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Déjà Vu: A Violent Correction Could Be Coming for Hampton Roads Bankshares

|Includes: BANR, CPF, DEAR, DRL, FBP, FFBH, Hampton Roads Bankshares Inc (HMPR), HOPE, PCBC, PFBC
On April 23, 2010, we wrote an article titled "Pacific Capital: A Violent Correction Could Be Coming" that presaged the 77% collapse in PCBC's stock. In that piece, we highlighted the speculative capital that was chasing small cap distressed banks: "examples can be seen with the stocks of Dearborn Bancorp (NASDAQ:DEAR), Banner (NASDAQ:BANR), and Preferred Bank (NASDAQ:PFBC). Possibly the most mind boggling example is Pacific Capital (NASDAQ:PCBC)." Since that article was published, the stocks of the four referenced banks have been crushed, including a 77% decline in PCBC's shares.



We recently came across the most outlandish bank dislocation since PCBC -- an anomaly we believe is only temporary due to an unusual addition to the Russell 2000 Index. Historically, bank stocks have not been able to maintain speculative share increases over any reasonable time frame. Banks are heavily regulated entities that are required to hold specific levels of capital. Investors can look at decades' worth of data to justify reasonable rate returns and the appropriate premium or discount on that capital. While bubbles in bank stocks tend to be ephemeral, there are examples (like the ones we highlighted last year) of bubble-type moves over limited time periods. These bubbles can be driven by short-term dislocations, greed, or even by algorithmic high frequency trading. We believe investors in Hampton Roads Bankshares (ticker HMPR) have been subject to one of these unique bubbles and potentially face 50% to 80% downside from current levels. HMPR is one of the most expensive banks in the U.S. based on every conceivable valuation metric (price to tangible book, price to book, market cap to assets, market cap to loans, and market cap to deposits). But it isn't solely valuation that is a red flag. The company also faces the crippling combination of nasty credit issues, a sizable capital hole, and limited profitability even when excluding credit costs. Ironically, HMPR actually has one of the WORST credit profiles of any U.S. bank. Despite a huge capital raise in the second half of 2010, HMPR has a large capital deficiency AGAIN. In addition, according to the company's filing, as of April 2011 the SEC is conducting a "formal investigation related to certain accounting matters" and the company received a grand jury subpoena from the U.S. Department of Justice, Criminal Division last fall. As the bubble in HMPR's stock price deflates, any investor that does not take advantage of the current supply/demand imbalance, may be subject to the same type of violent correction that PCBC investors experienced.

A Quick History of HMPR's Blow-Up
HMPR is a Virginia based bank with $2.7 billion of assets and branches in Virginia, North Carolina, and Maryland. It operates under three brands: Bank of Hampton Roads, Gateway Bank and Shore Bank. Both Shore and Gateway were acquired in 2008. The acquisition of Gateway Financial (former ticker GBTS), which closed in December 2008, was suppose to be a transformational acquisition. Before being acquired, Gateway suffered losses in Fannie Mae and Freddie Mac preferred shares that created a capital hole earlier in 2008. Prior to a capital raise, HMPR swooped in with $100 million offer to buy GBTS. The much smaller HMPR (with only $845 million of assets) acquired the much larger Gateway ($2.1 billion in assets). The combined HMPR ended 2008 with over $3 billion in assets and $211 million in common equity. The acquisition caused some controversy at the time because HMPR "used part of the $80.3 million received from the Treasury" under TARP program to fund the acquisition and pay "Gateway's senior executives significant retention bonuses." Ironically, a few months later HMPR's then CEO complained, "we've learned to live in the world of TARP, including the restrictions on compensation." In another ironic and frightening twist (to the US taxpayer), just a few months later HMPR defaulted on its TARP dividend payment.
The acquisitions turned about to be a disaster for HMPR. Less than three months after the acquisition, Gateway's credit blew up. The following quarter, credit at the legacy HMPR dramatically deteriorated. The destruction of capital was incredible, even for that painful part of the financial cycle. From December 2008, to December 2009, HMPR had blown through its entire $211 million of common equity and actually had negative equity exiting 2009. By mid-2010, private equity investors were scrambling to invest the massive funds they had raised to recapitalize U.S. banks. Despite HMPR's disastrous credit and capital profile, a group of private equity investors recapitalized the company at $10 per share. The US Treasury agreed to convert TARP into common equity at the same price, accepting a nearly $60 million haircut on TARP (a 74% loss on paper). The loss to the Treasury (U.S. taxpayer) was painful, but Treasury would have faced a total loss had HMPR been taken over by the FDIC. In total, HMPR raised $295 million of equity in the second half of 2010. As a frame of reference, its peak equity market capitalization after the Gateway acquisition (when the outlook was very bright) was only $207 million, 30% less than the equity raised in the second half of 2010 alone!! Based on the unusual short-term dislocation from the Russell 2000 reconstitution, HMPR's market cap has actually ballooned to $650 million today. 
Capital and Credit Very Questionable Despite 2010's Massively Dilutive Cap Raise
After suffering an additional $66 million of losses in the two quarters following its equity recapitalization, HMPR once AGAIN finds itself in a very precarious capital position. HMPR currently has a 5.52% TCE ratio, a 6.34% leverage ratio, and a 10.73% risk-based capital ratio. While these are technically still above some regulatory hurdles, they are far below other healthy banks, and significantly below typical requirements established in regulatory agreements. Many MOUs require 9% leverage ratios and 12% to 13% RBC ratios. Based on our analysis, HMPR would have to raise $35 million to $100 million of common equity to attain those levels and may need more to provide cushion for future losses.
As tenuous as the issues appear with the thin capital position, the credit profile is even direr. At March 31, 2011, HMPR had $304 million of non-performing assets (including troubled debt restructurings). This represents a whopping 16.2% of loans and REO and 11.2% of total assets. A screen of U.S. banks with greater than $75 million market cap examining NPAs to tangible capital plus reserves shows HMPR has the FOURTH LOWEST ratio in the country. This suggests that HMPR is not carrying sufficient reserves or capital. The three other banks that screened worse than HMPR (two of which or Puerto Rican banks), currently trade at 16% to 45% of book value (nearly a 10x discount to HMPR). 


NPAs / Tang Eq + LLR
Mkt Cap
Price to tangible bv
Doral Financial
First Federal Bancshares
First BanCorp
Hampton Roads Bankshares
So given the woeful financial profile of HMPR, why have the shares gone parabolic? On April 27th HMPR executed a 1 for 25 reverse stock split. This reverse stock split was actually out of desperation, allowing the company to regain compliance with NASDAQ listing requirements (May 12th press release). Amazingly, the reverse merger listing qualified HMPR for inclusion into the Russell 2000. The significant number of shares that were required to be purchased by index investors, combined with the small float (at least TODAY), has driven the stock price to levels that we believe are unsustainable.

HMPR = Significantly Worse Credit and Capital at 4x the Price of its Peers
For comparison purposes, we wanted to highlight two other banks with similar characteristics and asset sizes to HMPR (but trade as a massive valuation discrepancy). All three of these banks have recently completed sizable capital raises following credit and regulatory issues. Additionally, all three of the banks below have sizable valuation allowances against their deferred tax assets. Central Pacific Bank (ticker CPF) completed a $325 million equity raise in February 2011 with the same investors that led HMPR's capital raise at $10 per share. Similar to the HMPR deal, the U.S. Treasury converted their TARP to equity at $10 per share in conjunction with the raise. Wilshire Bancorp (ticker WIBC) also recently completed a $100 million equity raise following a recent regulatory exam.  


 $     12.91
 $       3.06
 $     19.59
Shares outstanding
Market cap
Tangible book value per share
Price to tangible bv
Massive premium
TCE capital ratio
Significantly worse
Reserve / loans
Reserves / NPAs
Significantly worse
NPAs / loans + REO
NPAs / assets
Significantly worse
Valuation allowance per share
% increase in bv w/ full add back
As the table above highlights, CPF and WIBC appear far more attractive from a credit and capital standpoint, but trade at an inexplicable discount to HMPR. The only area where HMPR appears favorable relative to CPF and WIBC is with its valuation allowance against its deferred tax assets. We wonder if some investors mistakenly view this as a hidden asset. After a change in control, there are significant restrictions of the use of NOLs. As of today, 97.3% of HMPR's shares outstanding were issued at $10 in the second half of 2010, clearly triggering a change in control. HMPR appears to agree, stating in its most recent 10-q that "section 382 limitations related to the capital raised during the quarters ended September 30, 2010 and December 31, 2010 add further uncertainty to the realizability of the deferred tax assets in future periods."
Given the massive valuation, one would assume that HMPR possessed solid earnings power. However, this does not appear to be the case. When excluding ALL credit costs (so provision and losses on REO) and other one time expenses (like FDIC charges), HMPR still had NEGATIVE "pre-tax, pre-provision" earnings the past two quarters. Even if investors think HMPR can shrink into its capital base (closer to at 8% TCE at $1.9 billion assets) and generate a very optimistic 1.1% return of assets, these assumptions would only generate a measly $0.60 of earnings power at its current share count. Applying a benevolent multiple of 12x (in a world of single digit multiple for banks) to this generous earnings scenario, HMPR's stock price would be fundamentally valued at $7.35 per share.  

So why could the collapse be imminent?
The clock appears to be ticking with the Russell reconstitution scheduled to occur on June 24th, 2011. The additions and deletions have already been publically announced. Many index funds, active traders, and quant funds begin accumulating shares of stocks to be added prior to the "official" announcement. To be added to the Russell Index an objective market cap cut-off is used that can be determined by many traders. What can not be easily identified is how the Russell Selection Team will determine weightings, which are based on "float adjusted market cap." Russell excludes shares owned by the government and board members in their "float adjusted market cap" definition. We believe it is likely that indexers and traders may have materially overestimated the number of HMPR shares that needed to be acquired. As a result, we expect very little impact on HMPR's shares on June 24, and could in fact see large amounts of shares that need to be sold by overzealous traders into a potential vacuum of bids.
Second, we believe it is likely that the US Treasury will take advantage of the dislocation (before the shares collapse) and sell their roughly 2.1 million shares. In fact, as US tax payers, we IMPLORE the Treasury to sell their shares ASAP to minimize the losses associated with OUR money. At conversion in the fourth quarter 2010, the Treasury agreed to take a 74% loss on TARP. With the artificial move in the stock price, the loss today has decline to around 50%. We fear this 50% loss may be the best case scenario for the Treasury. If HMRP trades to our price target (around $4.48), this represent a greater than 90% loss. The Treasury recently sold its AIG position, and on June 15, 2011, announced plans to sell its CPF shares (see table above). CPF had the exact same lead investors as HMRP and in both instances the Treasury converted TARP to common shares at $10 per share. The U.S. Treasury will recognize a 20% to 25% gain from its 5.6 million shares of CPF that they converted in February 2011. As seen from the table above, CPF compares very favorably to HMPR with most important financial metrics (including reserve coverage, credit and capital). Given the fact the Treasury appears willing to sell their CPF stake at 1.3x to 1.4x book value; we think it is reasonable to assume the Treasury will jump at the chance to sell their massive HMPR stake at over 4x book if they are given the chance. The capital position of HMPR has only deteriorated since the Treasury converted TARP to HMPR equity at $10 per share. As a result, we think it is likely that the Treasury floods the market with its shares soon.
Finally, we believe management realizes its valuation is unsustainable (and that it needs capital). Just four days after they were added to the Russell list of Index additions, the company announced a 5 million share "at the market" equity offering (June 14th). We believe the company is going to try to flood the market with shares to take advantage of the massive valuation before the temporary Russell demand vanishes and the stock price heads back to the levels it was at a month ago ($11.50 per share). Who can blame them? We believe management has strong incentive to issue shares anywhere above tangible book value (so $4.48 per share). We find it hard to believe that any new investor would be willing to infuse fresh capital into this bank at or above this level. The best outcome in our opinion would be if HMPR's investor group is willing to continue to fund the company at $10 per share--inline with their previous investment. This is still almost 50% below the current price and may represent the best outcome for current investors.
In early 2009, HMPR's peak equity market capitalization after the acquisition was only $207 million. This was a time when credit was pristine and the bank was viewed as a high growth bank that had yet to be exposed as a construction lender with shoddy underwriting. At that same market cap today, the bank would trade at $6.20 per share. But as the last few weeks have reminded us, 2009 may have been a much better time to be involved with troubled financials than 2011. So what is a bank with large credit issues, limited capital and negligible (actually negative) near term earnings (and even faces regulatory investigations) actually worth? If HMPR where to trade inline to CPF and WIBC, it would trade between $4.35 and $5.82 per share, or 65% to 80% lower than today's price. We believe this is the most likely outcome for the investors involved with HMPR.

Disclosure: I am short HMPR.