Back to The Garden State
Regional Banking has been a sector that I have been following for quite some time. The often miniscule size of the banks that populate the sector limits the potential for competition amongst investors, as large institutions are typically unable to devote the required time and resources to analyze so many small companies. This collective lack of attention is something that makes it significantly more likely that a few companies will slip through the crack and furnish investors with an attractive investment opportunity.
If you have followed my articles, you will by now notice that I spend a large amount of time searching for regional banks located in the Mid-Atlantic and New England area, which I believe is in the midst of a wave of consolidation. The impetus behind sector consolidation at such a rapid pace is largely due to the burden of regulatory costs and the benefits afforded by economies of scale. Due to more stringent lending and reserve requirements, many banks are not able to generate robust "front end" growth and instead must rely on "back end" efficiency capture. In plain English, this means that banks are not trying to make riskier loans that could be potentially disastrous and instead they are focused on generating SG&A savings through consolidation (reducing back office functions, generating more economies of scale due to size or getting to a size where they are able to engage in more types of lending).
While these very same regulatory costs are often derided by investors in large banks as being crippling impediments to achieving attractive returns on equity, they create significant opportunities lower on the food chain via M&A potential. Smaller banks which have assets of less than $1 billion and equity of less than $100 million are faced with a tremendous incentive to consolidate through either merging, acquiring or selling themselves. Investors in these institutions with the patience to identify promising companies and the time to wait for these investments to mature are often handsomely rewarded. They might have their shares purchased at a significant one time premium, receive shares in a larger bank or have their own bank turn into an acquisitive entity and benefit from significant increases to earnings power through regional consolidation.
One regional bank that I have recently identified, Unity Bank (NASDAQ:NASDAQ:UNTY), represents an attractive candidate for investment for several reasons. The first is the fact that the bank is at a "Goldilocks" size - that is to say that the bank is "just right" in size to either acquire other nearby banks or itself be acquired. The bank also has posted robust earnings growth, increased its dividend, started to expand its footprint and has optimized its capital structure. All of these attributes combine to form an effective business model and an attractive investment candidate.
What Unity Bank does
Headquartered in Clinton, Unity Bank is a small regional bank that operates in the state of New Jersey. The bank has fifteen branches in northern New Jersey and engages in lending oriented towards businesses and individuals including commercial, 1-4 family, construction, consumer loans, SBA lending and more. As of March 31st, the bank reported assets totaling $1.12 billion. Like many regionals, Unity Bank differentiates itself from competitors on the basis of high quality service and a deeper level local knowledge about the communities it serves.
The Numbers on Unity Bank
With a market cap of $99 million, Unity Bank is solidly in microcap territory. With $1.1 billion of assets, a P/E ratio of 10.5 and a Return on Assets of .91% for 2015, the company has a return on equity of 12.86%, solid numbers for a small bank in a challenging macroeconomic environment. Priced at $11.45 per share against a book value of $9.72 per share, shares of Unity trade at a slight premium to their underlying assets, something which I think is justified given the above average EPS, RoA and RoE metrics of the company. Insider ownership in the company is extremely high, with 45% of the bank held by insiders, something that I am always very happy to see due to the alignment of interests that this produces.
Most recently the bank reported Tier 1 Capital of 10.97% indicating that it's strongly capitalized with the most recent Net Interest Margin or NIM coming in at 3.48%, down slightly from the previous period. The bank's efficiency ratio stood at 60.5%, a number which has been sequentially declining for the past several quarters - meaning that the bank is spending less in order to generate profit, something that is important for investors to consider when it comes to the overall quality of business being underwritten by the bank. In a commodity type industry such as banking, the long term focus on consistent quality businesses can make a "good" bank "great," helping to sow the seeds for future growth and significant shareholder returns.
The company's loan book, from most recent quarterly filings, can be found in this table, with a quick glance revealing a significant amount of the company's loan book devoted to commercial loans which are loans to finance inventories, provide factoring services and are typically secured by real estate (with 96% of the company's total loan book secured by real estate). The maturity profile on the company's securities book, particularly those securities held for sale, is a weighted average life of 3.8 years for securities classified as Available for Sale (AFS) and 6.5 years for securities Held to Maturity (HTM), meaning that the bank has less exposure to duration risk (i.e risks related to interest rates increasing). The company's holdings of commercial, SBA7 and Consumer loans relative to Residential also reduce the company's duration risk profile as these types of loans are of shorter duration, making the bank well equipped to absorb and benefit from increases in interest rates.
| Loan Type | Loan Amount | % of Loan Portfolio |
| SBA loans held for investment | 38,863 | 4.40% |
| SBA 504 loans | 27,482 | 3.10% |
| Commercial loans | 467,266 | 52.70% |
| Residential mortgage loans | 260,957 | 29.40% |
| Consumer loans | 79,198 | 8.90% |
| Total loans | 886,990 | 100% |
| Loans Held for Investment | 873,766 | 98.50% |
| SBA Loans Held for Sale | 13,224 | 1.50% |
Return on average equity for the most recent quarter stood at 13.67%. Non performing assets as a percentage of total assets has also fallen for the past three quarters and was most recently reported at 0.74%. The combination of both an improving efficiency ratio and a continually falling non performing asset base indicates that the bank is not only enjoying more profitable lending, but is also benefiting from a high quality lending portfolio.
Since resuming their dividend, investors have seen a significant and regular increase in dividend payments, as this table shows.
| Year | Dividend ($) | Payout Ratio | EPS | Notes |
| 2013 | 0.03 | 0.057 | 0.53 | Div. resumed in 2Q |
| 2014 | 0.10 | 0.123 | 0.81 | |
| 2015 | 0.14 | 0.125 | 1.12 | |
| 2016 | 0.04 | 0.129 | 0.31 | EPS & Div. figures for Q1 |
For the years of 2014 to 2015, the company's dividend has increased 40%, with dividend increases coming typically in the third quarter of each year. With the bank's increased earnings power in recent years, I believe that investors have reason to look forward to a dividend increase as early as the third quarter of 2016. What is even more attractive in my mind is that the payout ratio of the company has remained relatively low (under 13%, a number much lower than the typical payout ratio of banks) which indicates that the company is able to continue to increase its dividend as well as to invest earnings in growth or cost cutting initiatives.
Operational Efficiency: Repurchase of Debentures and other Expense Management Reduces Costs Bringing Near and Long Term Benefits
In addition to increasing its dividend over the past several years, Unity Bank has also recently repurchased outstanding subordinated debentures at an attractive price, generating EPS accretion and reducing interest costs for the company, something that I believe is a positive development for common shareholders who are likely to benefit from this in the future through further dividend increases. The bank has also made other strides in expense management, and has been pursuing a strategy of owning rather than leasing the properties that its offices and branches are located in. The bank recently announced the purchase of the building in which its headquarters is located, making it the owner of 12 out of 15 total locations.
Due to low interest rates, it is important for me as an investor to see that the management of a bank is willing to search for ways to proactively cut costs in order to improve shareholder returns as well as the earning power of a bank during "lean times." During a period of more gradually rising rates, not only does this expense management produce significantly improved shareholder earnings, but it also helps a bank more effectively make acquisitions and harvest operational efficiencies when they do acquire other institutions. Banking institutions that enjoy shares trading at a premium to book (typically anywhere from 1.1 to 1.3x book) are able to use their equity (or, in other words, currency) more effectively to make stock-for-stock acquisitions (or acquisitions of stock plus cash). Effective expense management combined with the natural advantages provided by scale as well as a better ability to absorb Dodd-Frank regulatory costs over a larger asset base can help create and sustain significant value for shareholders.
Expansion Potential: Very Well Positioned to Grow Organically and Through Acquisition
In addition to focusing on operational efficiency, the management of Unity Bank is also pursuing a strategy of gradual expansion into attractive New Jersey communities. The company recently announced plans to expand into the Somerville market with the construction of a new branch, something that I believe is prudent and will help to increase the "footprint value" of the bank which comes with stable and logical geographic expansion.
When one examines the banking landscape in New Jersey, particularly banks with under $500 million in market capitalization, it becomes increasingly evident that consolidation is likely to occur at an increasing pace over the next several years. If one were to examine the branch footprint of Unity Bank, and compare it to similar banks that operate nearby, one would find several potential institutions that would appear to be a "good fit."
From a cursory glance (and only for the purposes of a thought experiment), if one were to examine the branch footprint of Unity Bank and the nearby Two Rivers Bancorp (NASDAQ:TRCB), one could see significant strategic rationale behind a potential tie up in the near future. Both companies have similar sized market capitalizations, relative attractive RoA, RoE and EPS metrics and there is very little geographic overlap between the two institutions despite the fact that they lie in close proximity to each other (with the exception of the Westfield portion of New Jersey, were both institutions have several branches). A tie up between the two banks would substantially reduce the compliance costs involved with Dodd Frank as well as create a significantly more valuable geographic footprint and considerably increase the scale at which the institution could operate, in addition to generating significant SG&A savings.
This is also not a cherry picked example, as there are numerous potential takeout and merger targets among small banks in the Mid-Atlantic region. As this current wave of consolidation continues, investors stand to be rewarded significantly over a longer period of time as marginally profitable banks and thrifts can have their larger (and often under-performing) reserves of capital deployed over a larger geographic network, translating into increased capital efficiency, loan growth and earnings on a per share basis.
Risks
Like any regional bank I have discussed, Unity is vulnerable to the economic conditions of the communities and broader region in which it operates and the success of the bank is tied to the financial condition of the area that it serves. Any downturn in the economy or real estate prices in New Jersey or the New York Metro area has the potential to damage the earning power of Unity as more loans could migrate to troubled or distressed status.
From a mechanical standpoint, investors must be aware of the fact that Unity Bank is a microcap stock which is thinly traded. Investors must be aware of the fact that there is the potential for significant price volatility in the near term due to the mechanics inherent to entering and exiting large positions.
Despite the fact that the management of Unity Bancorp has demonstrated that it is able to navigate the current prevailing low interest rate environment, it is important for investors to be aware of the fact that should interest rates remain stagnant for a long period of time there is a risk to the profitability of the bank's interest income.
The potential for increasing (or changing) regulatory burdens are also of significant concern to investors, as this could increase the SG&A spend for the company and/or make it more difficult for the bank to underwrite certain types of business.
Conclusions: Why Now? A Good Bank to Own in a Market Ripe for Consolidation (even if there is none)
I believe that shareholders of Unity Bancorp who are patient will eventually be handsomely rewarded. Not only has the bank made steps to improve its capital structure, increase its dividend and reduce other expenses (through purchasing, rather than leasing its operating properties), I believe that by virtue of Unity's geographic location that the bank has the potential to enjoy significant and profitable growth in the future or itself to be acquired.
With above average RoA and RoE, the company is an attractive takeout candidate for larger banks in the area that are seeking to improve their footprint or increase penetration into the New Jersey market. Conversely, Unity Bank has no shortage of potential acquisition targets to consider, and is at a size where "The Next Deal" has the potential to significantly increase the earnings power of the bank due to finally being on the cusp of reaching scale (Where "scale" can be defined as over $100M equity value and over $1BN in assets, a level where banking institutions are authorized to originate larger and more diverse types of loans).
Even as a standalone entity, I believe that investors at current price levels will be well positioned in the coming years. At current prices, investors are getting approximately a 10% earnings yield in a conservatively managed company with high insider ownership. Also due to the company's modification of their capital structure through the repurchase of an issue of Subordinated Debentures earlier this year, I believe that investors will benefit from dividend increases (as the company has consistently increased dividend payments since the program was reinstated in the aftermath of the financial crisis).
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
