Deeply discounted regional banking stocks have been increasingly harder to find after last year's run-up. But, most are still priced below their long-term book values and a different sort of search, one based on performance, has started.
I previously suggested and bought into Alerus Financial Corp. (OTCQX:ALRS) near the end of last summer and have only one regret, that I didn't buy more! At that time, shares traded for ~$42.50, slightly below 1.8Xs tangible book value, and looked primed to grow between 15-20% a year. I stand by my growth prediction but shares now trade at $58.00 per share (up 36% since September) which has moved up the book value premium to 97%. At ~2Xs book value the bank trades above most of its peers but this premium is backed by results and if and when the tide rolls out Alerus has exactly the sort of protection you want.
The operations of Alerus Financial are divided into three divisions: Banking, Trust and Mortgage.
Banking margins, as everyone knows, have continued to face heightened pressure from competition fed by lack of supply (of incoming loans) and depressed interest rates. This will most likely continue for longer than anyone can predict, and it already has, but the bank is taking advantage of lower rates by slowly building up deposits and shifting from more costly accounts into cheaper and/or non-interest bearing ones. Evidence of this can be seen in 2013's 6% deposit growth compared to a 14% rise in non-interest bearing deposits. As of December 31, the bank had a loan to deposit ratio of 78% and had cut all non-deposit liabilities down to $43 million from $64 million at the end of 2012.
The strong North Dakota markets are not short of money and the bank's $1.38 billion in assets are now supported mostly of deposits (85%) and shareholder's equity. This, along with the low L/D ratio sets the bank up in a great position to increase margins when rates rise. The bank's net interest margin of 3.95% is down 12.6% from last year's but net interest income has held steady on the higher loan balances. Net interest income of $45.6 million was just $2 million less than in FY12. I'm thinking that rates will inch up but 2014's net interest income will stay steady as loan growth and the roll-off of higher yielding loans balance out. While the loan portfolio continues to grow it's important to be mindful of quality and it's reassuring - as it stands now- that nonperforming assets to loans plus other real estate owned is at a very low 1.1% (and at 0.4% if you take out covered assets). In addition to this type of quality, the bank's own Tier 1 capital ratio is at 13.0% and the new leverage ratio stands at a high 10.7%.
In 2013, mortgage revenues were down 10.2% but let's stop and think about this for a while. Lower interest rates drove in customers wanting to refinance and/or take on more debt but that also came with larger commissions. Last year's mortgage fees were down 12.5% to $27.17 million but salaries were also down. In the last quarter alone, the bank paid $12 million in salaries which was 19.1% less than the $14.82 million paid in the last quarter of 2012. All in all the refinance/origination supply was definitively pushed forward and will be lower this year but, Alerus capitalized on that and is working on a more longer-term fix.
While mortgages were walking in the door, management focused on growing more steady trust revenues and its presence in Twin Cities and Phoenix, Arizona. On this front, the bank acquired Tegrit Administrators which added $1.3 billion in assets to wealth management while also beefing up staff in Twin Cities and, more recently, announcing to acquire Twin Cities-Based Private Bank Minnesota. The announced acquisition will add $142 million in banking assets to the bank's balance sheet (a 10% increase) and is scheduled to close in the second quarter.
The effects of the upcoming acquisition are not yet on the books but the Tegrit one is and has already started to impact revenues. Trust income for 2013 was up 10.1% to $43 million (54% of all non-interest income and 159% larger than mortgage originations) and momentum is picking up with the last quarter alone representing 27% of the yearly total and it was 13.7% higher than the prior quarter. With $14.6 billion in trust assets and counting, this growing line of business has compensated for much of the lost origination fees and can continue to grow earnings more consistently for a very long time.
In hopes of not beating a dead horse, Trust income of $43.3 million almost equaled net interest income of $45.59 million and this was made with only 10% of the assets. Granted, there are a lot of shared expenses and one does sort of feed the other (more customers = more trust funds), but it would be a miss to discount this very profitable line that most other regionals do not have. Going forward, a checkup on the balance of trust assets and their corresponding revenues are a must as they represent the bread and butter behind this investment - along with LOCATION that is!
Not too many people would consider 2Xs book value a great deal but I'm looking forward and trying to transition to a higher performance based standard as compared to the last two year's equity based one. Even so, Alerus is focused and located in one of the most profitable banking environments you can find in the United States. This is one of the only non-private banks in North Dakota and the health of the loan portfolio and above average earnings give just a glimpse into this bank's potential. Pre-provision pre-tax income of $37.15 million and a 10X hurdle rate indicate a share price of ~$80.00 (37% higher). This may be a stretch for some investors, and I don't expect it to happen over night, but the path is set and shares still look like a great bargain.
Again, banking and trust assets are growing and my valuation is based on an already lower origination expectation. Originations would have to dip 70% lower to wipe out all of the discount and that's assuming zero corresponding salary savings. On the plus side, the intangibles of past acquisitions are impacting current earnings by ~$3 million a year (~10% of net earnings after adjusting for taxes) and this cushion doesn't appear in the calculation. This amortization is a noncash charge that will be fully 'spent' at the end of September 30, 2018 ($11.0 million left assuming no additions from future acquisitions).
A lot of regional risk is taken care of since the bank operates in healthy markets but there are unique circumstances that could depress the banks ability to perform to investor's satisfaction. Some but not all of these are heavier banking competition, limited supply of housing in the area and a slow down in the regional oil and gas markets. In addition to this, the bank is a small cap and very thinly traded. Alerus Financial ended the year with only 4.6 million shares outstanding and a large position could be hard to sell and/or accumulate.
The bank is also growing and could have a hard time integrating new operations. The announced acquisition is not in a new market but making it profitable is no guarantee. Also, a lot of the value I find in Alerus Financial is tied to the performance of the Trust division so any changes there could completely alter my view of the bank as an investment vehicle.
Most regionals are still in a position where cost savings is key to earnings growth but Alerus Financial is not and has plenty of flexibility to aggressively grow the business. I use the word aggressive here but in no way mean careless because the bank has identified exactly where it wants to expand and is already building upon that with quality assets and an edge (Trust division) that will easily make up for short-term slow downs in mortgage operations and bank margins. There are very few opportunities to invest in such profitable banks and even fewer that are tied to North Dakota which make the bank even more attractive regardless of where shares trade in comparison to tangible book value. This is one I have no problems buying at or below a fair price and I will continue to track it and pick up shares until either operations take a turn or the discount for earnings power disappears.
Disclosure: I am long ALRS. 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.