On the surface, Franklin Financial's (NASDAQ:FRNK) story has a lot of support. The bank was converted from a thrift in 2011 and it still has a massive amount of excess capital that it has been using to continually repurchase a substantial amount of shares, most of which have helped add value as they were executed under book value. On top of this, and consistent with the conversion theme, there is the hidden upside that could come from a potential acquisition, and well-known bank investors are on board (Michael Price and Lawrence Seidman).
All-in-all, the bank appears to be right on the path to higher returns for patient investors and downside is limited. Unfortunately, shares have just eclipsed book value and from here, future upside is increasingly tied to a higher bid from a bank looking to acquire, and this is a scenario that gets less profitable as time goes by. With that said, below I have laid out my concerns to highlight what an investment in Franklin Financial looks like now as well as what it might look like for a bank wanting to acquire.
Franklin has every excuse in the book to produce lower than average returns on equity. Actually, they may not have every excuse but with an asset to equity ratio of only 4.5x, the bank can't be expected to report much higher than a 5% ROE considering a return on assets of 1% has been hard to find throughout the industry. This may sound very small to a non-financial investor, but this is where banks are at right now. Although the ROE is not impressive, Franklin could still represent a good investment if that ROE is available at a low price. However, Franklin is still trading at a P/E of 17x and P/EBT of 13x (based on trailing six-month annualized earnings).
On a YOY quarterly basis, 2Q2014 earnings per share were up 65% to $0.38 per diluted share but, after uncovering the earnings drivers responsible for the increase, I'm doubtful that these results can be relied on as a benchmark for the future.
Even though the loan portfolio growth has been 10%, the loan book is still small at only 50% of all earning assets. And, an increasing deposit balance means that the loan to deposit ratio has made a smaller advance. All in all, these numbers are moving in the right direction but there is still a lot of work to do to get all assets in more productive investments. With the larger loan portfolio, Franklin Financial has seen net interest income improve moderately, but it's in the margins that we find my major concerns.
High cost of debt trumps liquidity benefits
We can justify the bank's low returns because of the excess liquidity but the sources supporting assets have me wondering what benefit they produce. Deposits fund 61% of all assets and have a balance of $670 million but zero of them are non-interest bearing. On the low-end, I've seen some regional banks manage to carve out a 0.5% yield paid on all interest bearing liabilities. This is somewhat of the holy grail of low-cost funding but at over 3Xs that amount (1.69%), Franklin's "liquidity story" doesn't look so favorable. Total deposits may amount to $670 million but more than half of them are in CDs that yield 1.39%.
Typically, a bank attracts customers by offering either more services or by paying more on deposits. It's clear Franklin pays up on deposits but this doesn't account for the cost of other non-deposit liabilities. With an average balance over the past three months of $165.9 million, FHLB borrowings come with a massive 4.43% yield which adds up to 52% of all interest charges. And, the balance has grown over the past few months!
What in the world is going on here? I thought we had a bank with too much liquidity and then I find that it's paying almost 2x net interest margins (at 2.86%) for the ability to hold $551 million in non-loan assets. The security balance is at $367 million but only 20% of those make more than 4.43% and they don't clear the FHLB bar by that much. There is $89 million in cash too, but is it worth paying 4.43% for? Remember, that's almost exactly what the bank is making on equity.
To put the cost of these liabilities into context of the bank's net income, the removal of these expenses could potentially lift pre-tax earnings by over 40%. This, of course, is not accounting for the fact that they would take away from some earning assets so this is a more relative review and nobody should expect the removal to result in that large of an improvement if cash is used to pay them off. Luckily, the moderate increase in the balance of these liabilities actually helped bring down the average yield. The $10 million issued in the past three months yields a much lower 1.65% and matures in September 2018. Going forward, more steps in this direction will help increase margins and drive down liquidity costs but, either way, I hope we can agree that it's hard to justify the presence of such a large position in these earning busters (They also require collateral with a carrying value of $327.1 million as of 3/31/14).
Removing non-recurring gains reveals an even weaker core
In addition to this liquidity/cost puzzle, the very low reported earnings have been significantly supplemented by one-time gains on sales of investment securities. This may somewhat offset the high funding costs, but it would be very unwise to factor this into earning projections indefinitely. Over the past six months, half of pre-tax earnings have come from these sales ($4.6 million and $9.52 million respectively) and the supply of future gains is limited to what we can see in accumulated other comprehensive income and the unreported difference in fair value on securities classified as held to maturity (approximately $12 million). Keep in mind though, this number is negative at some other banks and could be drained by prepayments, credit deterioration and increasing interest rates on fixed assets. Speaking of credit deterioration, some of the gains reported this year were from sales of held to maturity assets that were made to avoid further losses. Gains are good and losses are bad but when it comes to these assets, we need to factor in that they are not a part of core earnings that are closer to producing 2% on equity than they are of producing the sub-5% that the bank is reporting.
What are they buying?
Management has been banking on repurchases which have helped add to book value as most of them have been completed below tangible equity. This is positive, and it's good for investors, but let's stop and think about what has been bought. A bank, earning less than 5% on equity, that doesn't pay out a dividend. Franklin's loan quality has always been sub-par (5.17% of all loans are nonperforming) and allowances could be questioned (only 37.11% of all nonperforming loans, more realistically it should be double this amount which would drain more than six months of pre-tax income) but investors don't have much to fear considering the large balance of equity.
Unfortunately, the book value ($20.37) is now right at the market price and future repurchases will have less of a positive impact on reported returns and earnings per share compared to the benefit they had in the past when there was more of a discount. The repurchase program is still enormous but at what point do we start to evaluate opportunity cost? Like, for instance, the opportunity to pay a dividend that decreases equity and raises returns or the opportunity to stop and pay down liabilities? Both of which I'd rather have!
From most 2Q2014 10-Q
It's true the industry is consolidating, but I've started to think of this opportunity as more of a lottery ticket. Don't get me wrong, this lottery ticket has better chances than anything you buy at the grocery store, and the odds of winning increase when we see very knowledgeable bank investors like Price and Seidman on board, but we have to remember that they didn't buy yesterday. In fact, Price got in after the 2011 conversion and is already up close to 100%. An ROE of 5% a year for you means more than a 10% annual gain on his initial investment. In addition to this, acquisition rates have been in the 1.3-2x book value range which could give new purchasers a potential 30-100% gain, based on recent mergers, if Franklin were to be acquired. That means Price has a 60-200% incentive to sit on his original investment after it has already been successful. And, a deal could never materialize. As of now we only know what we're getting and to pay at this price it's best to be sure you're happy with the bank's current outlook because it's not the same as what these fund managers bought.
As a bank, Franklin Financial could be a good acquisition candidate, but the liquidity that another team might be searching for is lower than advertised because the potential Franklin has to grow a loan portfolio comes from expensive liabilities and shareholders' equity. If the company's lending power came from less costly deposits, however, this would be a completely different story. On top of that, a bid may never come and it would only adequately compensate new investors based on the asset quality and earning power you can find at other banks.
With that said, this one may have run its course, but I think it's a valuable reminder of why a newly converted bank could be such a great opportunity. Even in this case, a very sub-par performance has been a great deal for early investors.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.