Hanmi Financial Corp. (NASDAQ:HAFC) is a $700 million regional bank that has very little to not like about it. The books are clean, it is well capitalized, making money and a merger is on the way. But, the million dollar question is always pricing and there appears to be very little discount for anyone interested in looking for a cheap bank.
With that said, I have to be honest, from the start of my research I was very skeptical and started searching for a hole or any little reason to write this one off and I didn't know why until I moved from the financials to valuation. This bank is trading above any other bank with similar numbers because the market is pricing in growth that hasn't yet materialized.
The pending merger appears to be very cheap with the bank paying $50 million for Texas based Central Bancorp who has approximately $1.42 billion in assets and $1.25 billion in deposits. How profitable the bank will be is a big missing link but Hanmi Management is expecting the 23 new branches to generate an internal rate of return in excess of 20%. Central Bancorp only has $640 million in gross loans so I don't think there's much to worry about as far as bad assets but again, that's only because there aren't many loans. And, on the other side of this is the fact that a small loan portfolio typically translates into smaller revenues. So, this bargain purchase is only guaranteeing a lot of dry powder in new markets which means Hanmi Financial will still have a lot of work to do. Luckily, if the bank's most recent success is any indication of the future, this could be a home run.
Hanmi Financial focuses on Korean-American Communities and has been in turn-around mode for the better part of five years after losing ~$200 million in 2009 and 2010 combined. Last year's net income was $39.9 million and this is probably the best benchmark year to project future returns from because of several irregular and large revenue items that have occurred over the past five years. 2012's reported income of $90 million, for instance, included a deferred tax asset valuation allowance that lead to a reported tax benefit of $47.4 million. While the current $51 million deferred tax asset will save the bank on future tax payments, it's important to remember that this very large line item is not making the bank any money and could potentially be worth less than what it is reported should Hanmi Financial fail to utilize all of it. This asset is also reported in tangible equity so it results in both lower returns and a larger book value.
Total assets grew by 6% last year with net loans up 10% to $2.17 billion. The bank's loan to deposit ratio improved to 86% (from 82.3%) but this number alone means little when you factor in the additional $800 million held in cash and available for sale securities that are not reflected in it. Net interest income, mostly from these two assets, came in at $108 million last year compared to $95 million in 2012 and $89 million in 2011.
This is quite a bit of money and the financials confirm that almost the entire portfolio is in commercial and industrial loans (for either commercial lines of credits or commercial property). Compared to one built with mostly residential real estate loans, this portfolio is on the more risky side but big steps have been made in cleaning up nonperforming assets which are now covered two times over by allowances. As you can see from the graph below, the current non-performing asset total is 10% of what it was in 2009.
There appear to be very little non-interest income items that aren't related to deposits and insurance commissions so investors can expect close to $31 million from non-interest activities to help cover part of non-interest expenses that have come in between $78-84 million in each of the last three years.
The bank's efficiency ratio is at a very low 55.8% and I don't think there's anyway to improve this on the expense side. Interest rates are still very low and over time we should see some top line growth as the yield curve moves into a more favorable position but, even without this, Hanmi will more than likely keep growing income by expanding the portfolio and utilizing low cost deposits even if rates stay as they are now. The efficiency ratio is dependent on a lot of things but it helps get an idea of how management has been able to utilize assets and, hopefully, how they will be able to clean up those coming in from the merger. Unlike most acutely located regional banks, Hanmi is covering a lot of ground with operations in California, Washington and Texas. The merger will add Illinois, Virginia, New Jersey and New York and it's not hard to imagine management will need to hurdle a little bit of a learning curve as it adjusts to the new territory. The merger means more opportunity but investors will need to monitor and weigh in these new risks and the time it will take to get everything going at the new branches once ownership has changed hands.
Trading at ~1.78 times tangible book value and ~18 times trailing earnings per share may not be expensive compared to historic markers but this is a very full valuation compared to other regionals in today's market. And, we need to remember that the bank's tangible equity includes the $51 million tax asset (12.7% of tangible book value). This large number may be loved by the crowd but it can only be summed up as a tax prepayment that has the ability to 1) not be realized fully and 2) take a very long time to exhaust. The bank's financial condition has strengthened but this asset earns zero dollars and was created from weak loan assets that disappeared during the financial crisis. Lending standards may have changed but the bank's focus on business lending has not and these are the exact types of loans that almost crippled the bank four years ago.
Management is only where it is today because of a lot of hard work and very large capital infusions. This is backwards looking but it needs to be at least given some thought when the landscape changes and strategy moves to a more offensive stance. The bank is about to venture out into new markets and, based on last year's earnings, there is little other than hope to justify paying for shares at their current price. 2013's earnings were not weighed down by large debt that can be refinanced and the loan portfolio is growing but a lot of money is still sitting on the sidelines (which weighs down margins) and the new merger only looks to add to that. Cash on hand and other short term investments may be liquid and less risky but even they experience declines when parked in fixed rate assets that devalue when interest rates rise. The bank may have earned $39 million last year but the equity line tied to the market fluctuations in available for sale securities took a $14.7 million turn for the worse when they devalued over the course of 2013. These may reverse over time as the investments mature but this illustrates the other side of hoping for rising interest rates and has to make one question whether or not the shares are currently worth 1.78x book value, even if you don't agree with my thoughts about the deferred tax asset.
I was definitely strong on the bank's value but there is a lot to like about the improvements that management has made. In fact, the main part of my conclusion that the bank is overvalued rests in the thought that management can't do much more than it already has up to this point in time. Shares are up and will probably stay up on the merger news and turnaround story but I would rather pay less for hidden value that just isn't in Hanmi Financial right now.
Risks to this thesis involve mainly the opportunity lost which for me is cheaper than being told a future plan wasn't as successful as it has been projected. This may be setting the bar high but the last three banks I covered moved it there and I will continue to search out ones that the market hasn't found.
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.