While the rest of the market is focusing on the food fight for Hillshire Brands (NYSE:HSH), I suggest you look at the small community banks (assets below $1 billion). Because these are microcap stocks, the market has ignored this rapidly consolidating group. Literally, community bank takeovers get announced two to three times a week.
Consider LSB Financial (NASDAQ:LSBI) and TF Financial Corporation (NASDAQ:THRD). Their investors won the acquisition lottery last week: Both LSBI and THRD soared over 40% on takeover announcements. While the acquirers paid sizable premiums even though neither bank generates strong returns. In fact, both companies' earnings were subpar. Simply, the buyers figured the assets were more valuable under a bigger tent. For instance, ONB expects to lower LSB Financial's noninterest expenses a whopping 40%; LSBI would never have been able to achieve those cost cuts on its own.
In short, M&A can make your financial year in a day.
So what made LSBI and THRD so attractive?
The two microcap banks shared a highly motivated large insider position, modest ROA and ROE, an appealing market, and under $1 billion in assets. These tiny financials could not make it in a highly regulated and competitive world. With a small asset base, their chances for meaningful standalone existence were slim. Management was motivated to create shareholder value and took the simplest and fastest approach - a lucrative sale.
There aren't that many publicly-traded banks in attractive markets below a billion in assets with similar ROAs and ROEs, easy-to-swallow market capitalizations, and large insider holdings. In fact, there are fewer than 15 - several of which are in the process of being bought.
New Jersey-based Unity Bancorp (NASDAQ:UNTY) is one. It, too, has an immense insider position (37%). With 900 million assets, Unity doesn't have the scale required to generate large earnings streams. Even with excellent cost control (low salary and premise costs), returns are stuck at a modest 0.59.
Moreover, Unity serves high-income New Jersey counties - a region ripe for consolidation. Ten banks control nearly 75% of the New Jersey deposit market share, leaving the remaining hundred to scramble for the rest. Already, we've seen ConnectOne Bancorp (NASDAQ:CNOB) grab Center Bancorp (NASDAQ:CNBC). While Unity's slice of the New Jersey pie is only a tiny 0.22%, its customers live in some of the wealthiest communities of the Northeast.
Further, management has engineered a turnaround.
Unity is attractive even without an acquisition. The loan portfolio grew 15% over the last year. Remarkably, commercial loans increased 19% while residential skyrocketed 32%. Unity is shifting to high-yielding commercial loans while selling its out-of-market SBA loans, pushing up its net interest margin. Moreover, Unity repurchased its TARP preferred shares, relieving the company of $1.6 million in preferred dividend obligations. And to top it off, the bank purchased 3 of its branch premises last year (it now owns 11 of its 15 locations). Owning the premises has paid off: Occupancy costs are down. Besides, the branch purchases were well-timed as commercial real estate has appreciated in value. In short, Unity has added assets and taken out costs, making for a much more appetizing acquisition target.
Particularly intriguing is a rights offering in the near future. Investors will have the right to purchase one share for every ten shares owned. The subscription price has not yet been determined. The proceeds will be used to replenish capital spent to redeem TARP shares. Depending on the discount to market price, Unity could give shareholders a quick return.
Unity sells for 1.17X TBV. Management likely can get 1.5X TBV for the bank, maybe even upwards of 1.7X TBV from a determined acquirer as its ROA and ROE are similar or better than THRD and LSBI. The downside is limited, simply because banks under $1 billion in assets are in high demand. Should share price fall you might need to get a bucket to catch the drool of a Valley National (NYSE:VLY) or Investors Bancorp (NASDAQ:ISBC). Even if Unity does not get bought, it is a good bet that at least one of its peers (TRCB, BKJ, or FCCY) will catch a bid. And that, in itself, would likely lift Unity's valuation as investors get wise to a potential takeover.
And should an offer never materialize? Unity has been getting stronger throughout the year, growing its loans 15%, deposits 18%, and net interest 9% - statistics likely to draw in investors. Moreover, credit quality has steadily improved with declining nonperforming loans and net charge-offs suggesting that the company is not sacrificing loan quality for market share.
- Needless to say, this is a tiny community bank operating within a few New Jersey counties and vulnerable to any downturn in its local economy. Response: This region has very strong demographics.
- Competition is fierce to find credible borrowers. Response: The bank has been growing its market share.
- Loan yields have been falling, pressuring margins. Response: Unity has shifted to higher paying commercial loans.
- And, of course, there may never be a Unity acquisition. Response: Takeovers of similar banks puts a floor under the stock.
Unity is an especially appealing target, operating in one of the wealthier regions of the country. With a heavy insider position, management is likely exploring an advantageous sale. In the meantime, the bank is growing, paying cutting costs, and improving credit quality - making Unity attractive by itself. This is a win-win situation: Investors win big on an takeover or they simply own an improving bank story. BUY.
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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