Regional banking stocks, in general, have gone up significantly in the past two years making obviously mispriced companies harder to find. The trick now appears to be uncovering a bank that still has some fat to cut but there is one other option that probably sounds more simple than it is to realize. Any ideas? How about paying a fair price?
The choice is yours but I would much rather pay the same price for a company already doing well and moving forward than one with a magic x-factor that investors are paying for ahead of time. This may sound elementary but there are hundreds of regional banking stocks and many of them are so under-followed that Mr. Market has no possible way to value all of them with any sort of coordination.
In this article I will be discussing Community Bank Shares of Indiana (CBIN). This small regional bank, in my opinion, has a little bit of the three opportunities I highlighted in the paragraphs above. After much improvement, Community Bank Shares has a lot of potential, is being sold at a fair price and is still holding onto some high cost liabilities that can be replaced to produce larger profits in the not too distant future.
Business Strategy and Asset Quality
Community Bank Shares, like most regional banks, offers fairly uncomplicated products that rely on attracting deposits and offering loans and lines of credit (secured and unsecured) to businesses as well as to consumers through equity lines of credit, automobile and residential real estate loans (along with other common loan products).
From the company's 2013 10-K
A couple of things that set this bank apart from other regionals is that over the past few years earnings have not been boosted by large increases in non-interest mortgage banking activities. In fact, less than one million dollars has been made over the past three years from this line of business. This may be looked at as a big miss because of the failure to capitalize on the increased refinancing activity, because it is, but now that demand has slowed, it means that Community Bank Share's revenue will not be taking a large dive like other banks who have become dependent on these one time gains.
Another interesting aspect of the bank is found in the amount of loans held with variable rate maturities. Community Bank Shares' loan portfolio grew to $560 million last year (up 20%) and 39% of those loans are variable rate. This construction strengthens the ability of the bank to take advantage of rising rates while mitigating a large amount of interest rate risk but it also shifts some potential problems into credit quality because each increase means a larger burden for debtors to bear.
Image from 2013 10-K referenced above.
Fortunately, credit problems have significantly improved with nonaccrual loans falling to $7.7 million at the end of 2013, or 1.39% of all loans. However, 2013's provision charge was $3.4 and allowances moved down (to $8.0 million, down from $8.7 million) so I don't see any reason to believe management has some hidden assets tucked away in reserves.
In some banks I have reviewed, allowances have grown to upwards of 700% of nonperforming loans even though they only covered 1-2% of total loans. With an allowance balance of $8 million, the bank has nonperforming loans covered by a little over 100% with total loans covered by 1.4%. These ratios are good and safe but not exceptional and we will need to keep track of them closely going forward.
New loans mean higher revenues as much as they mean more potential bad apples and the portfolio grew by $100 million in 2013. These were not all variable rate loans but the larger percentage of them mean management is taking on more credit risk which directly effects the provision charge. The balance of future nonperforming loans is yet to be seen but I wouldn't expect much lower than last year's $3.4 million loss provision charge which I hope we can agree is a material amount considering it is 25% of last year's pre-tax pre-provision net income. Again, this number could improve but the amount of nonperforming loans and allowances is small in comparison to the company's recent growth and I would expect to see allowances grow by 1% of the loan portfolio's expansion going forward.
I might sound a little negative above but that's just me digging for hidden profits in the bank's allowance and provision line items. None were found but this bank has high quality loans and management appears to be allowing the portfolio's performance dictate reserves and annual provisions. This is not a bank tucking away an unreasonable amount for a rainy day so earnings are closer to current reality. If credit quality can stay at this level while margins slowly expand, earnings would have no where to go but up.
Earnings Power and Value
Net income to common shareholders has been on the rise and has a three year compounded annual growth rate of 9.25%. Last year the bank made $2.32 per share which was good for a 1.04% return on average assets and a 10.3% return on average equity.
Based on last year's results, shares currently trade for only 9.9Xs net income per share. With a market cap of $78 million, shares can right now be purchased for only 7.8Xs last year's pre-tax earnings. We still need to see if the new loans printed in 2013 will effect future provision charges but they should also grow revenues and, with a loan to deposit ratio of only 85%, the bank has a little more room to grow its portfolio even without needing to attract more deposits.
At this point, I need to stop and comment that this is only forward thinking and the bank is already earning enough to make its current share price look attractive. You may not find shares to be extremely cheap but it would be hard to argue that a 2% dividend payout, trading at less than 10Xs net earnings and only 1.29Xs tangible book value is anywhere near overpriced.
In the opening of this article I described three attractive ways to buy a bank:
1) paying a fair price
2) paying for future earnings potential based on higher performance
3) paying for future earnings potential based on the ability to cut costs
At this point I've covered a little bit of each but there is one more large piece of fat that the bank has a growing incentive to cut. In owners equity, the bank holds $28 million in preferred stock that ate ~10% of potential net income to common shareholders ($802K).
These preferred shares were issued in 2011 as part of the Small Business Lending Fund (SBLF) to take advantage of the relatively cheap rate being offered on them (1.6%) but, that rate increase to 9% in June, 2016 which would increase last year's $802K bill to $2.5 million annually. The inability to redeem these shares is a very large threat but also a very large opportunity to increase earnings by removing future preferred dividends. And, reassuringly, Community Bank Shares' balance sheet is growing and Tier 1 ratios are very high (17.2%) which tips the odds significantly in the favor of redemption barring any large unforeseen problems.
Community Bank Shares is safe and trading at an attractive price based on current earnings and book value alone. And, in addition to these basic valuation ratios, the bank has several ways to increase future earnings while operating under a strategy that significantly mitigates interest rate risks (holding a lot of variable rate loans) by boosting earnings potential for the time when interest rates start to rise.
Interested investors would be wise to continue to monitor the bank's credit quality while looking for announcements regarding the redemption of the preferred shares. I don't know how many people are watching this bank but I would imagine that shares will get an immediate boost if and when redemption of the preferred shares is announced.
In full disclosure, I'm starting to build up cash and have no intentions to purchase any shares in the near future but that could change at any time. As for now, I'm only putting this bank in my personal 'must follow list.'
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.
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