despite the strong move, the bank continues to face the crippling combination of high problem loans (8% NPAs to Loans) and extremely low capital levels (2.4% TCE) and a Texas ratio of 97% at December 31, 2009. In addition, the company is currently in default of its TARP loans and has been in violation of its regulatory agreements with the OCC and the Federal Reserve Board for over a year. Incredibly, Pacific Capital is trading ABOVE its tangible book value per share of $3.82 per share. Banks with similar credit, capital and liquidity issues as PCBC are trading at 40 to 60% of tangible book value (see below).
With the euphoria of the strong move in distressed banks, investors have bought first and asked questions later. We believe PCBC investors should have asked more questions up front. We expect concerns about credit and their ability to issue massive amounts of equity capital could result in a violent correction in PCBC shares. As a “best case” scenario near term, we believe investors face massive dilution and 50% downside. As a worst case scenario, PCBC will not be able to access capital and could be taken over by the FDIC (not our belief, but it is possible outcome). With its 10 day average daily volume of over 3 million shares, its roughly 3 days to cover ratio is one of the lowest in financial services.
In early November 2009, we correctly predicted that PCBC’s regulators would not allow the bank to operate its tax business (we also predicted JTX could face bankruptcy—down 65% since—and HRB could be a beneficiary
. PCBC’s tax business was their most profitable business and generated a significant percentage of earnings. However, under the gun of the regulators, the bank had to sell the business at a fire sale price of only $10 million to the private equity firm Platform Partners.
Based on the stock momentum, we believe investors expect PCBC to beat consensus estimates when it announces earnings on April 29, 2010. According to FirstCall, consensus expectations are $0.16 per share. However, despite taking their $10 million gain from the sale of the tax business, we expect PCBC to lose a substantial amount of money. This will pressure capital levels further and be a major shock to investor expectations. We believe PCBC will continue to struggle on credit with their $1.9 billion commercial real estate portfolio and their $400 million construction portfolio. Without the tax business, PCBC operates a bank that has struggled to be profitable and needed to reach for low quality construction and commercial real estate loans out of their footprint (i.e. Nevada, Arizona, and the Inland Empire). We do not believe the bank has addressed these issues fully yet.
According to PCBC’s 10-k, the company is on a short leash with bank regulators. PCBC entered into a memorandum of understanding with the OCC on April 16, 2009—over a year ago—and has shown little progress in complying with the order. PCBC’s capital levels have been below the agreed upon levels since June 30, 2009! Under the MOU, PCBC agreed to maintain a minimum Tier 1 leverage ratio of 9.0% and a Total Risk Based Capital ratio of 12.0%. At December 30, 2009, PCBC was significantly below those levels at 5.5% and 10.7%, respectively. To get to a 9% Tier 1 leverage ratio, PCBC needs to raise $275 million to $300 million of equity capital just to comply with the MOU. We believe the company will need a substantial margin to absorb future losses and provide a cushion. This type of capital raise could likely leave today’s equity with little value.
With little institutional support, we believe PCBC will have a difficult time raising that much capital. PCBC’s top seven shareholders are either index funds (Vanguard, Blackrock, State Street, Northern Trust) or quantitative funds (Dimensional and Renaissance). In addition, with such a large capital raise, the large change in ownership percentage would mean that their deferred tax asset could not be utilized in the future.
PCBC’s liquidity situation has been so poor that it has been in default of its TARP payment since May 2009. If PCBC misses the next two payments, the Treasury has the right to elect two representatives to the Board of Directors.
On March 12, 2010, PCBC’s auditors issued a “going concern” qualification in their 10-K
, stating: “The Company has recently incurred significant operating losses, experienced a significant deterioration in the quality of its assets and become subject to enhanced regulatory scrutiny. These factors, among others, were deemed to cast significant doubt on the Company’s ability to continue as a going concern. If the Company cannot continue to operate as a going concern, it is likely that shareholders will lose all or substantially all of their investment in the Company.” Since that time of this dire warning, the stock has more than doubled.
The table below highlights some bank comps to PCBC. KeyCorp (NYSE:KEY
) trades at a discount to PCBC despite significantly better capital, liquidity and credit. Banks with similar credit, capital and liquidity issues are trading on average of 40 to 60% of tangible book value. At this multiple, PCBC has downside to $1.50 to $2.30 per share.
We believe it is highly unlikely that PCBC will be acquired (unless in an FDIC-assisted transaction). In a deal, an acquiring bank would not only have to pay $230 million market cap, but also need to infuse over $300 million into PCBC’s banks, take on over $400 million of non-performing assets, repay missed TARP payments and be on the hook to pay back $180 million of TARP. To our knowledge, there has not been one acquisition of a distressed bank in a non-FDIC deal, and do not expect PCBC to be the first.
Another option for PCBC is to shrink by selling loans or branches. We believe these options are not viable without selling assets at a substantial loss. Given the capital hole PCBC currently has, absorbing additional losses could create a larger capital hole for the company.
Finally, the tax business had historically been the major driver of earning. In 2005 through 2007, PCBC averaged 0.75% ROA in the second through fourth quarters (so excluding the tax business results in tax season in first quarter). Assuming PCBC shrinks to $7 billion assets and can reach this “normalized” ROA in two to three years, we believe earnings power could be $0.30 per share (assuming a capital raise of $300 million to recapitalize the bank and an additional $180 million to pay off TARP raised at book value). If PCBC must raise capital at more distressed levels of $2.00 per share (in line with comps), its earnings power falls to $0.18 per share. So today, the stock trades at 15 times or 25 times what could be the peak earnings power of the company two to three years from now. Unfortunately, not even the “normalized earnings” argument can justify PCBC’s valuation under rational scenarios.
We believe the only option for PCBC is to raise a massive amount of dilutive equity. This “best” case scenario could still mean a greater than 50% fall from current levels. The worst case scenario could mean the equity is worthless.
Disclosure: Short PCBC