Bar Harbor Or Camden National?

Summary

• Bar Harbor Bankshares has many positive attributes.
• The merger with Lake Sunapee Bank Group has the potential to dilute many of the company's best qualities.
• We view Camden National as the superior bank in a market characterized by local competition and deep local market knowledge.

Bar Harbor Bankshares (NYSE: NYSE:BHB) is a community bank based in Bar Harbor, Maine, primarily serving Downeast Maine and, through its recent merger with Lake Sunapee Bank Group, markets in adjacent New Hampshire and Vermont. The company is one of the largest Maine based financial institutions, especially with its recent Lake Sunapee Bank Group merger, and retains a leading market share position its core geographic locations.

We have long liked Bar Harbor Bankshares for a number of reasons, including the unique markets served by the bank in Maine, the company's consistent growth, strong returns on assets and equity, and the relatively modest valuation of the bank. In the past, the company has also been very consistent achieving a return on assets in the range of 1.0% and a return on equity in the range of 10%, metrics we look for as an initial indicator of strength, unlike many community banks which struggled during the financial crisis and continue to deal with sub-par returns on assets and equity. However, the completion of the merger and the post-election rise in valuation have led us to conclude that it's prudent to begin reducing our position in favor of other opportunities.

Interestingly, the conclusion of the merger with Lake Sunapee Bank Group has also propelled Bar Harbor to be essentially identical in terms of scale, deposit and loan composition, market dynamics, etc., with another Maine based bank also in our portfolios, Camden National Corporation (NASDAQ: NASDAQ:CAC). This article focuses on Bar Harbor Bankshares but compares the company with its similar cross state rival to illustrate key similarities and differences between the banks and develop a rationale for recommending one institution versus the other.

Market

The company's traditional market area is Downeast Maine, an area roughly consisting of the coastal regions of Maine from the Canadian border down towards but not including Portland. The region is generally characterized as rural with a widely dispersed population, relatively small coastal and interior towns, and a small business oriented economy.

Maine's banking market is relatively unique since most of the state's regions outside of Portland are dominated by Maine based institutions. The local character of banking in the state and relatively dispersed small communities has limited competition from major regional and national banks and reduced (though by no means eliminated) the tendency towards aggressive and promotional pricing of deposits and loans. In addition, the unique economic drivers in coastal Maine, including the blueberry and lobster industries, vacation ownership, and seasonal tourism permit local banks to develop a more specialized knowledge of the dynamics of local industries which is neither easily replicated nor particularly attractive to larger institutions more focused on loan volume and scale. The resulting stability of the Maine banking market has been an attraction for many years relative to more competitive regions with more standardized economic bases, in part reflected in the tendency of both Bar Harbor and Camden National to achieve relatively high and very consistent net interest margins and returns on assets and equity when compared to typical community banks.

Loan Composition and Performance

The region is certainly not immune from national economic trends, but has historically fared better than average due to the nature of its economy and industries and the relative lack of drivers which cause local economic excesses.

Bar Harbor's loan composition has long consisted of a larger proportion of residential real estate loans than more traditional community banks. The same is true for other Maine based institutions, including Camden National, in part because of the region's economic mix but also due to the nature of lending in the region where local banks have proven more comfortable lending on local properties in areas with a higher mix of vacation and second homes than most areas. In addition, the availability of commercial loans in the small business based communities it not as robust as in larger markets and both banks have significantly more deposits than could be deployed in local commercial lending.

However, Bar Harbor's loan composition has shifted even further towards fixed rate residential real estate loans over the last two years, with significant growth in 2016. The composition of the loan portfolio has also shifted materially towards fixed rate loans versus variable rate loans, limiting the company's ability to benefit from repricing as interest rates rise. In comparison, Camden National has a higher proportion of variable rate loans and, though this has shifted towards fixed rate in the last year, has done so at a much slower rate.

Source: Bar Harbor Bankshares and Camden National Corporation

The merger with Lake Sunapee should marginally increase Bar Harbor's overall proportion of variable rate loans, but only marginally given that Lake Sunapee's portfolio was approximately 55% variable rate loans, still lower than that of Camden National. The increasing allocation to fixed interest rate loans in the face of rising interest rates in somewhat concerning given the potential for narrowing net interest margins relative to peers.

Loan performance between the banks has been similar over the years as well and generally superior to the community bank average. Non-performing loans peaked late in the financial crises although actual loan losses and provisions for loan losses, though elevated, remained relatively low by industry standards. Loan losses and non-performing assets for both banks have declined substantially over the last four years; however, the nature of the merger with Lake Sunapee has significantly reduced Bar Harbor's allowance for loan losses relative to loans in the most recent quarter due to the nature of accounting for loans acquired in an acquisition or merger. In the longer term, we expect the allowance to come back up to historic levels as loss experience is incurred and new loans replace legacy loans, representing a potential long term drag on Barf Harbor's earnings.

Net Interest Income

The nature of the company's market and somewhat insulated characteristics relative to the national economy has allowed Maine banks, including Bar Harbor, to maintain relatively strong net interest margins despite the housing crash and subsequent low interest rate environment. However, now that rates have begun to rise, it's important to consider the impact of rising rates on the company's net interest margin. In this regard, the company's deposit and loan portfolio, as noted above, leave something to be desired, especially when considering the bank's own estimated impact of rising interest rates. In fact, Bar Harbor's two year projections for net interest income sensitivity to rising interest rates are negative, meaning rising rates will actually negatively impact net interest income. The merger with Lake Sunapee will not help this situation as the last available report for the bank detailing its own net interest income sensitivity also projected negative impacts from rising rates. In comparison, Camden National projects a minor decline in the first year and then rising net interest income in the second year, a stark contrast to the Bar Harbor.

Source: Bar Harbor Bankshares and Camden National Corporation

The contrast is actually quite stark - whereas Bar Harbor is negatively impacted under either a rising or declining rate scenario, the company is far more heavily impacted by rising rates. In comparison, Camden National is geared towards benefiting from rising rates but would be significantly impacted by declining rates. This is perhaps the most striking difference between the two institutions which are in many other ways very similar and behooves investors to take a view as to the trend in future interest rates to determine which bank is better positioned for the expected trends going forward.

It should be noted that these figures represent the impact before the merger with Lake Sunapee. However, as indicated in Lake Sunapee's most recent available report before the merger, that bank as well projected negative impacts to net interest margin under either a rising or declining rate scenario.

In addition, rising interest rates will have another negative impact by reducing the market value of the company's fixed rate loan portfolio. The impact can already be seen to some degree in the company's accumulated other comprehensive income, where rising rates have reduced realized gains from sales of securities and increased unrealized losses within the company's securities portfolio and imputed loan portfolio.

Lake Sunapee Merger

Our view is admittedly colored by the recently completed merger with Lake Sunapee Bank Group, formerly New Hampshire Thrift Bankshares. Our interest in local New England banks had led us to research Lake Sunapee as a potential portfolio addition but the dynamics of the business led us to conclude that the company has fairly valued and that its relatively lackluster performance did not provide a basis for investment. In retrospect, we certainly could have received a premium through the company's later acquisition, but ultimately the same factors which led us to conclude that lake Sunapee was not a compelling investment now contribute to our reduced view of Bar Harbor.

In particular, Lake Sunapee had shown relatively little growth or leverage in prior years. We liked the company's geographic markets, despite being on average larger and more competitive than those of Bar Harbor, but the company was clearly unable to leverage net interest margin and loan growth to achieve significantly higher returns on equity and assets, key measures for us in evaluating the operating performance of a bank. In addition, while the shares traded close to book value and paid a relatively significant dividend of around 5%, the lack of growth, leverage, and loan performance dissuaded us. The fact that Bar Harbor purchased these same assets at a premium to the value at which we passed only furthers our concerns about the impact of the merger on what is otherwise an excellent operation.

The merger had a number of negative impacts to the overall business. The most fundamental is that it diluted the company's exposure to its core geographic market, a market we considered superior for a number of reasons discussed earlier. However, the merger also diluted book value (the tangible kind, which we consider more relevant for valuation purposes), added a significant book of comparatively less attractive assets, and will likely impact future operating performance despite operational efficiencies. In short, we were negative on the merger and the closing of the transaction has reduced our opinion of Bar Harbor by diluting its best attributes.

A Small Pot of Gold

A small interesting footnote in Bar Harbor's financial statements relates to the company's Class B shares of Visa. The Class B shares were issued to financial institutions when the company went public with a limitation on their ability to be liquidated based on the outcome of litigation related to merchant fees. The exchange rate on the Class B shares is approximately 1.648 Class A shares per Class B share, subject to adjustment when contributions are made to the litigation reserve fund such that the contributed value is essentially taken out of the value of the Class B shares. Bar Harbor carries it's 19,158 equivalent Class A shares on the books at zero based on "the transfer restrictions and uncertainty of litigation," an extremely conservative decision given that the exchange ratio hasn't been adjusted in over two years and the last adjustment was very minor. The market value of the outstanding Class B shares greatly overwhelms any probably negative adjustment on the outcome of litigation, and the likely upper end risk is probably in the range of 25%. In this case, assuming a worst case outcome, Bar Harbor's shares of Visa have a market value of around $1.2 million - or nearly $0.08 per share - which is not currently accounted for on the books.

Conclusion

The merger of Bar Harbor and Lake Sunapee may ultimately have a favorable long term impact as the company reduces expenses and realizes cost savings by leveraging operating costs over a much larger base of interest earning assets. We certainly don't see doom in the company's future, and Bar Harbor remains a solid community bank. However, given the dilution of many of the features which recommended Bar Harbor in prior years, we feel compelled to reduce our position in favor of better community bank investment opportunities. We would recommend Camden National Corporation over Bar Harbor Bankshares, largely on its greater exposure to rising interest rates and positive net interest income sensitivity, or Katahdin Bankshares (OTC: OTCQX:KTHN) based on its potential for operational improvement and, secondarily, as a potential acquisition target in the long term.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long BHB, CAC, KTHN. 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.