Farmers & Merchants Bank Of Long Beach Is Significantly Undervalued

Summary

  • FMBL is a top-tier bank within its peer group, yet its price to tangible book multiple is the lowest.
  • Unlike its peers, FMBL has demonstrated its ability to generate consistent profitability and steady ROA over a full economic cycle.
  • At less than 1x tangible book value, FMBL is worth significantly more and offers limited downside.

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Editor's note: Seeking Alpha is proud to welcome Maverick Value, LLC as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA PREMIUM. Click here to find out more »

Editor's note: Seeking Alpha is proud to welcome Maverick Value, LLC as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA PREMIUM. Click here to find out more »

A High Quality Bank

If I were to tell you the following about a community bank, what price to tangible book valuation multiple would you assign it?

  • Has the 2nd lowest cost of funds
  • Generated return on assets (ROA) that was:
    • 2nd best among peers from 2008-2018, encompassing both bear and bull markets
    • Best during the depths of the banking crisis from 2008-2011
    • Middle of its peer group during the last 12 months ending 9/30/2019
  • Consistently profitable over a full cycle and specifically outperforms during downturns
  • Best capitalized and with the highest quality loan book
  • Grows its business organically instead of relying on acquisitions and share issuances
  • Low volatility stock price

Low Cost of Funds

In banking, the real differentiator between the good and the bad banks is the liability side of their balance sheet rather than the asset side. The banks with the lowest cost of funds are at a competitive advantage for a number of reasons: First, these banks have loyal customers who aren’t shopping around for the highest interest rate on their deposits. In addition to providing the bank with a cheap source of funds, these deposits are stable and therefore long-term in nature. Finally, banks with low funding costs are able to fund their loans more cheaply and therefore earn a greater profit. There’s no magic formula to earning more on your assets as a bank. You either take on greater credit risk (Risk that the borrower won’t make their payments) or duration risk (Maturing at a later date). This is why the main differentiator is the cost of funds. Here’s how FMBL stacks up:

Source: Maverick Value, LLC

FMBL’s cost of funds is 0.49% vs. its peer median of 1.40%. That’s nearly 1/3 the rate of its peers and a difference of 0.91%!

Considering that the average 30-year fixed rate mortgage is only 3.76%, this is a significant advantage for FMBL. A lower cost of funds generally leads to a higher P/TBV multiple, with a correlation of -76%. The only other bank with a lower cost of funds than FMBL is CVB Financial (CVBF) and it trades at the highest P/TBV multiple of 2.5x.

Consistent Profitability and Steady ROA

A common metric many investors use to assess the quality and efficiency of a bank is its return on assets or ROA. This is calculated as the bank’s net income divided by its average assets. A bank with a higher ROA demonstrates that is more profitable relative to its asset level versus another bank. Because banks can earn more income on their assets by taking on greater credit risk, this ratio is not perfect. However, it is still a decent way to tell the good banks from the not so good ones. Here’s how FMBL performed over the last 12 months:

Source: Maverick Value, LLC

For the last 12 months ending 9/30/2019, FMBL has performed just above its peer median. However, this is just the last 12 months and does not show how a bank performed over a full economic cycle, especially during the industry trough. Here’s how FMBL and its peers have performed from 2008 - 2018 and during the industry downturn from 2008 – 2011:

Source: Maverick Value, LLC

FMBL’s ROA over the long term, from 2008-2018, was 2nd best

Source: Maverick Value, LLC

FMBL maintained the highest ROA during the Great Recession, which was significantly above the peer median….And this is compared to the banks that actually survived!

These charts illustrate that FMBL’s ROA and overall profitability has been consistent over the years, unlike its competitors. Its ROA over the last 12 months is not much different from its 2008-2018 average or its 2008-2011 average. This just goes to show you that Farmers and Merchants is a strong performer during the good times AND during the bad times. Most of its competitors, the ones that actually made it through the Great Recession, performed well when the economy was good, only to later crash when the economy crashed.

Source: Maverick Value, LLC

ROA has a 76% correlation with P/TBV multiples. The higher the ROA, the higher the valuation multiple

The top 4 banks ranked by ROA have the highest 4 valuation multiples, while the bottom 5 banks ranked by ROA sport the 5 lowest P/TBV multiples. It therefore seems reasonable to conclude that the higher the ROA, the higher the P/TBV multiple.

The Safest Bank

Companies that are safer are generally valued at a higher multiple relative to their riskier peers. As risk increases, investors demand a higher return (lower valuation multiple), to compensate them for the greater uncertainty. In no other industry is safety more important than in banking. During the Great Recession it was the banks’ low capital ratios that led to their failure. Those with the highest capital ratios survived. Many banks had tangible equity (tangible book value) to tangible asset ratios of 5% or less. This meant that a decline in the value of their assets of only 5% wiped out their entire equity. Today the banking system is much better capitalized and here is how FMBL stacks up:

Source: Maverick Value, LLC

FMBL, by far, is the best capitalized!

Another way to assess a bank’s safety is to compare the percentage of loans that are noncurrent to its total loans as well as to look at how much the bank has reserved for potential loan losses. Noncurrent loans are those where the borrower is 90 days or more delinquent on their scheduled interest or principal payments.

Source: Maverick Value, LLC

Source: Maverick Value, LLC

FMBL’s loans are performing the best AND….it has accrued the most reserves to cover these loans!

Noncurrent loans as a percentage of total loans has a negative 73% correlation with P/TBV multiples and allowance for loan losses as a percentage of noncurrent loans has an 84% correlation with P/TBV multiples. This makes sense since it indicates a bank’s accounting is conservative and there is a lower likelihood of negative earnings surprises from problem loans in the future.

What Valuation Multiple Does FMBL Deserve?

Taking a high-level view of the data I’ve presented there are a few takeaways:

  • FMBL’s and CVB Financial’s (CVBF) metrics consistently ranked best or 2nd best
  • On only one metric did FMBL not rank in the top 2. It ranked 5th on LTM ROA
  • Banc of California’s (BANC) and Hanmi Financial’s (HAFC) metrics consistently ranked near the bottom
  • These metrics are highly correlated with P/TBV multiples

Here’s how FMBL’s peers are valued:

*Source: SEC filings

It is no wonder that the top performing bank, CVBF, has the highest valuation multiple, while the bottom performing banks, BANC and HAFC, have the lowest valuation multiples!

So FMBL is likely valued somewhere between 1.52x to 1.95x?

Source: Maverick Value, LLC

Wrong! FMBL’s Valuation Multiple is DEAD LAST!

To emphasize how absurd this is, here’s how the bottom 5 banks look:

Source: Maverick Value, LLC

Each of FMBL’s metrics is by far better than any one of these banks, yet they trade at a P/TBV multiple that is 36% higher than FMBL!

What is FMBL Worth?

FMBL’s share price today is $7,850 per share and its tangible book value per share is $8,311. Here’s how much it should be worth:

Source: Maverick Value, LLC

FMBL is a top tier bank and is worth $16,166 / share or 106% higher than where it trades today!

Possible Reasons for FMBL’s Undervaluation

There are a few reasons why FMBL is undervalued, most of which have nothing to do with the fundamentals of the actual business:

  • Not covered by Wall Street research analysts
  • Trades on the OTC Market instead of on a major exchange, such as the NASDAQ
  • Low liquidity, especially for day trading. Each share costs nearly $8,000
  • Family controlled
  • Overcapitalized

Just because FMBL lacks Wall Street coverage and doesn’t trade on a major stock exchange doesn’t mean the business is worth less than a well-covered, NASDAQ-trading bank. In fact, this allows it to go under the radar and not be bid up. Throughout history, the best investment opportunities seem to be the ones where others were not looking.

One of the biggest reasons for FMBL’s undervaluation is that it is misunderstood and not appreciated by investors for being defensively positioned and almost countercyclical. While its high capital ratios reduce its return on equity (ROE), they also act as a buffer during economic declines. This positions the bank to take advantage of opportunities when other banks are pulling back from lending and allows it to shine in good times and in bad times. This is especially clear from its performance, during the 2008-2011 market downturn. In 2008 alone, FMBL grew its loans by 27 percent and its deposits by 33 percent! It did this also while repurchasing 14 percent of its shares outstanding. I don’t think you need to be reminded how Southern California banks performed in 2008.

None of FMBL’s peers were able to perform so well. Certainly not organically and certainly not also having the capital to repurchase shares too. With fears that we are late in the economic cycle and talk about a recession around the corner, shouldn’t FMBL be the bank to own? If the banking industry pulls back on lending because of elevated loan losses and other factors, FMBL would only benefit as it would have the capacity to lend on attractive terms and develop and/or expand relationships on the lending and the deposit side at the expense of its competitors. Shouldn’t such a bank trade at a premium multiple to its peers, or at least trade in line with its peers, NOT dead last in its peer group?

Conclusion

To conclude, Maverick Value owns shares of FMBL because:

  • FMBL is a top tier Southern California bank
  • Top tier banks trade at 1.9x TBV
  • FMBL trades at a multiple that is not only bottom tier, but last among its peers
  • Even if FMBL traded at a median multiple it would still be worth 61% more
    • All its metrics are better than even the median valued bank
  • Under the radar due to lack of Wall Street coverage.... Potential opportunity?
  • FMBL should trade at 1.9x TBV, or 106% higher than where it trades today!

This article was written by

Long-only value investor with a concentrated investment approach
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Disclosure: I am/we are long FMBL.

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