Katahdin Bankshares (OTCQX:KTHN) exceeded our expectations in 2018. The company’s earnings per share came in at $1.89 versus our estimate closer to $1.60 largely based on a better than expected efficiency ratio and a lower than expected provision for loan losses driven by notable improvements in credit quality.
The company’s shares, however, remain modestly valued on both an absolute and relative basis and present patient investors with an ongoing opportunity for long term incremental growth. In this roughly annual update, we comment on the company’s performance during the prior year (both positive and negative), the potential for the current year, and the possibilities surrounding a redemption of the outstanding preferred stock.
Overall, our view of Katahdin has not changed substantially since nearly a year ago as presented in our last article on the company. Katahdin remains an undervalued and underappreciated local community bank on the fringe of investors’ minds (both geographically and metaphorically) which nonetheless offers the potential for consistently compelling ongoing returns. In addition, the potential for an acquisition at some point in the future, as discussed in earlier articles and which we continue to consider a possibility despite the company’s presently stated commitment to remaining independent, only adds to the company’s allure.
Loan Portfolio Credit Quality
First, a couple positive attributes.
Katahdin experienced ongoing improvement in credit quality during the last year after a remarkable improvement in the prior year. The company has long had a somewhat elevated (though relatively stable) percentage of non-performing loans and non-performing assets. However, the apparent improvements in credit quality over the last two years have resulted in the allowance for loan losses as a percentage of non-performing loans reaching 92%. The ratio of non-performing assets to total assets also improved to just under 0.8% and 1.0% for non-performing loans to total loans, both of which represent the lowest ratios in the last decade.
Indeed, in comparison to peer institutions such as Bar Harbor Bankshares (BHB) and Camden National Corporation (CAC), Katahdin’s elevated non-performing assets and comparatively low allowance for loan losses has long stood out as unusually weak.
We’re also impressed with the significant reduction in past due loans from the prior year as reflected in the following table:
Notably, past due loans declining more than 40% and nonaccrual loans declining by more than 20% with the biggest improvements in the commercial loan portfolio.
Of course, it remains to be seen whether this trend persists – the shift is rather dramatic given the company’s long history since the housing crisis of comparatively uninspiring credit metrics – but even if the loan credit quality ratios returned to more recent levels, these have been factored in to our earlier analysis.
A second noteworthy achievement is the company’s ability – once again – to effectively control costs which has boosted the company’s efficiency ratio. The company’s non-interest expense has been essentially flat since 2016 after rising by a relatively consistent $1 million a year for the prior six years. The reduction in non-interest expense has, in part, come from the company’s closure of three branches in 2017, a relatively bold move for a community bank with only 16 current branches, but this effort has clearly benefited the company on the expense side of the ledger.
A Couple Challenges
However, the company did experience some challenges over the last year which warrant attention.
First, the improved performance in loan quality is tempered somewhat by the sudden decline in loan growth over the last year. Indeed, after growing at a decent single digit clip for nearly a decade, the loan portfolio finished the year slightly smaller than the earlier year. The company hasn’t commented significantly on the causes of the lack of loan growth other than to note that it was rather broad based, but this is an area which will attract additional attention as the company reports results for the first quarter.
Second, while noninterest expense has remained essentially flat so has noninterest income. Katahdin experienced a significant rise in noninterest income between 2013 and 2016, but this trend has abated in recent years similar to the company’s performance after the housing crisis. The majority of the company’s improvement in earnings per share for the most recent year relied on an almost equal combination of benefits from higher net interest income, lower provisions for loan losses, and a lower corporate tax rate. We’d prefer to see greater benefits from noninterest income as an additional boost to the bottom line, although this may be more challenging in a rising interest rate environment as fees associated with loan originations decline in tandem with refinancings.
The Preferred Stock
We’ve previously discussed Katahdin’s outstanding preferred stock which becomes redeemable in June. The preferred stock, with a redemption value of $10 million, bears a variable dividend rate with a floor of 8.75%, resulting in $875,000 in annual dividend distributions to the preferred shareholders. The company issued the preferred shares five years ago in an effort to redeem the company’s previously outstanding preferred stock – a legacy of the housing crisis – which would have been exceptionally expensive barring a redemption.
We suggested a year ago that the company should consider leveraging its rising share price by issuing common shares to raise sufficient funds to redeem the preferred shares. In retrospect, given the company’s operating performance during 2018, our suggestion was premature. Indeed, while disappointing from an operating perspective, the relative lack of asset growth during the most recent year in the face of rising retained earnings does have one potentially salutary effect for the company in that shareholder’s equity grew as a percentage of assets, improving overall capital ratios. The result places the company in the position to possibly redeem its preferred shares this year from existing capital.
We believe the company should redeem the preferred stock this year using currently available funds. Our rough estimates - developed internally from capital ratio data in the company's annual report - suggest that the company could do so utilizing existing cash (without the need to issue additional common shares) while maintaining bank capital ratios well in excess of those required to be considered well capitalized for regulatory purposes.
Source: Winter Harbor Capital
Indeed, per our estimates, by the end of the current year assuming profitability is similar to that of the last year, the company’s capital ratios would not be significantly different than they were at the end of 2017.
The redemption of the preferred shares, especially without the issuance of any preferred shares, would add approximately $0.26 to annual earnings per share due to the elimination of the preferred stock dividends. In 2018, this would have boosted earnings per share to $2.15 versus $1.89. In addition, the redemption would allow the company to either accelerate growth in accumulated earnings thus improve the company’s capital ratios or allow for increased dividends while maintaining the payout ratio – or, better yet, a combination of both. In fact, simply maintaining the current payout of approximately 25% ratio on the higher earnings base would require a 20% increase in the dividend to yield around 3.0%.
We’ve been in communication with the company’s management on this issue and continue to do so to express our view that a redemption of the preferred stock would be a significant benefit to the company.
Expectations and Valuation
We expect the company’s performance during the current year will roughly match the most recent year. The lack of significant loan growth will be partially offset by relative improvements in the cost of funds as brokered deposits continue to be replaced with local deposits. The company’s provisions for loan losses should also remain muted assuming ongoing improvement in credit quality. The improvement in past due loans suggests that the improvement in credit quality has staying power although this is not a certainty. We therefore expect earnings per share in the coming year to be around $1.90 per share with the potential for earnings to exceed $2.00 per share in the event the company’s preferred stock is redeemed with existing cash in June.
We project a forward valuation for the company based on our earlier valuation metrics of between $21.00 and $23.00 per share, approximately 24% to 35% above the current valuation, based on still modest multiples of earnings per share and book value. However, prior experience suggests that the nature of the company will likely introduce a persistent discount to peers, so year ahead results may not actually reach these robust returns. However, even a year consistent with last year would support a 12% return (or better including dividends) based on the company trading at roughly 1.0 times book value and 10 times earnings.
In an acquisition scenario, we believe the company’s valuation to be closer to $25.00 to $30.00 which would still represent relatively modest valuation multiples.
In any case, the incremental growth of the core business should support annual returns in excess of 10%, including dividends, simply assuming stability in the core business through ongoing contributions to book value.
Katahdin Bankshares remains one of our top community banks. The investment time horizon is, however, measured in years and requires a high degree of patience from shareholders to realize the full potential of incremental growth. The company is not especially exciting from an operational standpoint (the company isn’t going to become the next major regional bank through a series of acquisitions), but the very modest valuation close to tangible book value, consistent and recently improving performance, decent dividend yield, ongoing accumulation of retained earnings, and prospective benefits to common shareholders from a potential redemption of the company’s outstanding preferred stock all represent significant positives. The ongoing potential for an eventual acquisition of the company is an additional attraction.
However, even without an acquisition, given the potential for 11%-13% annual returns on tangible equity, we intend to continue adding to our existing position as blocks of shares come available from time to time, especially in the event the shares again fall below tangible book value.
Katahdin Bankshares, with a market capitalization of less than $60 million, is a micro capitalization bank with thinly traded shares. The company may be suitable only for investors who can accept the potential lack of liquidity associated with such companies, and we advise the prudent use of limit orders when approaching companies such as this to minimize risk associated with wide bid/ask spreads.
Disclosure: I am/we are long KTHN, BHB, CAC. 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.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.