Who is Talmer Bancorp?
Talmer Bancorp (NASDAQ:TLMR) is a regional banking franchise that is concentrated in the Midwest with a majority focus in Michigan and Ohio.
On 2/14/2014 TLMR held an IPO and sold 3,703,703 shares of stock for $13/share, and selling shareholders sold 11,851,852 shares, for gross proceeds to the company of $48.1 million. The stock has since traded in a range of $13.05-$15.42 and most recently settled at $14.27, which is unusually low volatility for a financial IPO. I believe this lack of volatility can largely be credited to the fact that TLMR's business model is not traditional and that the model itself has done little in the 4 months since IPO to clarify the future of the company.
This article will make the argument that TLMR is a risky long position to initiate at this point but should not be shorted based on the unknowns still inherent within the underlying business model. This article will detail developments to watch for that will signal an actionable trade in either direction.
What do they do and what is the business model?
TLMR's business model is to acquire other failed banking institutions in receivership from the FDIC. TLMR believes that it can benefit from the significant discounts at which it can purchase assets from the FDIC and the loss sharing agreements that come as a form of insurance as a result of taking on such stressed portfolios. The company made the transition to this model in the fall of 2009 in an effort to quickly and cheaply expand its business. Prior to utilizing the "growth by acquisition" model, TLMR operated the traditional banking model from 2007-2010 - when it officially completed its first acquisition.
In the time spanning April 2010 to April 2014, TLMR completed the acquisition of six banks totaling $5.9 billion in assets, $5.8 billion in liabilities, and more specifically consisting of $3.6 billion in loans and $4.79 billion in total deposits.
The following graphic displays TLMR's branches as located by region and also presents several projections for each demographic. TLMR has recently sold its branches located in Wisconsin and has sold a branch not listed that was located in New Mexico. The Wisconsin branch sales won't close until what is being estimated to be the third quarter. As a part of the transaction, TLMR will not be selling any of the underlying loan portfolios within those branches and will sell the branches in aggregate minus the loans for a $13.5 million gain to the current estimated net book value of the assets being sold. The terms of the New Mexico branch sale, which will close in Q3/14 as well, have not been disclosed other than TLMR will be selling all of the single branch deposits and $20 million of the branch loans. The total amount of loans within the branch is unknown.
A few things that jumped out to me about the graphic were the unemployment rate and the population growth of the areas where TLMR is located. The unemployment rates for most of the areas are higher than the national average and the population growth projections are negative. Obviously the reason these particular branches were available to TLMR in the first place was because they were either in bankruptcy or on the brink of bankruptcy. The branches were being assumed from imperfect situations but the demographics of the locations are not ideal to say the least. There are the positives that the median income of the locations is a touch higher than the national average and so is the projected income growth (Source: US Department of Labor), but it appears that the development of these branches will be an uphill battle for TLMR, which is not groundbreaking analysis but deserves to be pointed out.
Also, it doesn't appear (at least from statistical averages taken from publicly available bank feasibility data and from my own personal knowledge of desired bank feasibility demographic statistics) that TLMR will be the beneficiary of even normal lending or deposit growth from purely a statistical projection standpoint. For clarity, what I'm saying is that in the process of establishing a bank - and I've primarily worked in the central Texas region so my knowledge of this is not national and should be considered anecdotal - the bank holding company would gather statistics encompassing and often times dwarfing the graphic above to get a purely statistical comparison to other banks opened in similar markets. The comparison becomes especially important, if the comparisons are taking place during times of high correlations and if the data and situational expansion has a high correlation, to helping project growth and long term viability. The statistics displayed in the graphic above are far from ideal to say the least. That doesn't mean that TLMR won't experience growth and long-term success from these branches, just that the company doesn't appear to be in the highest statistical categories in terms of the likelihood of that happening. Again, this is probably not groundbreaking analysis but deserves mentioning.
The greater point that I am trying to make by pointing out what is probably relatively obvious is that TLMR stepped into these situations with a greater degree of information than is privileged to a new owner in traditional situations (not only did the company have the benefit of the readily available market statistics but the company also had a good look at the book of assets) and the company still decided to acquire these extremely stressed assets, along with conditional risk sharing agreements. In my opinion, TLMR did this with three logical reasons in mind: as a way to quickly expand its presence and asset base with the understanding that it has a better operating strategy and can turn these locations around; with the idea that it would buy these at a discount and sell some or all of the locations with the above mentioned operational improvements and/or when the environment deemed these same assets less risky (because of demographic improvements, a greater risk-on environment macro-economically, a further reach for yield making the loan assets more attractive, etc.); as a short-term Band-Aid to help cover up its at the time non-growth and to kick-start a growth movement for the other company assets.
The first reason, if that was the reason that drove the assumptions, at this point is yet to be displayed - at least from the information we're being given from the company (more on this later). The second reason, the selling of the branches for a gain when the environment presented an opportunity, has clearly already taken place and has been very profitable for the TLMR bottom line as mentioned above. If that was the strategy or a large part of the initial growth by acquisition motive, well done TLMR - you should pound the table on this on a call or make this clear to the investment community because at this point we have not heard this from management. The final reason, while that could be true to a degree, probably wasn't a substantial driver. But the possibility that TLMR wanted to use either of the first two strategies to generate income to help facilitate other growth (purchasing branches in better statistical situations for their long-term holdings) is realistic and until otherwise shot down by management has to be kept on the board.
In summary, the uncertainty of the strategy that forced the change from a more traditional model to growth by acquisition and the lack of informational specifics being given in regards to a lot of the organic growth that is or is not happening (discussed further in a later section) has helped keep the stock in a tight range in either direction - even in the face of a pretty decent financial picture. The organic growth is important because that would help lend credibility to what appears to be a fundamentally solid slope-line of FY net income growth, interest income growth, deposit growth, loan growth, etc. I'm more interested in the growth that the company creates from operations than acquisitions, although that matters too.
In the meantime, the acquisitions and activities of TLMR over the last few years have done well to slowly and steadily increase the tangible book value per share, which is important to a company like TLMR. It's also important for the company to be able to show TBVPS growth long-term as the risk sharing agreements with the FDIC expire. Investors want to know what the assets of the company are worth in a worst case scenario.
So, in summary of this section: we know that TLMR has been growing almost exclusively as a result of acquisition. We know that the company at least appears to plan to continue this strategy for the foreseeable future, although management did mention on a recent call that the environment for acquisition is getting more competitive, and that the company has done a good job with shedding assets that it was forced to assume with an acquisition but that didn't fall into a direct target market. We also know that TLMR seems to want to hold onto as many of its loans - even non-target market loans - as possible as the company has held onto the majority of the loans in both asset sales. We're beginning to see a fairly solid foundation established.
Competitive Advantages and Growth Strategy
TLMR's expressed growth strategy is vague, but it makes sense - similar to just about everything else with the company. The company plans to make smart acquisitions, drive organic growth with excellent customer service, expand and promote its lending product portfolio (little color has been given on the product expansions), and make operational improvements across its entire portfolio of branches to increase synergies and to decrease costs (read: expand margins). Again, outside of the acquisitions the other channels of the growth strategy have yet to be seen to a large degree. There has been some expansion of margins that we'll go over but for the most part this company is currently all about the acquisitions.
TLMR believes its competitive strengths lie in its management's ability to spot and execute smart and profitable acquisitions (beginning to see a pattern?). TLMR believes that management's experience and depth of knowledge across the full bank risk management spectrum is its key to future growth of market share. There isn't much else to say here. Banking is banking. If somebody found out a way to do it better we would all know because the stock of the company that did would be on the moon. Maybe that's where TLMR's stock is headed and we'll look back and think how poetic that sentence really was, but I think it's too soon to bet on it. The growth strategy and competitive advantages are centered around nothing else but the acquisitions in the short-term with no detail being given on any longer term, more sustainable plans - something that I don't mind for now, but for now gets shorter and shorter in duration each day.
What do the financials look like?
The financials look volatile, and they look dependent. The financials go a long way into providing the underline to the theme of this article so far - that we don't quite know about the organic profitability and the organic growth of the underlying business and that the company is dependent on bargain purchase gains (as a result of acquisitions), which have nothing to do with recurring net incomes and cash flows (and are completely subjective and arguably made up). For clarity, the bargain purchase gains are :
"Equal to the amount by which the fair value of the assets purchased in the applicable acquisition exceeded the fair value of the liabilities assumed and any consideration paid. The bargain purchase gain recorded in connection with each acquisition is a one-time extraordinary gain and would only be repeated in the event that we consummated future acquisitions where the fair value of the assets purchased exceeded the fair value of the liabilities assumed and any consideration paid" (Source: TLMR S-1, 10-K).
I alluded to the fact that I don't place a whole ton of importance into this number, other than what it does to the income statement, because "fair value" is extremely subjective and can vary wildly with little change to the actual assets being "valued" (take into account the "values" associated with financial assets just prior to the financial collapse and what that volatility did to the books of financial firms). Depending on the prevailing winds of the macro-economic and typically the interest rate environments, the value of a portfolio can sway greatly - especially in the case of the "stressed" assets at TLMR. So what was once a huge recognized bargain purchase gain, which was priced into the equity, can disappear into thin sentiment change and will not be retroactively adjusted into the previous income statement. The idea here is that the historical net income line which is highly tethered (to this point) to the bargain purchase gains is not credible in my book other than taking it for what it was and is; the company may or may not have underpaid for assets at the exact moment they bought them.
That to me is the punch behind the theory driving the wait and see approach to TLMR stock. We won't actually know if TLMR had a bargain purchase gain until there is a triggering event (sale of assets for a gain or loss - in aggregate, as was the case with the WI and NM assets; sale into securitization chain for gain or loss; maturation of the asset; etc.) to drive a financial realization. What I don't like is that I'm being asked by the market to value an equity based in large part on a fair valuing of assets that are impossible to assign a fair value to, at this point. For me, not being willing to take on that task, I'm left trying to look for and project organic growth and the percentage of the possibility of a realization of gains from the acquired assets to give me a base-line value of the company and the stock.
Starting with the historic financials, you can appreciate the large upticks in interest income dating back to 2010, and the upticks have been substantial, but you'll notice the upticks in net income have resulted largely (as mentioned above) not due to interest income growth but rather to those one-time bargain purchase gains. FY Y/Y growth of interest income since 2010 has been 138%, (14.15) %, and 75.22%, which gives us an average growth rate of 25% Y/Y with 2012 largely skewing the slope-line. Both the 2012 interest income and net income numbers saw significant decreases Y/Y as a result of slowing pace of acquisitions - which is perfectly illustrated by the dash in the bargain purchase gains line for 2012.
I'm also concerned historically with the Y/Y increases in noninterest expense, which have skyrocketed with overall company growth from $41 million to $251 million. While this line item has always been much larger in proportion to the interest expense, its growth has been a huge limiting factor to overall net income growth. For instance, all factors included, because of the huge noninterest expenses at TLMR the company would have made ~$27 million in 2013 FY without recording a bargain purchase gain and would have had a net loss of ~$6 million in 2011 and a net loss of ~$9 million in 2010. The one saving grace is that even removing the bargain purchase gains from the calculations the company is still tracking positive on a net income level for a 5 year duration. The results of the historic financials aren't horrible, especially tracking from what could have been net losses in 2010 and 2011 to positive net income in 2012 and 2013 but they don't exactly provide clarity to an investor.
The most recent quarter's financials look to be in line with the greater historical trend with net income being highly tethered to the mark to market accounting for of the bargain purchase gains, which "fell" ~$35 million Y/Y. Something I am concerned about within the recent quarter that I believe matters longer term was the drop in deposit fee income, significant drop in the mortgage banking and other loan fees, significant drop in the net gain on the sale of loans, and the loss on the sale of securities (which worries me the least of all these items). All of these items are indicative of the efforts at the company to drive organic growth and all didn't look healthy during the quarter. This could be a one-off situation but if those line items don't show substantial improvement in the following quarters this will not sit well with the investment community and could signal a an opportunity to get short the stock. If TLMR can't generate organic growth and proves to be dependent on mark to market accounting, its equity will be punished.
One last note on the most recent quarter - looking at the expenses, it should be noted that while the interest expense remained relatively flat (which is good) most of the drop in noninterest expenses came from a drop in salary and employee benefits (one-time expense cuts that may increase in the future to meet infrastructural demands) and bank acquisition due diligence fees (which could increase in the case of any further acquisitions and would partially offset bargain purchase gains). The drop in salary and employee benefits, should that line have held flat Y/Y, would have eaten ~50% of the net income for the quarter, which is something that should be pointed out.
Because of the uncertainty that I found in the actual profitability of the underlying business I decided to take a line by line look at the cash flows of TLMR to look for anything that would sway my decision one way or the other. While I wasn't turned outright bearish from what I found, I wasn't made comfortable. The company generated less cash flow Y/Y and saw their cash derived from operating activities halved Y/Y. The investing and financing activities (and the operating activities were cash flow positive as well) were positive on a Y/Y basis but so was net cash used which left TLMR with less cash Y/Y. Cash on hand is not a concern at this point, and won't be for a long time at the current historic run rates, but the cash flow generation here didn't leave me wanting to jump into the stock in size or at all. I won't elaborate any further on the cash flow statements because they're fairly self-explanatory but they're worth a closer look:
Finally, a few miscellaneous notes and thoughts from the most recent quarter:
- (+) TLMR grew net interest margins from 3.74% to 3.95% Y/Y during Q1. This was largely due to an increase in the composition of commercial real estate loans from the acquisition of Talmer West Bank.
- (+) TLMR had a $40.7 million drop in bargain purchase gains but only a $27.8 million drop in net income, which could be indicative of underlying operational growth but with the lack of granularity from management in regard to deposit growth and other items this is only speculation.
- (+) As of 3/31/2014, TLMR had $3.6 billion in loans of which $2.3 billion (64%) were acquired and $1.3 billion were organically originated, which is actually really solid loan growth. This is the largest positive for a long position that I have found so far into my research.
- (-) The company saw an uptick in Uncovered Performing Troubled Debt Restructurings (+54%), Total Uncovered Impaired Assets (69.5%), and Total Uncovered Non-Performing Assets (+70.7%) - "uncovered" is in reference to any FDIC loss share agreements.
- (+) TLMR saw decreases across the board on the covered side of the above noted categories - covered is in reference to any FDIC loss share agreements.
Where's the trade?
The trade here is to be cautious and wait for more clarity. I don't think Talmer has shown the kind of ability - the stock sure hasn't - to run away from the alpha train. If TLMR can prove its profitability and come away from its dependence on what are largely made up bargain purchase gains, this could be a decent stock to own. If the company can't show these kinds of improvements over the next few quarters being valued at ~$1 billion would make it a candidate for a short position. As of the most recent quarter, I'm leaning more toward this being an opportunity for a short position but I won't make that commitment just yet.
Another positive indication for the stock and for the company that I am looking for is any further selling of its book of assets at appreciated prices. I do think there will be opportunity for TLMR to do this considering the risk-on environments of the general markets and the continued search for anything with yield by parties in need. This unmentioned channel of the growth strategy is one that I am watching closely for development. I am also hoping, on the long side, that TLMR can strike some type of loan origination agreement with a partner in the MBS or CMBS space as the company appears to have quite a bit of commercial loans to unload via sale or securitization to reach its stated goal of book composition of ~1/3 commercial/industrial loans, ~1/3 commercial real estate loans, and ~1/3 being a mix of residential real estate and consumer loans. The CMBS space in particular is one that is growing at historic paces and that could be forced to look to non-traditional providers (read: smaller regional banks like TLMR) to help meet demand. Again, this is a channel of the growth strategy that has not been expressed by management but is highly possible given the current environment in the financial arenas.
I'm not willing to make a move on TLMR just yet but I have added it to my watch list and added it to my alerts list at SA. I'll look for further development and discussions with management and try to provide updates in time. Good luck to all.
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.