Quaint Oak Bancorp: Mortgage Business Masks Bank Underperformance

About: Quaint Oak Bancorp, Inc. (QNTO)
by: Carlton Getz, CFA

Quaint Oak Bancorp's apparent earnings growth over the last several years is less impressive than it first appears.

Mortgage banking and other non-core noninterest income dominate the company's pretax earnings despite consistent growth in net interest income.

The noninterest income masks what appears to be significant underperformance in the company's core banking operations.

We estimate the company's shares are overvalued by 10-30% based on earnings projections and sum-of-parts valuations relative to peer community banks.

Quaint Oak Bancorp (OTCQX:QNTO) is the holding company for Quaint Oak Bank, a two-branch community bank serving the region north northwest of Philadelphia, Pennsylvania. In addition to the company's traditional banking operations, the bank's subsidiaries offer insurance, mortgage, real estate brokerage, and title abstract services which generate noninterest income. The nonbank operations account for an additional two offices, an insurance office and a mortgage office, which are not bank branches.

Quaint Oak Bancorp came to our attention as a result of research associated with a small community bank serving an adjacent region. The bank has a decent track record of growth in net interest income and earnings over the last several years. The bank's valuation also appears potentially modest in an absolute sense (although above that of community banking peers about which we have written favorably) with price-to-book and forward price-to-earnings ratios of approximately 1.1 and between 13-16, respectively. In addition, the company's dividend yield of 2.8% is decent for a community bank after having been raised by 27.7% in the last quarter.

However, despite these attractive features, our research suggests that there are material weaknesses in the company's operations that dissuade us from recommending the company. The earnings growth experienced over the last several years can be largely attributed to factors other than the core banking operations and, in combination with other considerations, suggest this growth may not be sustainable over the long term. The valuation, however modest on first blush, is thus not as compelling in light of these factors and may, in fact, be excessive - potentially by 10%-30% over fair value. We, therefore, recommend community bank focused investors seek opportunities elsewhere.


Quaint Oak's core geographic markets are Bucks County and Lehigh County to the north and northwest of Philadelphia. In general, the company's market area has experienced variable population growth in the range of 5%-12% per decade over the last several decades as the city's suburbs have benefited from increasing suburbanization, the growing popularity of outlying towns, and their proximity to both the Philadelphia and New York markets. Lehigh County has, in fact, recently been one of Pennsylvania's fastest-growing counties.

Source: Google Maps

The company's deposit market share in each county is only a fraction of a percentage point, per the Federal Deposit Insurance Corporation, making the bank a small institution in a region with many competitors of different sizes. In each county, there are more than 25 insured banking institutions with the largest deposit market shares held by national and regional banks. The bank's geographic region is thus highly fragmented and very competitive.

Investment Securities and Loans

Quaint Oak's interest-earning asset portfolio is intriguing on first glance due to the concentration of assets in relatively higher yielding loans versus investment securities and other assets. The company does have a meaningful proportion of total interest-earning assets in interest-bearing deposits at other financial institutions (about 8.25%), but this is not unusual for institutions experiencing stronger deposit and loan growth. The interest-bearing deposits rose from the prior year as deposits increased and the company issued subordinated debt to broaden its capitalization.

Loans represented more than 88% of interest-earning assets on an average balance basis for 2018 and grew 7.5% during the course of the year. The composition of the loan portfolio from a maturity and repricing standpoint is reasonably distributed between shorter and longer time periods, as reflected in the following table:

Source: Federal Financial Institutions Examination Council

The balanced approach to loan maturity and repricing with a near balance at the three-year mark should allow the bank flexibility in either a rising or falling benchmark interest rate environment.

Investment securities, on the other hand, are almost immaterial to the bank's operations, as reflected in the following table:

Source: Federal Financial Institutions Examination Council

The overall maturity and repricing schedule is highly leveraged to take advantage of rising interest rates due to the short time periods until maturity or repricing. The portfolio is also simultaneously exposed to declining rates which have recently been the subject of speculation in the markets. However, the small allocation to investment securities - less than 3% of loans - makes this exposure essentially immaterial to the company's net interest income.

The consolidated portfolio - excluding interest-bearing deposits which are largely classified as short term investments and thus mature or reprice in relatively short time frames - is slightly weighted towards the longer end of the maturity and repricing matrix. However, with an unusually high 80% of the company's loans and securities scheduled to mature or reprice within five years, the company has somewhat limited exposure to persistent changes in benchmark interest rates:

Source: Federal Financial Institutions Examination Council

The company's interest-bearing liabilities, particularly deposits, have historically repriced more quickly than assets (as discussed in more detail shortly), so this distribution would suggest the company, on average, should benefit from declining benchmark interest rates while suffering short term net interest margin compressing in a rising rate environment. Indeed, we find this to be exactly the case for Quaint Oak, providing a potential source of strength in the event the federal funds rate is cut in the future. However, this otherwise compelling distribution and potential interest rate sensitivity lose some luster in the context of the bank's overall operations.


The bank's sensitivity to changes in benchmark interest rates is, in part, due to the distribution of the bank's deposits. The bank's proportion of noninterest-bearing deposits - at a mere 6% of total deposits - is much lower than most community banks about which we have written. On the other hand, the proportion of deposits represented by more expensive certificates of deposit (at nearly 80%) is much higher than most community banks we review and closer to the deposit distribution expected from a traditional savings and loan.

Source: Federal Financial Institutions Examination Council

The potential attraction of the bank's concentration of interest-earning assets in loans is thus somewhat offset by a comparatively unattractive distribution of deposits which inflates the bank's overall cost of funds.

Interest Rate Sensitivity

Interestingly, Quaint Oak's own presentation of its gap analysis with respect to changes in interest rates shows something quite different. Instead of being negatively impacted by rising interest rates, the company's presentation suggests that the company should benefit from rising interest rates, per the following table:

Source: Quaint Oak Bancorp Annual Report (2018)

This presentation - indicating a larger dollar amount of assets will reprice compared to liabilities - implies that rising interest rates should generally boost net interest income (and indirectly net interest margin) as more assets are repriced at higher rates than liabilities in the near term before reversing in the intermediate term.

However, from a historical standpoint, we don't see this reflected in the company's net interest margin performance. Instead, the company actually appears to be leveraged towards lower interest rates with net interest margin rising as interest rates fell and beginning to decline as benchmark interest rates have risen, as reflected in the following chart:

Source: Winter Harbor Capital

Granted, the exact impact on net interest income and net interest margin is also heavily dependent on the relative movements of the applicable rates, not just the impacted amounts of assets and liabilities, so that a larger proportion of assets repricing to higher rates in a given period may not result in higher net interest income if the increase in rates associated with the smaller proportion of liabilities is larger than the increase on assets. In fact, this differential in the magnitude of changes in average interest rates earned and paid appears to be a key driver of the recent decline in net interest margin despite the apparent positive gap in the company's presentation, as illustrated by the following chart:

Source: Winter Harbor Capital

Notably, in the 2007-2010 time period, yields on liabilities (primarily deposits) decline much faster in the aggregate than yields on loans, boosting net interest margin. The declines persisted through 2011-2014 although average asset yields stabilized or only modestly declined, while more recently liability yields have outpaced the increase in asset yields, once again compressing net interest margin. A trend of this type is to be expected when liabilities are concentrated in certificates of deposit which tend to reprice in much larger rate increments than other deposit types on a given change in benchmark interest rates.

Our own model of the company's repricing gap more closely aligns with recent and historical experience, showing a persistent negative impact on net interest income assuming rising rates (and positive impact assuming declining rates) as reflected in the following table:

Source: Winter Harbor Capital

The company's presentation of the gap analysis differs quite significantly from our own which is based solely on maturity and repricing schedules without considering the potential prepayments of loans. Indeed, while only $46 million in loans are contractually scheduled to mature or repricing within the next year, the company's projections expect nearly $100 million of loan balances will actually mature or reprice within the next year after including projected prepayments, etc. In addition, the company's gap analysis suggests that large proportions of the company's money market and other deposit accounts won't experience rate adjustments until well into the future. In our view, we find some of these assumptions to be rather improbable, but in any case, it's clear that rising interest rates negatively impact the company's net interest margin - at least in the short term.

Rates have clearly been a headwind for the bank even as volume has grown with volume driving growth in net interest income and offsetting rate headwinds in a rising interest rate environment.

Source: Quaint Oak Bancorp Annual Report (2018)

Impact of Changes in Benchmark Rates

The advent of stable to potentially negative adjustments to benchmark interest rates in the foreseeable future, versus projections of persistent increases only a year ago, thus may well be a distinct positive for Quaint Oak Bancorp. It's an open question whether - and to what degree - the Federal Open Markets Committee may ultimately reduce benchmark interest rates, but we developed a model for the company to assess the company's net interest margin and earnings sensitivity to changes in benchmark rates.

Our projections indicate that a decline in benchmark rates of about 50 basis points could yield a positive impact to earnings per share ranging from $0.10 to $0.15 while a return to near zero interest rates could yield a boost of $0.35 to $0.40. A modest decline in benchmark rates could, therefore, boost the company's earnings although it's likely any boost would be partially offset by near term challenges on the speed at which assets and liabilities reprice.

Regardless, this would be a decent benefit for shareholders - if benchmark interest rates do decline. However, this is not yet a foregone conclusion.

Yet, all is not quite so straightforward….

We noted at the beginning of this article, however, that despite the apparently attractive attributes of the company, we'd recommend investors avoid the shares. So, what makes Quaint Oak Bancorp unattractive to us in the face of a high concentration of interest-earning assets in loans and positive net interest margin exposure to a declining interest rate environment? The company's deposit base, though more expensive compared to other community banks we consider appealing opportunities, isn't the key factor. Instead, it's the company's reliance on gains on sales of residential mortgage loans (and other noninterest income) for much of its profitability. In fact, in our view, this relatively recent concentration of pretax income originating from noninterest sources has served to conceal significant underlying weaknesses in the bank's core banking operations and negate the positive aspects discussed earlier.

Gains on Sales of Loans

In 2011, Quaint Oak Bancorp began expanding beyond its traditional banking business into mortgage banking and other associated operations such as insurance, real estate brokerage, and title abstract services. Insurance subsidiaries are not unusual for smaller community banks and, in general, we consider sources of stable noninterest income (such as brokerage, insurance, and trust services) positive factors when assessing investment opportunities in for community banks.

However, there are limits to the attractiveness of noninterest income sources, especially when those sources are more volatile than other sources of noninterest income and, in particular, when those volatile sources come to represent a significant portion of a bank's overall profitability. In itself, a bank whose earnings are driven by potentially volatile gains on sales of loans is inherently less attractive than a bank that relies on more stable sources of noninterest income. In the case of Quaint Oak, this cautionary aspect is taken to an extreme due to the bank's significant exposure to gains on sales of residential mortgage loans.

Indeed, nearly all of the company's growth in earnings over the last several years - mentioned in our introductory comments - can be attributed solely to gains on sales of loans. The gains have risen to account for more than 80% of the company's total pretax income. In the meantime, the contribution to earnings from all other sources - including net interest income - has essentially stagnated, as reflected in the following table:

Source: Winter Harbor Capital

The divergence is stark beginning in 2011 when the bank entered the mortgage banking and ancillary real estate businesses and began generating gains on the sale of loans. Prior to this, noninterest income from any source, including gains on sales of loans, was essentially immaterial to the bank's pretax income which was driven by net interest income. However, after 2011, pretax income from all other sources has wilted while gains on sales of loans have more than driven the company's earnings growth performance.

Granted, simply deducting gains on sales of loans from pretax income likely amplifies the erosion of pretax income from other sources since, presumably, these operations contribute to profitability as a segment. However, the decline in pretax income from sources other than gains on the sale of loans is still notable and concerning, especially since this pretax income figure continues to include income from other ancillary noninterest income sources on which the company began focusing about the same time - insurance, mortgage banking, real estate brokerage, and title abstract services.

Indeed, during the last few years, these other sources of noninterest income not directly associated with the company's banking operations (insurance, mortgage banking, real estate brokerage, and title abstract services) have themselves exceeded the company's remaining pretax income after deducting gains on sales of loans. The result is that, absent these other ancillary noninterest income sources, the company's pretax income would be negative even including such banking noninterest income sources as fees on deposit accounts.

We suggest considering this for a moment - absent the noninterest income earned from these sources, the bank would have negative pretax income. The implication is either (a) these ancillary businesses are not as profitable as implied by the company's financial results (that is, profitability driven by net interest income is being offset by losses in the ancillary businesses) or (b) the ancillary businesses are profitable but growth in profits associated with the ancillary businesses is masking growing underperformance in the bank's net interest income driven core operations. A third possibility is some combination of these two factors.

The deviation between pretax income less gains on sales of residential mortgage loans which began eight years ago is even more dramatic when considered in the context of the company's growth in net interest income before provisions for loan losses, as reflected in the following chart:

Source: Winter Harbor Capital

In the last decade, the company's net interest income has more than quadrupled while pretax income - including gains on sales of loans - has not even tripled over the same period of time. The company's performance before the introduction of significant mortgage banking and loan sales operations in 2011 is equally notable with essentially no growth in pretax income despite a near doubling of net interest income even as net interest margin expanded between 2008 and 2010. We'd expect to see a closer correlation between pretax income excluding gains on sales of loans and net interest margin for a well performing financial institution.

The result is our view that the company's mortgage banking and ancillary real estate operations have created a mirage of earnings growth over the last several years. The results conceal serious weaknesses in either or both the ancillary businesses and the company's core net interest income related banking operations. It's difficult to tell from the available financial information exactly which of these is the actual case or why it is occurring, but it's unquestionable that underperformance exists.

Is this due to fundamental weakness in the company's core markets (despite the company's loan growth and high ratio of loans to deposits)? Is the focus on the company's mortgage banking, insurance, real estate brokerage, and title abstract businesses distracting management from the bank's core net interest income related operations? Indeed, are the company's ancillary business generating noninterest income actually all that profitable (and, if not, why has the bank persisted to focus on these businesses for years or is it that the core banking operations are unusually weak?)

Whatever the case, there is clearly weakness somewhere in the business and the gains on sales of loans are effectively obscuring what would otherwise be significant underperformance in the company's operations.

Loan Quality

In addition to reservations about the bank's core operations and sources of noninterest income, we're also not particularly enamored by the company's loan quality metrics. Quaint Oak recorded a large increase of 37.7% in past due and nonaccruing loans over the last year from $6.0 million at the end of 2017 to $8.2 million at the end of 2018. The large increase was primarily attributable to loans 30-89 days past due with only $928,000 in loans classified as nonaccrual loans. The company's past due loans also notably run across the company's loan book rather than being concentrated in certain loan types as is sometimes the case with community banks, as reflected in the following presentation:

Source: Quaint Oak Bancorp Annual Report (2018)

It's worth noting that an unusually large proportion of owner-occupied residential and construction loans are currently past due relative to total loan balances.

The past due and nonaccrual loans which together represent 3.75% of total loans receivable contrast with an allowance for loan losses of just under $2 million, less than 1% of total loans outstanding. The figures would suggest Quaint Oak may be rather lightly reserved for the potential losses in the event of an economic downturn in the region. On the other hand, the company's loan charge-off experience over the last few years has not exceeded 0.16% of loans in any given year indicating that the company's past due loans may be reasonably well secured despite the nature and quantity. However, on balance, experience suggests prudence in approaching these metrics since it's more likely that outcomes will be adverse than beneficial should the economy weaken.

Earnings and Valuation

A valuation of the company is made somewhat difficult by the nature of the company's business and the inherent assumptions about the future performance of businesses which are more volatile than traditional banking operations. Quaint Oak, unlike most community banks, has a bottom line driven by gains on sales of loans. We, therefore, approached our valuation from a couple of different perspectives, including an assessment of the company's forward performance based on first quarter operating results as well as attempting to value the bank on a sum-of-parts basis by separating the real estate related noninterest income businesses from an assessment of the company's core banking operations.

The earnings models we developed all indicate a range of consolidated earnings per share for the current year of $0.80 to $1.00, with a mild bias towards the lower half of the range due to an expectation that net interest margins will remain challenged even though benchmark interest rates have remained stable. The models included one in which we assumed, to varying degrees, the actual underlying profitability of the mortgage banking, insurance, real estate brokerage, and title abstract businesses (i.e., the non-core banking businesses) including a breakeven scenario that yielded earnings per share values within the same range. Indeed, whatever approach we took, the projected earnings per share all fell within this range.

The resulting implied returns on assets and equity for the bank are around 0.7% and 8.5%, respectively, at the upper end of our projected earnings per share range. The values by no means imply a particularly well-performing bank, especially relatively to peers in the community banking sector with significant non-banking noninterest income (Thomasville Bancshares (OTCPK:THVB) is an extreme example) whose noninterest income tends to increase, not decrease, these return metrics. This is especially true for banks, such as Quaint Oak, which have an equity to asset ratio of less than 10%.

The implied price-to-earnings ratio range based on our projections and the current share price is thus 13-16, well above the earnings multiples we see in comparable or superior community banks with returns on assets and equity closer to 1.0% and 10%, respectively, such as Katahdin Bankshares (OTCQX:KTHN), Pinnacle Bankshares (OTCPK:PCLB), and United Bancorporation of Alabama (OTCPK:UBAB). Instead, we'd expect Quaint Oak to trade more in line with a lower performing bank, such as United Financial Bancorp (UBNK), with valuation metrics closer to 0.9-1.0 times book value and 10-12 times earnings. On this basis, the suggested fair value is closer to a range of $10.00-$12.00 using the upper end of our earnings projection range for the company, indicating the company's valuation is approximately 10%-30% above fair value.

Insider Ownership

A final factor bears mentioning in the context of Quaint Oak - the company's high insider ownership. The company's management owns an unusually large 31.7% of the company's outstanding shares. The ownership is among the highest insider ownership ratios we've seen in the community banking sector for publicly traded banks that were not founded in the last twenty years in which case many of the founders remain involved in the bank's business.

We'd consider such high insider ownership a positive sign under most circumstances but, in the case of underperforming companies, it can also act as a detriment for shareholders since it limits the ability to instigate necessary change. In short, high insider ownership can act as an impediment to improvement whereas, under different conditions, such underperformance would provide an opportunity for better operators to acquire the company or push management towards better outcomes.


Quaint Oak Bancorp has certain attractive features that begin to tarnish under closer examination. The company's valuation, while generally modest, begins to look somewhat excessive once the drivers of the business and the apparent weaknesses in the company's core banking operation are better understood.

We clearly have significant reservations about the company's operations. In particular, the way in which gains from the sale of loans (and similar sources of noninterest income other than those traditionally associated with banking operations, such as service charges on deposit accounts), have overtaken the company's contribution from net interest income and dominated such pretax income and masked underperformance of the overall bank.

We, therefore, see downside risk in the company's shares without any corresponding potential reward and recommend investors look elsewhere in the community banking sector.

Disclosure: I am/we are long KTHN, UBAB, PCLB. 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.