A Safe 7.5% Yield In A U.S. Niche Industry At A Perfect Time In The Credit Cycle

Summary

• The yield is 7.5%, on a unique company that lends $ to a solid US community-based niche industry.
• Its customer base has been the most stable part of the financial industry.
• It's currently 9% below analysts' lowest price targets and is also selling below book value.
• You've probably never heard of it, but it deserves a strong look.

Do you have a community bank in your town? Just like George Bailey's little bank in the classic film, "It's A Wonderful Life", community banks play a vital role in small and mid-sized towns in the US.

As income investors, we've owned several community bank stocks through the years and have had good results. These aren't flashy growth stocks but are usually Steady Eddie stocks with a dependable, attractive yield, AND, their business model is much more conservative than the infamous, "too big to fail" money center banks.

However, before you start snoring, take a look at these impressive Q2 '17 growth numbers for the community bank sector:

(Source: FDIC)

That being said, though, it'd be nice if we could squeeze a bit higher of a yield out of our community bank holdings - they often yield in the 2% - 3%+ range, which is OK, but we've often wished there were some higher yielding community bank alternative.

It turns out that there is a higher yield investment available:

StoneCastle Financial Corp. (NASDAQ:BANX) has a very unique business model. It lends money to community banks throughout the US, through preferred equity, subordinated debt and common equity investments and gives income investors a secure, high yield exposure to them. These banks may be much smaller than the money center banks, but they make up for it by having a strong market share in their towns, which can run up to 70% in some cases. (We'll refer to the company as SCFC, BANX, OR StoneCastle in this article.)

A big part of SCFC's strength in the community banking sector comes from its alliance with StoneCastle Asset Management, which is the investment advisor for SCFC. StoneCastle Asset Management is run by SCFC's CEO Josh Siegel and George Shilowitz, who is the Chairman and President of the Investment Committee. Mr. Siegel has forged many strong ties within the community banking industry. Indeed, his bio states that "his research and financial innovations have brought nearly $40 billion of capital to over 1,600 banks across America during the past 13 years". (Source: SCFC site)

(There's more information on SCFC's management team at the conclusion of this article.)

SCFC's website states that the company's "primary investment objective is to provide stockholders with current income, and, to a lesser extent capital appreciation". SCFC also invests in "similar securities of larger U.S. domiciled banks and companies that provide goods and/or services to banking companies. Together with banks, we refer to these types of companies as banking-related and intend, under normal circumstances, to invest at least 80% of the value of our net assets plus the amount of any borrowings for investment purposes in such businesses". (Source: SFCF site)

These top 10 states comprise ~ 75% of its geographic holdings:

(Source: SFCF site)

Credit Securitizations, Term Loans, Trust Preferred Securities, and Preferred stocks make up the lion's share of SFCF's investments:

(Source: SFCF site)

Here's a sampling of some of the community bank investments SCFC currently holds, via term loans and debt securities - the yields range from 7.25% to 10.5%:

Here's the list of SCFC's Preferred holdings. The left column is the Par Amount in $, and the right column is the fair value, which is driven by broker quotes.

SCFC's 2016 annual report noted that, since the Chicago Shore Series A 9% Preferreds are cumulative, "as of 12/31/16, this investment has deferred, undeclared, and compounding dividends of $675,747.00 that will be recognized by StoneCastle Financial Corp. once they are declared by Chicago Shore Corporation.

Likewise, for the Chicago Shore Series B 8.9% Cumulative Preferreds - "as of 12/31/16, this investment has deferred, undeclared and compounding dividends of $15,838.00 that will be recognized by StoneCastle Financial Corp. once they are declared by Chicago Shore Corporation". (Source: SCFC site)

In our discussions with SCFC's management, it pointed out that this is one of the strengths of SCFC's portfolio - its Preferred holdings are all cumulative, meaning that the issuers must pay SCFC any skipped distributions before paying any common distributions.

(Source: SFCF site)

Trading Details:

SCFC is an SEC registered non-diversified, closed-end investment company listed on the NASDAQ Global Select Market. It has an average volume of ~11,000 shares, with fairly tight bid/ask spreads.

Other than BANX, the only other investment vehicle somewhat related to community banks we've found is First Trust NASDAQ ABA Community Bank ETF (QABA), which holds various, much larger regional banks, ranging in size, up to ~ $9B. QABA also only yields ~1.25%, vs. 7.5% for BANX.

BANX (purple line) has outperformed QABA (green line) so far in 2017 - it was up ~8%, as of 12/27/17 vs. QABA's -.41% loss:

(Source: Schwab)

Distributions:

BANX goes ex-dividend in a March-June-Sept-Dec. cycle and pays in March-June-Sept-Jan.

(Source: SCFC site)

Management raised the quarterly payout from $.37 to $.38 in September '17 and maintained it at $.38 in December '17. It yields 7.54% at a $20.15 price level.

Taxes - SCFC issues a 1099 at tax time. The amount of the distributions which are treated as qualified dividends varies each year - in 2016, it was 55.37%.

(Source: SCFC site)

Distribution Coverage - We measured SCFC's distribution coverage against its Net Investment Income/Share, which shows a Payout Ratio of 94.9%, or 1.05x coverage over the past 4 quarters.

Earnings:

BANX isn't a growth stock, which makes sense, when you consider that it makes $ mainly via debt investments, with fixed interest rates. Management is also savvy - it doesn't chase new business if it's not attractive.

On the Q3 '17 earnings call, CEO Siegel said,

"Over the past few months, we have seen the equity markets reach record levels. As a result, we've seen pressure on investment yields resulting in more aggressively priced transactions in the market, and therefore, we are not in a rush to deploy a lot of capital at this time".

Tailwinds:

SCFC's CEO Siegel also pointed out on the earnings call, that, due to its position in community bank lending,

"When the credit cycle turns, we believe, we should outperform on capital preservation, and we'll be in a strong position to invest at attractive rates to the benefit of our shareholders".

Comparing corporate equities to small banks -

"it's not even close. It's just a far more stable regulated capital-intensive free cash flow industry that tends to have a counter-exposure credit-wise to interest rates, right? Interest rates go up, banks do better, corporates do worse. So it has a lot of really fantastic attributes for where we are in the cycle".

"(In) recent community bank results from the Q2 FDIC quarterly banking profile - Net income increased by 8.5% year-over-year. Approximately two-thirds or 62% of community banks saw increases in net income during the past 12 months. Net interest income also increased 8.9% year-over-year. Nearly 80% of community banks saw increases in net interest income from the prior year. Annual loan growth rose 2.7% from the previous quarter. Loan growth increased at 78% of community banks. Small business loans from community banks increased nearly 3% year-over-year, totaling $296.6 billion. Non-community banks reported a decline of 0.3% or $1.1 billion."

This FDIC chart clearly illustrates the momentum in loan growth that community banks have generated in Q2 '17, with strong growth in the NonFarm/NonResidential Real Estate, C&I, 1-4 Family Residential, and C&D loan segments:

(Source: FDIC)

Credit Issues - Management also commented on emerging credit issues in the marketplace.

"We have seen anecdotal evidence of some investment vehicles, namely BDCs, seeing credit issues with their portfolios. In general, BDCs make higher yield second-lien corporate loans, which carry commensurate risk".

"In contrast, StoneCastle invests in debt and preferred stock of typically conservative community bank lenders. These banks generally make secured first-lien loans to their customers. We believe StoneCastle investments are reasonably uncorrelated to general credits since they are sourced from local markets rather than correlated to national markets."

"Due to the recent hurricanes and wildfires as well as an uptick in interest rates, large money center banks and dedicated consumer lenders have been increasing loan loss reserves, primarily for subprime auto and credit card lending."

Risks:

As with all financial institutions, SCFC has counterparty risk. However, consider these points:

"Community banks have a lower than average exposure to consumer loans, typically under 5% of their total loan portfolios. At the end of the second quarter, that number was 4%. In comparison, during that same period, consumer loans, excluding mortgages, at all FDIC-insured institutions were 16%, half of which was credit card lending".

In discussing historical bank failure rates, CEO Siegel said,

"If you put $1 investment into every bank in the U.S. since 1934, your average annual bank failure rate would be about 0.38%. That includes the Great Depression, the savings and loan crisis and this crisis". (All quotes from Q3 earnings call)

Analysts Targets And Ratings:

As of 12/27/17, BANX was 9% below analysts' lowest price target of $22.00, and 12% below the average $22.60 price target.

BANX has 3 Buy and 2 Outperform ratings from the 5 analysts who cover it:

(Source: Reuters)

Valuations:

At a price of $20.60, BANX is selling at a discount to book value, with a P/Book (Price/Q3 Ending NAV) of .93. Its yield is also much more attractive than broad industry averages, and it has a lower Price/Sales valuation.

Financials:

Its ROA and ROE ratios also look better than broad industry averages, and it has a lower Debt/Equity ratio.

Debt And Liquidity:

Management renegotiated and decreased its credit facility with Texas Capital Bank in May, down from $70 million to $62 million, which reduced fees on unused borrowings. Its new rate on the credit spread on the facility decreased from LIBOR plus 2.85% to LIBOR plus 2.35%.

"Depending on the amount drawn, the credit facility's net savings and additional income could be as high as $156,000 for a quarter. In Q3 '17, the renegotiated facility saved the company approximately $77,000 or just over $0.01 per share". (Source: Q3 earnings call)

As of 9/30/17, SCFC had $36.5 million drawn from the facility, Net Assets of $141 million, and Total Assets of $178 million. It may only borrow up to 33.3% of its total assets. Its leverage percentage at the end of the quarter was 20.4%:

SCFC has good ratings from the credit agencies, as noted in these investment highlights from its website:

(Source: SCFC site)

(Source: SCFC site)

Management:

As we mentioned previously, SCFC has strong management. CEO Siegel is a noted authority on community banking - in fact, he has been invited to educate bank regulators about the community banking industry and is often quoted in financial publications and broadcasts.

(Source: SCFC site)

SCFC's management also includes two veterans of the banking industry - George Shilowitz and Patrick Farrell:

(Source: SCFC site)

Summary:

We rate BANX a long-term buy, based upon its attractive yield, its unique position in a niche industry with significant tailwinds, its conservative portfolio, and its management team, which has strong expertise in the community bank industry and was very constructive in our conversations with it in researching this article. This is by far the best and safest ongoing yield you're going to find related to community banking.

Disclosure: I am/we are long BANX. 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.