Paragon Commercial Looking To Drive Growth From A Highly-Focused Model

About: Paragon Commercial Corp. (PBNC)
by: Stephen Simpson, CFA

Paragon is pursuing a branch-light banking model targeting commercial lending in two fast-growing North Carolina markets (Raleigh-Durham, Charlotte).

The bank's loan/deposit ratio is high, as is its exposure to commercial real estate lending, but management is actively seeking out deposit growth and growth in C&I lending.

Mid-to-high teens earnings growth can support a fair value above today's price and the opportunity is there for Paragon to be a very cost-efficient commercial lender.

If things go right, Paragon Commercial (OTCQX:PBNC) could be a really interesting growth story to follow for the coming years. This branch-light bank company is following a model similar to that used by Bank of the Ozarks (OZRK). That's not to say that Paragon is "the next Bank of the Ozarks," but a bank model focused on service-oriented private lending to businesses and high net worth individuals and efficient non-retail deposit gathering through a small branch footprint can work.

Paragon is one of the very few banks I've looked at recently that looks undervalued. That triggers my paranoia and leads me to question whether I'm overestimating growth/underestimating risk, or whether this is simply a bank that most investors don't really know about yet. Whatever the case, there are things management must address (like improving its deposit base), but the growth potential from this model is worth exploring further.

A Small Player In Attractive Growth Markets

Paragon has been around for less than 20 years and operates just three offices - one in Raleigh, NC; one in Cary, NC; and one in Charlotte, NC. Paragon has no expectation or intention of becoming a typical community bank. This is a bank that targets its business at other businesses and high net worth individuals that are frequently employees, officers, or owners of those businesses, and it only needs a very limited number of branches to execute that model, as business banking relationships are rarely predicated on convenient branch locations.

While small, Paragon is a top 20 bank in North Carolina, with just over 0.3% deposit share in the state. The large majority of its deposits are concentrated in the Raleigh MSA, where it is a top 10 player with almost 3% deposit share. As a large percentage of the banks above Paragon in deposit share terms are large national and regional banks (names like Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), and PNC (NYSE:PNC)), Paragon is well-placed in this market in terms of "home grown" banks, and that actually matters to some business clients.

The company's position in Charlotte is much smaller, well behind the likes of Wells Fargo and Bank of America, as well as smaller banks like Park Sterling (NASDAQ:PSTB) and South State (NASDAQ:SSB), but it has enough of a presence to be a credible participant in the market and grow loans from here.

As is typical for banks that focus on commercial customers, commercial real estate (or CRE) lending is a major component of the lending mix. Including multifamily lending, which at 9% is a higher mix than normal for its peer group, CRE lending makes up about 54% of the book, with most of that as investor (non-owner occupied) properties. C&I lending is a little bigger part of the book (around 14%) than is typical for banks in this size bracket, and management is looking to boost this to a third of the book over time. Mortgage lending is about 17% of the book and construction lending is a surprisingly restrained 6% of the mix.

Will Paragon Carve Out Its Niche?

I have never believed that success in banking is just a question of having more and/or cheaper deposits than your rivals. There is no shortage of banks in the country and no shortage of lending options for most borrowers with good credit. With that, I believe that banks, especially smaller banks, either need to craft niches for themselves or face the prospect of competing on price (lower rates) and/or credit (lending to lower-quality borrowers).

Bank of the Ozarks has staked out a strong competitive position by really becoming a specialist in commercial real estate lending, focusing on specialized and complex loans that many banks don't understand or don't want to bother with. Likewise, at least to some extent, with Eagle Bancorp (NASDAQ:EGBN) which has focused on C&I and CRE lending to small/mid-sized business that are outside of prime credits (focusing more on "B" credits).

At this point, Paragon is targeting that small/mid-sized category, with companies in the $5 million to $75 million in annual revenue bracket being the core market, as well as not-for-profits. Time will tell if Paragon can establish and maintain a truly differentiated niche, but management has prioritized service and I believe that can be an important differentiating factor in a banking market where many rivals are cutting staff and cutting back on service offerings to boost profitability. To that end, Paragon's minimal branch footprint keeps costs down and I believe some of those savings are reinvested in elevated service.

Paragon is also looking to target that base to improve its funding mix. Management has hired "Client Development Officers" to grow its deposit-gathering activities, with an increasing focus on business from non-profits.

The bank's core deposit make-up is around 75%, which isn't bad. Management has been making a concerted effort to reduce its reliance on brokered deposits, and those declined below 10% (to 8%) in the third quarter. The company's deposit costs are still higher than I'd like, though, particularly given that the bank's loan yields (averaging 4.4% in the third quarter) aren't meaningfully better than its peer group.

The Opportunity

Unlike most other banks, Paragon doesn't seem to have any particular interest in M&A at this point. Instead, the bank is looking to grow by leveraging the above-average growth in its core markets (Raleigh and Charlotte) into strong double-digit lending growth. The loan/deposit ratio is high (97% in the third quarter), but management intends to fund its lending growth through better deposit-gathering (ideally) or borrowing as needed.

One possible limiting factor is regulatory capital limits. The bank's CRE balances already make up 322% of bank-level total capital and that's a level that I believe will restrict the bank's options. Management has already said it is targeting more C&I lending (C&I loans were up 19% in the third quarter versus 17% overall growth), and the bank also has the option to sell CRE loans to manage its exposure if need be.

Credit should not be a limiting issue. Paragon was smacked by having way too much exposure to construction lending when the bubble burst (over 300% of risk-based capital in 2009), but credit is clean today. Credit quality isn't likely to get much better, though, and Paragon would be at risk if the economic conditions in Raleigh-Durham and/or Charlotte deteriorated meaningfully.

I do believe that Paragon will succeed in gathering more lower-cost deposits, as I think Paragon is well-placed to provide high levels of service to commercial (and non-profit) clients who may be alienated by the cost-cutting measures of larger regional/national banks.

I also believe that the economies in Paragon's core markets will remain healthy and support ongoing growth in C&I and CRE lending. That, in turn, can fuel what I expect to be mid- to high-teens earnings growth over the long term. Discounted back, I get a fair value in the low $40s and a little bit above today's price. I'd also note that I get a similar fair value on the basis of the bank's near-term return on tangible equity.

Longer term, I wouldn't be surprised if Paragon got bought. Management is not young (the CEO is 65 and the Chairman is 69) and insiders own about a quarter of the shares. I could see Paragon appealing to other banks, especially mid-sized banks, that have a lot of under-utilized deposits (lower loan/deposit ratios) and a desire to get into attractive North Carolina markets. I'd also note that BancTenn, parent company of Bank of Tennessee (a small Tennessee bank with under $1 billion in assets) owns about 15% of Paragon.

The Bottom Line

As I said earlier, any U.S. bank that looks undervalued today makes me suspicious. In the case of Paragon, it's certainly possible that I'm overestimating the bank's ability to drive double-digit loan growth in North Carolina and/or attractive deposits from businesses and non-profits disgruntled with larger banks. On the other hand, it's also possible that this is just a bank that not many investors know about yet - the market cap is small the stock is illiquid.

Still, while it is much too early to talk about this as a future Bank of the Ozarks, I think that a very successful bank does show that a highly-focused commercial-oriented banking model can succeed and I believe Paragon is worth watching as it looks to grow its North Carolina commercial business.

Disclosure: I/we 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.