NASB Financial, Inc. (NASB), is the parent of North American Savings Bank, a traditional savings bank based in the Kansas City, Missouri, metropolitan area. The company initially attracted our attention in the community banking sector due to its relatively low earnings multiple (approximately 11 times projected forward twelve month earnings) and robust dividend yield (currently about 5% on an annual basis). In addition, the shares trade reasonably close to the company’s book value at 1.3 times.
However, NASB presents a significant risk for current and potential investors as the company’s deposit base is heavily weighted towards short term brokered and certificate deposits. This deposit base supports an investment securities and loan portfolio with significant exposure to long-term fixed rate loans and securities. The company has significant interest rate exposure without material offsetting interest rate hedges. In our assessment, the apparently low valuation is, therefore, not a matter of undervaluation so much as a recognition of the risks inherent to the company in a rising interest rate environment. Indeed, the question is whether this low valuation is low enough given the risks. We consider NASB Financial an unattractive investment despite the low valuation. Current shareholders would do well to carefully consider whether continuing to hold the shares in the current environment is warranted while, for those seeking such opportunities, a compelling potential short opportunity exists in the event interest rates continue to rise.
NASB Financial’s North American Savings Bank has 14 branch locations primarily concentrated in Kansas City, Missouri, and the surrounding suburban and exurban communities. The company’s market region is generally characterized by decent economic performance, which has contributed to regional population growth. In Jackson County, which includes downtown Kansas City, population growth has averaged around 3% per decade since 1990 while the U.S. Census Bureau estimates the broader Kansas City region, including surrounding counties (which encompasses most NASB branch locations) has grown by an even more robust 6% since 2010.
Source: Google Maps
However, the company’s local branch distribution belies its larger geographic scope. The company’s residential and commercial mortgage portfolio, which comprises virtually all of the company’s loans, are not especially concentrated in the company’s core branch markets. Loans on properties located in Missouri and Kansas represent only 27.7% of the company’s loan portfolio while relatively distant markets, such as California and Texas, represent 20.0% and 8.3% of the loan portfolio, respectively, with the balance scattered throughout the United States.
The company’s deposit base is heavily weighted towards brokered and certificate deposits which combined represented more than 56% of the company’s deposit base at the end of the prior year. The majority of the balance of deposits consists of interest bearing savings and money market accounts with a relatively small exposure to non-interest bearing accounts ($99 million), as reflected in the following table:
Source: NASB Financial Annual Report
In this article, all table values are presented in thousands of dollars.
Notably, this concentrated condition has shifted even more towards brokered and certificate deposits during the course of the current year. Brokered deposits, which stood at $27.4 million at the end of 2017, have subsequently risen to $204.5 million over the following six months. The increase in brokered deposits, in combination with certificate deposits which have remained essentially constant over the same period of time, has driven the proportion of total deposits represented by brokered and certificate deposits to around 61.5%. The increase has permitted the company to repay Federal Home Loan Bank advances, all of which are largely short term in nature, in a sense replacing short term variable rate debt with short term virtually variable rate (due to short maturities) time deposits.
Investment Securities and Loan Portfolio
In contrast to the deposit base, substantially all of which matures or reprices in less than two years as discussed in greater detail below, the vast majority of the company’s investment securities and loans are fixed rate long dated instruments. The investment security portfolio is somewhat less troublesome than the loan portfolio and is reflected in the following table:
While the company’s investment securities portfolio has few securities which mature or reprice within the next year, a significant proportion – nearly half – do so within the next three years. The distribution of maturities and repricings in the investment securities portfolio presents only a minor concern – although the company has a meaningful proportion of securities which don’t reprice for at least five years (and perhaps up to fifteen years, a rather broad time frame), these represent a comparatively small proportion of the company’s total interest earning assets.
Indeed, NASB’s securities portfolio as a whole represents a rather small proportion of the company’s interest earning assets. The relatively manageable duration of the investment securities portfolio is overwhelmed by the extended maturity and repricing schedules associated with the company’s loan portfolio.
This should, in fact, be both the greater concern and greater focus of current shareholders and prospective investors as the company’s exposure to interest rate risk is rooted in the loan portfolio. Less than a quarter of the company’s loans mature or reprice within three years while nearly half don’t do so for at least fifteen years, as reflected in the following table:
Source: Federal Financial Institutions Examination Council
The size of the loan portfolio relative to the company’s investment securities portfolio causes the consolidated interest earning asset portfolio to be nearly as heavily weighted towards long dated instruments as the loan portfolio itself:
Source: Federal Financial Institutions Examination Council
Interest Rate Sensitivity
The combination of a heavy reliance on brokered and certificate deposits, which we show below to be concentrated in short term time deposits, and a significant proportion of interest earning assets invested in loans and securities with long periods of time before maturity or repricing creates a significant interest rate gap risk for the company. The following table summarizes the maturity and repricing schedules of the company's assets and liabilities and the associated gap in assets which will mature or reprice in each time period:
Source: Winter Harbor Capital
The table above classifies deposit accounts without stated maturities (i.e., money market and savings accounts) and the company's floating rate subordinated debt in the three months or less category as rate repricing occurs (or may occur) within that time frame. The company's Federal Home Loan Bank advances are classified in the table in the time period during which they come due.
Clearly, the company faces a significant maturity/repricing gap between interest earning assets and interest bearing liabilities - a gap which may persist for years. In the next three months, or perhaps more clearly stated within the next year, nearly $1 billion more in interest earning liabilities will mature and/or reprice than interest earning assets. In addition, it will be several years before interest earning asset maturities and repricings could possibly close this gap even as new loans and securities are added to the portfolio. A significant portion of the interest bearing liability maturity/repricing activity will occur in the company's substantial brokered and certificate deposits which are particularly exposed to changes in interest rates.
Indeed, whereas roughly 26% of the company’s investment securities and loans mature or reprice within in the next three years, virtually all of the company’s brokered and certificate deposits – 96.6% – mature or reprice within the same period of time. The maturities of the company’s brokered and certificate deposits at the end of the prior year are reflected in the following table:
Source: NASB Annual Report (2017)
Indeed, the totals have only increased since the end of the year. The company’s most recent FFEIC filing, which includes the nearly $180 million increase in brokered deposits experienced during the first half of the current year, indicates that of some $900 million in total brokered and certificate deposits, only around 1% mature in more than three years. The bulk of the new brokered deposits, therefore, tend to represent “fast money” deposits seeking premium yields which can (and do) easily and quickly shift between institutions. The fact that brokered and certificate deposits represent, as of the end of the most recent quarter, more than 60% of total deposits necessitates a close look at the company’s interest expense associated with these deposits.
The company attracts these brokered and certificate deposits by offering high rates with very short terms. We developed the following table of offered certificate of deposit rates for the company in comparison to its largest competitors in the Kansas City market – UMB Financial (UMBF), Commerce Bank (OTC:CBSH), and US Bank (USB) – as well as large online bank Ally Financial (ALLY). The data is based on rates listed on each company's website, where available, as well as by contacting local branches in NASB's market region to account for local market variations and fill in unusual maturity terms. In addition, we include Perpetual Federal (OTCQB:PFOH), about which we have similar interest rate concerns, as a savings bank reference. In this comparison, NASB clearly offers – by far – the highest rates at the shortest maturities for certificate of deposit accounts:
Source: Data from Respective Financial Institutions
The yellow highlighted figures represent the highest interest rate offering for each maturity among the institutions. Interestingly, the company’s certificate of deposit rates are even higher than those offered by Perpetual Federal (OTCQB:PFOH), another traditional saving and loan institution that focuses on deposit collection through high certificate of deposit rates in its core market. In addition, whereas Perpetual Federal focuses its higher interest rates on longer maturities in order to lock in interest costs (in the face of rising interest rates), NASB is currently far more heavily focused on short term certificates of deposit. This focus could benefit the company in the event interest rate increases ultimately reverse, but we consider this relatively unlikely, especially over the very short maturities (one to two years) which the company is clearly encouraging at this time.
It’s here where we see, given the apparent absence of significant interest rate hedges, material risk to the company’s earnings and, possibly, its robust dividend. In comparison to offered rates for one year certificates of deposit of 2.6%, the company’s current average interest rate on brokered and certificate deposits, using the data presented in the most recent annual report, was closer to a comparatively low 1.2%. The fact that the vast majority of the bank’s brokered and certificate deposits mature within two years combined with their large proportion of total deposits presents a very real potential for the company’s average interest rate on deposits to quickly increase. In the meantime, the large proportion of long-term loans with fixed rates markedly limits the ability of the company to offset these increases with increases in the average rate on interest earning assets.
There is also very little incentive for a deposit customer to commit to a fixed term of 24 months or 36 months, despite the marginally higher rates for these maturities, when the interest premium over a one year certificate of deposit is, at best, a mere quarter percentage point. In the event interest rates continue their upward trajectory, even at a slower pace, this narrow gap will almost certainly be closed during the one year term such that higher rates – from NASB or elsewhere – may be readily available on maturity of the shorter certificate of deposit.
Moreover, the alternate source of funding should brokered and certificate deposits flee the bank in the face of lower offered rates – Federal Home Loan Bank advances – are no more appealing from an interest rate perspective. Indeed, Federal Home Loan Bank advances and loans tend to be rather similar to certificates of deposit with relatively short terms and, often, variable interest rates.
Finally, there is one other interesting aside about the company's deposit base and the potential for deposit flight - almost 17% of the company's deposits, according to the FFEIC filings, are deposits by other financial institutions. NASB is offering deposit rates that are attracting other financial institutions seeking higher yields on their own excess funds.
So, how sensitive is the company’s earnings to potential shifts in interest rates and a narrowing of the company’s net interest margin? In order to assess this, we developed a net interest margin model for the company to estimate the impact of changes in interest rates on the company’s net income and earnings per share under various scenarios.
The exact sensitivity of the company’s interest earning assets and interest bearing liabilities is difficult to assess and requires the use of a distribution of potential outcomes to establish a reasonable range of values. However, we do believe that the company’s interest earning assets are clearly significantly less sensitive to interest rate changes – at least in the short to intermediate term – than the company’s interest bearing liabilities.
In this vein, our models suggest that for every 33 basis point decline in the company’s net interest margin pre-tax net income declines by approximately 8.5% and earnings per share decline by approximately $0.65. A 33 basis point decline roughly equates to a 50 basis point increase in the company’s average interest rate for brokered and certificate deposits (as well as the company’s subordinated debt and more modest increases on money market and savings accounts). In the event that average certificate of deposit rates increase closer to 2.25% over the next year – still well short of the company’s offered rate on one year certificates of deposit and which would still represent a rather surprising proportion of brokered and certificate deposits in accounts at rates well below the company’s current best offered rates - earnings per share could fall by as much as $1.15 per share. The result is that earnings per share would fall from a projected $3.80 for the current year (roughly speaking) to around $2.65. In this case, the company’s dividend payout ratio would rise from around 50% to more than 75% at the current dividend rate.
It’s also worth noting that, from an historical perspective, a significant and abrupt erosion in the company’s net interest margin would not be unprecedented, especially as the company experienced a similarly stellar increase when interest rates fell during the last recession. The company’s net interest margin, for example, rose from 2.65% to 3.89% over the two year period from 2008 to 2010. In the event the company returned to a net interest margin around the rate prior to the recession – a not impossible outcome if interest rates continue to rise – earnings per share would fall by around half and the company’s dividend payout ratio would approach – or even possibly exceed – 100%. In this case, it’s difficult to see how the company would be able to sustain the current dividend for any extended period of time.
In addition, given the company’s significant focus on originating mortgages and generating related fee and other income, the company's profitability is also heavily reliant on gains from the sale of investment securities and loans. In the 2008-2010 period, such gains nearly tripled from around $14 million to $40 million a year and have remained at this elevated level as interest rates remained low. In 2017, the company’s $43.5 million in gains on the sale of loans represented nearly all of the company’s $47.5 million of income before taxes. In the first half of the current year, such gains have already declined by 30% relative to the prior year, providing yet another risk to the company’s earnings sustainability and, ultimately, its dividend.
In the event net interest income declined simultaneously with net interest margin, reversing the very trend which benefited the company so greatly as interest rates fell during the last recession, the company’s net income could experience a very significant, and abrupt, decline.
The magnitude of the ultimate adjustment both in terms of compressed net interest margin and reduced gains on the sale of loans make it somewhat difficult to define a clear forward valuation for the company. The uncertainty of the timing and course of interest rates contributes significantly to this challenge. In addition, it’s difficult to assess with a high degree of certainty how much impact rising rates in the mortgage market will have on the company’s gains on sales of loans. However, we’re reasonably confident that interest rates will continue to rise into the foreseeable future. The Federal Reserve's own forecast, published in September, predicts five more rate increases through the end of 2020 in the face of ongoing economic strength and as inflation – which until recently remained quite tepid – begins to reappear in the economic landscape. In this case, we foresee a clear and unavoidable downside risk for the company with no corresponding upside opportunity. We therefore base our forward valuation estimates on our projections for various interest rate scenarios and valuation metrics against financial outcomes with a focus on a moderate and severe case.
In the event of a moderate case, where average interest costs on deposits rise and net interest margins decline in the range of 50 to 75 basis points and there is limited ongoing impact on the company’s gains on sales of loans, we project a reasonable forward valuation range for the company of $25.00 to $30.00, or about 25.0%-37.5% below the current market price. This would represent a forward price-to-earnings ratio in the range of 10-12 and a multiple of book value of around 1.0 as return on equity would decline into the 8%-9% range. In our view, this approximates the best possible outcome with limited future rate increases from the Federal Reserve, a rather unlikely outcome.
However, in the event interest rates continue to rise at something approximating the recent pace, i.e., between 75 and 100 basis points a year for the next two years, we see significantly greater downside potential. In this worst case scenario, net interest margins would fall closer to the historical value and gains on the sale of loans would decline by at least half from the current pace, pushing down earnings. We project a valuation range of between $15.00-$20.00 under this more dire scenario as earnings approached or fell below $2.00 per share, putting the dividend at risk. In this case, the company’s shares would still trade at an earnings multiple in the range of 10-13 but at about 67% of book value (excluding unrealized accumulated losses on loans and securities), a not unreasonable valuation for a company with a return on equity in the range of 5%-6% and a significantly lower dividend rate.
Conversely, we see relatively little potential upside in the current valuation barring an improbable shift in interest rate trends or in the event the company somehow manages to avoid a significant repricing in its interest bearing liabilities. We see no immediately viable path for the company to achieve such an outcome on interest bearing liabilities and don't foresee a viable scenario which would result in a severe reversal in interest rates.
A Short Opportunity?
The result is not simply a concerted warning for those currently holding the shares but also a compelling short argument with significant potential contrasted with relatively little - if any - risk.
The challenge in this regard, however, may be taking full advantage of the potential for declining earnings, dividends, and ultimately share price. NASB Financial's market value is only around $300 million, not exactly the most liquid bank in the community banking universe. The company's shares tend to trade infrequently, even for a bank of the company's size, with intermittent transactions of large blocks of shares. The shares available to borrow from a short perspective, on the other hand, tend to swing from as low as a thousand shares up to several thousand. Clearly, this is not an institutional short opportunity, but the magnitude of the potential downside makes considering a short position worthwhile.
NASB Financial is heavily geared towards a falling interest rate environment – an environment the company is rather unlikely to see in the near future. A recession, should the economy take a turn for the worse, could shift the balance of risk by slowing the rate of interest rate increases (or reverse them) and potentially shifting our view. However, with more interest rate increases reasonably certain through the end of the year and into the next, the trend is running against the company.
The company thus faces a combination of factors which will impact its earnings performance going forward. We foresee growing challenges as interest rates rise on deposit accounts, particularly the company’s large balance of brokered and certificate deposits, reducing net interest margins and income as interest earned on assets fails to keep up with interest expense. In addition, we believe rising interest rates will likely continue to negatively impact the company’s mortgage business and the value of the company’s long duration loan portfolio, thus reducing – perhaps significantly – the company’s ability to generate income from mortgage activities and the sale of loans. The combination of these factors could result in a material decline in the company’s earnings over the coming years, possibly even impairing the company’s ability to support its present dividend.
The relatively low apparent valuation of NASB Financial is therefore not simply deserved given the risks inherent to the business in a rising rate environment – it is likely still excessive. The company’s shareholders – and potential shareholders – should carefully mind the company’s sizable interest rate gap.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in NASB over 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.