The Undiscovered Katahdin Bankshares

Summary

• Katahdin Bankshares is a microcap bank with compelling opportunities for efficiency improvements and growth.
• The lack of easily accessible financial information makes analysis more difficult and requires significant effort to develop projections for the bank's operations.
• Our calculations suggest the company may have an advantageous loan portfolio composition and maturity/repricing mix to take advantage of rising interest rates.
• Katahdin's consistent profitability and growth in book value provides long-term investors a significant opportunity even without significant operating improvements.
• Katahdin Bankshares may also be a compelling future acquisition target for Camden National Corporation.

Katahdin Bankshares (OTCQX: OTCQX:KTHN) is a Maine based community banking institution primarily serving the far eastern and northern reaches of the state. The company operates primarily in smaller rural communities with localized small business based economies.

In some respects, Katahdin is an unusual bank on which to focus since its operating metrics have historically been lackluster. The company’s return on assets and return on equity over the last five years have remained stuck around a relatively modest 0.7% and 7.5%, respectively. The company’s non-performing asset ratio has been elevated for some time – generally in the 1.75% range – and the allowance for loan losses relative to non-performing loans has been below average for several years. In addition, the company’s efficiency ratio has similarly been stuck in the 70% range. However, look past these generalized metrics, and it’s possible to see some very compelling positives. Deposit and loan growth has been strong and remarkably consistent over the last several years for a community bank serving rural areas. Earnings per share, although flat, have also been consistent, as has the positive upward march of the company’s book value on both a basic and tangible basis. Katahdin in itself may not be an especially remarkable bank, but it has remarkable potential. The shares also have remarkable potential – at the right price.

This article focuses on our view that Katahdin has several compelling attributes which warrant consideration for focused long-term investors which could yield superior long-term results. In particular, despite the relatively lackluster bottom line performance compared to peers such as Bar Harbor Bankshares (NYSE: BHB) and Camden National Corporation (NASDAQ: CAC), there are unique opportunities available to Katahdin which may prove significant, especially in light of the company’s relatively modest valuation in comparison to its acquisitive larger peers.

Market

Maine’s banking market has long been a positive for local institutions as we discussed in a prior article focusing on Bar Harbor Bankshares. In comparison, the company’s markets are somewhat more competitive than the markets of similar Maine institutions where market competitors are primarily local Maine based institutions. In contrast to much of coastal Maine, Katahdin’s market competitors include larger banks, primarily KeyBank and TD Bank, in addition to a collection of local competitors. The presence of large bank competitors, in our view, is a net negative as this tends to subject the bank of greater competition both from the scale and capabilities of larger regional and national banks in addition to the greater willingness of regional banks to sponsor competitive promotions for deposit and loan products. Nonetheless, Katahdin remains one of if not the top institution in terms of deposit market share in most of its communities.

Deposits

Katahdin has experienced significant deposit growth over the last several years through a mix of local deposit growth and the use of brokered and wholesale deposit financing. The company retains a higher proportion of brokered and wholesale deposits than we would generally prefer, but this is relatively common in Maine based community banks. In addition, Katahdin’s proportion of non-interest bearing deposits, at 15.5% of total deposits, is actually superior to that of either Bar Harbor (9.4%) or Camden National (14.4%). In addition, the company’s average deposit cost is lower than that of Bar Harbor. The exact figure is not disclosed in the financial statements, but backing out other debt expense, Katahdin’s weighted average deposit cost appears to be close to 0.65% versus 0.74% for Bar Harbor (before the company’s merger with Lake Sunapee Bank Group). In comparison, Camden National’s weighted average deposit rate is a rock bottom 0.31%.

However, some of this benefit is offset by repricing risk in the deposit accounts, largely related to the large proportion of deposits in savings, money market, and relatively short maturity certificates of deposit. Money market accounts represent 27.1% of deposits, other savings accounts 29.4%, and certificates of deposit due within one year 25.3%. In itself, this is not unusual for a community bank but does play a potential role in the impact on the bank’s net interest income in a rising rate environment, which we discuss later in this article.

Loan Portfolio

Katahdin’s loan portfolio is relatively traditional in terms of composition with allocations to residential, commercial, consumer, and municipal lending. In general, there is nothing especially surprising about the loan portfolio; indeed, the most surprising aspect is the relative lack of disclosures regarding the composition of the loan portfolio beyond general loan types.

Unfortunately, the company’s financial statements do not provide any of the typical details on the company’s mix of fixed and variable loans or any analysis on the sensitivity of net interest income to changes in interest rates. The company is also hesitant to provide supplemental information not included in the public financial statements. In order to estimate (or at least get a sense of) the loan repricing mix as well as potential impact of changing rates on net interest income, it's necessary to reference the reports available from the Federal Financial Institutions Examination Council.

The FFIEC reports don’t provide a very concise breakdown of loans relative to fixed versus variable characteristics but do, at least, provide a breakdown of the combined maturity or repricing periods for various types of loans in the bank’s loan portfolio. In order to estimate the loan rate type mix, it’s necessary to make some customary assumptions about whether specific classes of loans are traditionally fixed or variable and, to the extent there is a mix, the relative proportion of fixed and variable rate loans within certain loan classes. In generating estimates such as these, though, it’s necessary to be sensitive to the potential variance in one’s evaluation. It’s also possible to use the fixed and variable rate mix structures of comparable local banks as a check on the calculations.

We compiled the available information using various sources, primarily the FFIEC report, to generate and estimate the mix of fixed to variable rate loans to be approximately as follows:

Source: Proprietary Calculations based on Company Financial Reports and FFIEC Data

We checked our assessment of the loan mix against Bar Harbor and Camden National as a check of our figures and found that Katahdin’s allocation of variable rate loans, per our estimate, to be materially higher than that for either Bar Harbor or Camden National:

Source: Company Financial Reports

The difference gives pause and requires an explanation given the significantly larger allocation to variable rate loans for Katahdin versus either Bar Harbor or Camden National. In our view, the primary difference is Katahdin’s significantly lower exposure to traditional first mortgage residential loans relative to its competitors and higher concentration in commercial lending, as reflected in the following table showing the loan portfolio breakdown for each institution:

Source: Company Financial Reports and FFIEC Data

It’s possible, of course, that Katahdin’s allocations of commercial loans between fixed and variable may differ substantially from those of Bar Harbor and Camden National, although we have not yet found a specific reason to believe that there would be significant variation. In addition, as noted below, Katahdin’s blended mix of maturity and repricing dates is significantly more heavily weighted towards the shorter end of the maturity spectrum, suggesting that Katahdin’s loan portfolio, in the aggregate, has either shorter loan terms than either Bar Harbor or Camden National or a greater proportion of variable rate loans. We discuss this distribution in a moment but view the distribution as being suggestive that Katahdin’s proportion of variable rate loans is, indeed, higher than for either Bar Harbor or Camden National.

Nonetheless, the relative allocation between fixed and variable rate loans may still be excessive and would, in our view, represent a best case scenario for the structure of Katahdin’s loan portfolio. In order to provide a more conservative estimate, we therefore established this estimate of the proportion of variable rate loans to total loans as the top of the band with an allocation of 60% as the bottom reflecting our view that the mix of Katahdin’s loan portfolio, especially as detailed in the FFIEC breakdown, strongly suggests that Katahdin’s portfolio is more variable than either Bar Harbor or Camden National. In itself, this is a relative positive for the company.

Of course, there are inevitably certain judgments associated with this conclusion, partially informed by information Katahdin was willing to share (in general terms) and familiarity with the industry. It’s possible this estimation is well off the mark, a condition which would only be rectified by Katahdin’s provision of additional information in its financial reports. In the current case, however, we feel sufficiently comfortable using this band as a basis for evaluating potential impact on net interest margin and using sensitivity to variation in the ratios to develop a band of probable outcomes.

Regardless of the exact mix of fixed and variable rate loans in the portfolio, the company’s effective loan duration is also shorter, perhaps significantly so, than competitors such as Bar Harbor and Camden National as reflected in the following table:

Source: Company Financial Reports and FFIEC Data

Notably, Katahdin has the shortest maturity and repricing “tail” – that is, the proportion of loans that mature or reprice more than five years out is significantly smaller than for either Bar Harbor or Camden National. The FFIEC data is not sufficiently granular to definitively determine whether loans are maturing or repricing – or the relative mix between the two – but the effect is essentially the same. This adds an additional level of comfort with respect to uncertainty about the ratio of fixed to variable loans since the shorter effective duration would further mitigate the potential impact of rising interest rates.

In terms of loan performance, however, Katahdin does partially diverge from either Bar Harbor or Camden National in that the company’s proportion of non-performing loans to total loans has remained significantly elevated since the financial crisis. In comparison, Katahdin’s 2.45% ratio of non-performing loans to total loans is significantly higher than either Bar Harbor or Camden National, at 0.58% and 0.97%, respectively. In addition, relative to Bar Harbor and Camden National, Katahdin’s ratio of allowance to loan losses to non-performing loans is low at 39.6% versus 160.4% and 92.3%, respectively, for its peers. The relatively high non-performing loan ratio and low allowance ratio may be cause for concern and suggest that additional allowance for loan loss expenses may be necessary, which we address in a later section. However, the counterbalance is that Katahdin’s ratio of charge-offs to total loans over the last four years have not deviated substantially from those of Bar Harbor and Camden National, averaging a marginally higher 0.15% versus roughly 0.10% for the other institutions. It’s not clear from the financial statements why this is the case, although barring a significantly more aggressive stance in terms of taking charge-offs relative to Bar Harbor and Camden National, it may suggest that Katahdin’s average troubled loan is better collateralized or secured than those of Bar Harbor and Camden National. In this case, the comparatively low allowance would not be a concern, but in the absence of precise information, it’s a consideration when evaluating Katahdin.

Net Interest Income

Net interest income is, of course, the core earnings source of most banks. In spite of a competitive market and low interest rates, Katahdin has achieved rising net interest income in each of the last five years. In addition, the company’s net interest spread has consistently been higher than that of either Bar Harbor or Camden National, coming in at 3.56% for 2016 versus 2.86% and 3.22% for Bar Harbor and Camden National, respectively.

However, the key factor moving forward is how net interest margin will be impacted by rising rates, assuming rates continue to rise. Katahdin does not provide a net interest income sensitivity analysis in its financial statements, as noted earlier, so it’s left to the analyst to attempt to assess the company’s interest rate sensitivity. In this case, though, this is much more difficult and requires significantly more assumptions, than the prior estimates regarding the proportion of fixed versus variable rate loans in the bank’s loan portfolio.

We approached this analysis in a number of ways, including developing various estimates of the composition of the loan portfolio and repricing impacts and periods based on the FFIEC data, and making certain assumptions about the way that deposit account repricing would relate to repricing and/or maturity of related loans over given periods. The full extent of this analysis is impractical to present in this article, and the significant assumptions required about maturities, repricing, and timing, make point estimates of the dollar impact to net interest income sufficiently meaningless that we don’t present any of those values in this article. However, in the aggregate, our various approaches suggested that, on average, Katahdin’s net interest income sensitivity is likely neutral to marginally positive with respect to rising rates over the initial two year period. In other words, Katahdin would likely see net interest income rise slightly with rising interest rates.

We also considered the aggregate impact on net interest income projected by Bar Harbor and Camden National in their financial statements. In a prior article regarding those banks, we noted the large disparity in expected outcomes between the banks, with either rising or falling rates expected to negatively impact Bar Harbor’s net interest income (with the most significant impact from rising rates). In comparison, Camden National’s sensitivity analysis suggested the greatest potential impact from falling rates while rising rates, after a slight impact to net interest income in the first year, would yield positive net interest income outcomes in subsequent years. In this regard, in terms of loan portfolio maturity and repricing, Katahdin is much closer to Camden National than Bar Harbor, suggesting that in the aggregate Katahdin would benefit from rising interest rates roughly on par or somewhat more than Camden National depending on one’s conclusions about the composition of the loan portfolio. However, in contrast, Katahdin has significantly more of its deposit base in interest bearing deposit products than Camden National, suggesting that the positive benefit would be substantially offset by the negative impact from rising deposit rates. This is a purely qualitative check analysis in the absence of actual date in Katahdin’s financial reports, which may well prove our analysis entirely wrong, but it does appear to confirm our net interest income projection calculations.

Profitability

Katahdin’s operations have been characterized for years by suboptimal result, high operating costs, and unremarkable but stable operating performance. The company’s efficiency ratio of 73% is well above those of either Bar Harbor or Camden National whose efficiency ratios are consistently in the range of 60% plus or minus a couple percentage points.

In fact, the primary factor holding the company’s performance back has been its relatively poor efficiency ratio, a factor that the company has begun to proactively address.

In combination with the steady incremental growth in deposits and loans over time, we consider improving the operating ratio to be a major opportunity for the company. Indeed, the company has been moving recently to improve is operational cost structure. In January, the company closed three of its banking locations to reduce costs and improve efficiency, taking a small charge in the first quarter to reflect valuation adjustments for the former branch offices. We believe the company will continue to focus on costs which will yield outsized benefits for earnings going forward, yielding additional incremental gains in profitability for shareholders.

Moreover, regardless of whether regulatory hurdles are reduced in the future by the current administration, the company should benefit from ongoing growth by leveraging increased scale against relatively fixed regulatory compliance costs. Indeed, scale matters greatly when it comes to regulatory expenses for small community banks, as illustrated in a report from the Federal Reserve Bank of Saint Louis. The company’s assets have grown by nearly $200 million in the last five years, from $576 million to $754 million, and continued growth may very well see the company exceed $1 billion in assets within the next five year.

Ownership

Interestingly, while Katahdin is not widely held, the company’s board of directors owns a significant proportion of the company’s outstanding common stock. The members of the board, according to the company’s post recent proxy statement, hold 422,560 shares of the company’s stock, or 12.4% of the company’s outstanding shares. We consider this an additional positive attribute for the company in combination with all the other factors.

Preferred Stock

In 2014, Katahdin issued preferred stock carrying a variable dividend with a dividend floor of 8.75%. The preferred stock was issued primarily to redeem preferred stock issued as part of the financial crisis program to support community bank equity levels which was set to reprice to a significantly higher dividend rate. We consider the issuance of the preferred stock a net negative for the company given its very high cost relative to the company’s other funding sources. However, at the time, the company’s common shares were trading at a significant discount to book value and issuing the preferred shares may have seemed a more acceptable approach than the dilution associated with issuing common stock. However, the preferred stock may also be a net positive going forward in that, beginning in 2019, the company has the option to redeem the preferred stock. The current market price of the common would allow the company to issue common shares to redeem the preferred stock with essentially no impact to income per share and acceptable dilution of book value. We would hope that the company would proactively address this issue when the preferred shares become redeemable and replace the preferred shares with common equity.

Potential Acquisition Target

Finally, we consider Katahdin a potential acquisition target, especially for its acquisitive peers Bar Harbor or Camden National. The company’s branch locations in far eastern and northern Maine do not have significant overlap with either Bar Harbor or Camden National, but close market adjacencies which would allow either bank to leverage existing infrastructure to serve Katahdin’s communities and reduce operating expenses. In each case, Katahdin would be a relatively small, bolt-on type acquisition which would be mildly accretive to earnings with relatively little integration risk. A less likely scenario would be an acquisition by one of the other Maine based institutions which share market overlap or adjacencies, such as privately held Bangor Savings Bank or Machias Savings Bank, though an acquisition by either would likely be for cash. We consider it highly unlikely that Katahdin would be a target of either KeyBank or TD Bank given the company’s small size and the likelihood that these institutions would consider banking operations in relatively small rural communities in Maine a non-core business and be more likely to divest than acquire.

The most likely acquirer, in our view, would be Camden National. In part, this view is based on the strong market adjacencies in each bank’s branch networks in combination with Camden Nation’s long-term focus on consolidating Maine banking institutions. In addition to being able to take significant operating costs out of the existing business, thus reducing Katahdin’s operating ratio, Katahdin would represent a relatively straight forward bolt-on acquisition with little overlap but excellent adjacencies to its existing banking market.

Katahdin Bankshares Locations:

Source: Google Maps

Camden National Locations:

Source: Camden National Annual Report

Bar Harbor Bankshares Locations:

Source: Google Maps

Bangor Savings Bank Locations:

Source: Google Maps

Machias Savings Bank Locations:

Source: Google Maps

We approached estimating a potential acquisition valuation for Katahdin assuming Camden National as the most likely potential acquirer. We began by calculating Katahdin’s potential earnings per share under various efficiency ratios based on the assumption that Camden National would be able to achieve a certain level of operations efficiency in Katahdin’s operations through an acquisition. Camden National’s efficiency ratio has historically been about 60% or less, so we decided to set this efficiency ratio as the base for our calculations with a worst case outcome in the range of 65%. We calculated earnings per share under two scenarios, one in which Katahdin’s preferred stock remains outstanding and one in which Katahdin issues sufficient common equity to redeem the preferred shares. The calculated potential earning per share based on these scenarios is presented below:

Source: Proprietary Calculations

We also calculated a set of book values based on scenarios where Katahdin increased its allowance for loan losses to a level commensurate with Camden National’s ratio of allowance for loan losses to non-performing loans and where Katahdin issued common equity to redeem the preferred stock, as reflected in the table below:

Source: Proprietary Calculations

We then established an assumption that the likely band of valuations at which an acquisition would occur would range between Katahdin’s current valuation metrics and Camden National’s current valuation metrics, depending on the range of performance assumptions Camden National may make as an acquirer of Katahdin. The valuation metrics are reflected in the following table:

Source: Market Data

We then used these values to calculate matrices of potential valuations per share of Katahdin’s common stock. The results are reflected in the following table:

Source: Proprietary Calculations

Clearly, there are significant potential acquisition premiums to Katahdin’s current share price based on these calculations. In reality, we consider the probability that an acquisition would be executed at the high valuation relatively low, with a valuation somewhere between the midpoint and low valuation range the most likely outcome.

We also approached an acquisition valuation estimate based on the valuation assigned by Bar Harbor in its recent acquisition of Lake Sunapee Bank Group. In many respects, Katahdin and Lake Sunapee are very similar from an operations perspective, as reflected in the following table (based on year end 2015 values, though the performance of the banks remained consistent through the closing of the Lake Sunapee merger):

Source: Company Financial Reports

Indeed, Katahdin is a better performing bank than Lake Sunapee in most respects other than the ratio or non-performing assets and the coverage of non-performing loans in the allowance for loan losses. However, we can adjust for the difference in loan loss coverage, as we have earlier, to estimate the potential impact of this difference on the prospective acquisition price. In addition, as noted earlier, although Katahdin’s non-performing asset ratio is significantly higher than that of Lake Sunapee, the company’s loan charge-off experience over the last two years has been virtually identical, suggesting that Katahdin may on average have greater collateral coverage or other factors that support maintaining a lower allowance for loan losses relative to non-performing loans. It’s possible, therefore, that an adjustment to book value to account for the difference in non-performing loan coverage ratios may, in fact, result in too conservation a valuation.

We determined the following potential acquisition valuations for Katahdin using the Lake Sunapee merger ratios:

Source: Proprietary Calculations

We believe, based on the above valuation calculations, that a likely acquisition value per share for Katahdin would be somewhere in the range of $16.75 to $22.50, between the midpoint and low valuation range in comparison with Camden National and comparable to somewhat better than the range applicable to the Lake Sunapee merger, representing a potential acquisition premium to the current share price of 24%-67%. We believe that as these valuations, assuming a reasonable degree of operational improvement on the part of Camden National, the valuation would be compelling for both companies.

Summary

Katahdin Bankshares is not the next technology rocket (or bomb) and isn’t likely to hit the proverbial ball out of the park. However, Katahdin offers a number of opportunities for investors seeking allocations to profitable and stable financial institutions which provide compelling dividend yields and good relative valuations. The combination of ongoing incremental increases in book value of about $0.70 per share annually plus the annual dividend of $0.40 provides a stable and highly reliable $1.10 increase in value per year - a roughly 8.1% equivalent effective return at the current market value even without incremental growth or improvement in the efficiency ratio. However, the company also has significant opportunities to improve its operations and liability mix, providing further sources of potential appreciation. The possibility of an acquisition at some point in the future is a bonus feature in combination with the balance of the company’s compelling attributes.

Katahdin’s common shares, currently trading at $13.50, continue to reflect a significant 21.2% discount to the company’s book value albeit a much smaller discount than was available as recently as late last year. We believe the company’s long-term potential remains underrepresented by the current market price for the reasons presented in this article.

However, it should be noted that Katahdin Bankshares has a market capitalization of less than $50 million, well into the micro capitalization category and may not be suitable for all investors. The company’s shares are usually very thinly traded and are best for patient investors willing to hold the shares for the long term. In addition, the use of limit orders when acquiring positions is recommended along with the recognition that selling shares in the future could be challenging without significantly impacting the supply/demand balance.

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.

Comments

[Brent Barber]

A couple of things interesting in the quarterly report out today. Again, earnings were good and YTD ROE is up 1.2% to almost 12%.

1. The new senior notes are included in liabilities and, as such, now have the interest being tax deductible as opposed to the old preferreds which were paid as dividends.
2, The buyback is moving forward more quickly than I would have though given the low trading volume in the stock - As a follow-up regarding the announced Stock Buyback Program, Bankshares has purchased and retired a total of 31,160 shares during the third quarter at an average price of $17.49 per share.

[Brent Barber]

Nice to see the new Senior Notes at 5.375%, being used to redeem the preferreds which are at 8.75%.

Round number of $300,000 a year in savings, which is $0.088 per share before tax, so some incremental value.

Good management is doing some things to help shareholders - this seemed like an obvious one given the bank's good financial situation and the high rate they were paying on the old Preferreds.

[Carlton Getz, CFA]

Brent Barber -

We're pleased to see the bank redeem the preferred shares - we've discussed this with management on several occasions - although we're somewhat less enthusiastic about the issuance of $14.5 million in senior notes. We'd have preferred to see fewer senior notes issued to redeem the preferred shares. The net impact on the company, though, is closer to $0.04 to $0.06 per share since the company issued $14.5 million in senior notes and only redeemed $10 million in preferred stock, so the senior note interest is only $95,000 less than the preferred dividends. The majority of the benefit comes from deductibility of the interest.

[Brent Barber]

Thanks - missed the increase. Hopefully they have a plan to do something useful with the extra $4.5 million. it does not look like they have any higher interest rate debt they could pay off, so will be interesting to try and see where it goes.

[Carlton Getz, CFA]

GrayhawkAZ -

We continue to like Katahdin and, in fact, significantly increased our position in the last few months during which some larger blocks became available. The company's shares have risen faster than we'd anticipated but corporate tax reform changed the earnings power quite substantially so while the share price has approached our estimated range, that range needs to be adjusted to reflect the benefits from lower corporate income tax expense. Maine also has an unusual taxation approach to financial institutions. We've communicated with management in the meantime regarding the potential redemption of the preferred shares in the coming year and our thoughts on the financing of a redemption. The rising share price improves the potential economics. We also still believe Katahdin would be a compelling acquisition opportunity, especially for Camden National Corporation, but don't feel the need to count on that possibility to maintain our holdings. The company is moving in the right direction regardless, so we're watching to see if the momentum is sustained over the coming year.

We appreciate the comment!

[GrayhawkAZ]

Nice run so far.

Qtrly numbers were pretty encouraging. Any additional thoughts over the last year?

[Jeremy Blum]

The reason for the discount to peers and book is the trading volume, 331 shares a day. It would take most investors months if not years to get a full position. They would then have to go through the same excruciating process to get out. I in fact did do this once acquiring stock in an even more lightly traded bank stock in Indiana over a year period. I was able to sell out after a nice run up, which I probably was partially responsible for, to the bank's ESOP. I got lucky. I do agree they are buyout bait at the current price, but I usually don't play the buyout game, and this is too hard.

[Carlton Getz, CFA]

Jeremy -

We appreciate your comment - your observation is correct for most investors. In our case, our time horizon for portfolio holdings is exceptionally long, occasionally measured in decades. The company's earnings, even without any improvement in the business metrics, provide a relatively low risk annual return through a combination of dividends and growth in underlying value of around 8.5% per year with the potential for better outcomes whether or not immediately recognized by the market. It's not stellar relative to what many have come to expect from the market, but given a focus on absolute rather than relative returns, an highly consistent 8.5% annual rate compounded over decades remains compelling as a portfolio component. In time, the value will be recognized in one way or another.

[Brent Barber]

I agree with your approach with a stock like KTHN. Buy and be patient and collect the dividend and increasing value in the company. There will be a good time to sell, but could be a long time.

The valuation given to KTHN compared with most other small community banks is still somewhat surprising. Many other community banks have poorer profitability and had more trouble with the financial crisis trade at much higher valuations than KTHN. But this is just an opportunity for patient investors like us to accumulate shares on the cheap!

[Catahoula]

A fine article...a nicely balanced assessment. I have looked KTHN several times over the last two-three years. I have also found Matt Nightingale responsive my questions. I'm glad that the author dedicated so much effort to addressing and running scenarios on book value. The overhang from the preferred shares has kept me from pulling the trigger...so far...

[A Philosopher]

A great analysis on KTHN! I am worried that you are letting the cat out of the bag as I have been acquiring shares over the past two months based on a number of factors you mentioned. I was hoping to acquire more shares in the future but it is thinly traded and I am careful not to escalate the price.

It is difficult to find banks trading at such a discount to their TBV. I also acquired some shares in CRZY as it also has low cost deposits, trades less than TBV, and has little competition. Like KTHN, many of its metrics have room for improvement. Eventually management will fix these companies or the market will demand they be sold.

[Brent Barber]

Thanks for the detailed article - this is very valuable for a small, thinly traded company.

I have a couple of points/questions:

In their income statement, dividends for Preferred Shares are deducted from Net Income to give the Net Income Available to Common Shareholders and the calculation of EPS. So redeeming the preferred shares would increase the EPS earnings. I calculate the EPS increase at $0.21 per share. You say getting rid of Preferreds won't affect EPS, so am I missing something here?

I had the following email exchange with Katahdin Investor Relations, which shows they do think about these things:

Question: Can you please explain to me the rationale of continuing to have the Preferred D shares outstanding? They are expensive at an 8.75% interest rate and I think there should be cheaper funding sources of borrowing available to the company. One alternative would be to issue common shares. If you issued 700,000 shares at $14.00, you could pay off the preferreds and increase EPS by $0.21. Perhaps the plan is to just pay these off in the next couple of years, as the company easily meets capital requirements and generates enough profit after dividends to pay this off in about 4 years, which would avoid common share dilution. Is getting rid of this expensive source of financing a goal of the company?

Response: You’ve raised good questions/observations here. The Preferred Series D shares are callable by the company, but not until June 27, 2019 – five years after original issuance. I can’t say whether we will make a change here, but capital efficiency is important to us and we periodically discuss options.

The other thing I have been thinking about is prior to the financial crisis, KTHN generated an average ROE of over 16% for the years 2003 to 2007, granted a very good environment. Additionally, the traded at P/B's above 1.7 for at least 2 of those years and had an average year-end p/e of 13.

So being optimistic, if KTHN can improve its profitability as you suggest and net interest margins improve with rising rates, and they get a better valuation because of this increased profitability, I can project stock prices in the mid $30's:

EPS with 15% ROE $2.43
p/e of 13 gives Stock Price = $31.53
BV in 3 years = $23.39 (remove $1.20 for 3 years dividends)
If P/B can get back to 1.7 range
Stock Price = $39.77
Average $35.65

[Carlton Getz, CFA]

bbarberayr -

We appreciate the comments and questions. In regard to the preferred, our comment related to issuing common stock to raise the equity capital to redeem the preferred shares, in which case the dilution to earnings per share caused by issuing new common stock would be offset by the additional contribution to earnings per share by allowing the preferred dividends to drop to the net income available to common shareholders - thus, there would be essentially no net impact on earnings per share under this redemption scenario. We don't see a way the company could increase earnings per share by $0.21 while also issuing new common stock - the number of shares required would be about 750,000 while the dividends are $875,000, which happens to be equal to last year's earnings of $1.16 per share.

In regard to share valuation, your observations are correct, although we consider it unlikely the company would be able to achieve those margins and valuations (aside from P/E) in the current (or likely future) regulatory and economic environment. We generally take a more conservative view to projected valuations - when we can achieve a good long term compound rate of return on conservative valuation, anything beyond is simply icing on the proverbial cake.