A look at the Rurban Financial Annual Report

Rurban Financial is quickly becoming my favorite regional banking investment.

Under the retail name of State Bank and Trust Company, Rurban operates 20 branches in Northwest Ohio, servicing the mostly rural communities of Allen, Defiance, Fulton, Lucas, Paulding, Wood and Williams.

I’ve already discussed Rurban in a small amount of detail here.

The company is generating an improving return on equity, improving earnings, and has a reasonably low amount of non-performing assets.

I just finished reading through the Rurban Financial Annual Report that arrived in my mail box a few days ago.  There were a few highlights that I thought were worth noting.

The Ohio Economy

In the CEO Letter to Shareholders, Mark Klein pointed to improvement in the Northwest Ohio economy.  He noted that the downturn in the Midwest economy occured later than in other parts of the country and so the recovery has been likewise delayed, but that signs of recovery are appearing.

Klein also pointed out that Ohio has risen to number one in job creation in the Midwest, and is up to ninth nationwide from 48th a year ago.

As part of a section of the Annual Report titled “Commitments to our Communities” Rurban profiled two farm lending relationships that they have cultivated, as well a tractor parts dealer.  Rurban’s primary clientele is rural Ohio residents and business.  I feel quite confident that grain prices will remain at profitable levels and that opportunities to service these folks will only continue to grow.

The loan book

In 2011 loans outstanding grew by a small amount, from $428M to $443M.  Unfortunately agricultural loans decreased from $40.8M to $38.4M but I would expectt this to pick up in the next year as another year of strong grain prices is under the belts of farmers.

I was pleased to see that the company has no land loans and no contruction loans.

Non-performing assets make up a fairly small 1.77% of total assets.  This is down from 2.87% at the end of 2010.

Increasing exposure to mortgage banking and mortgage servicing

Mortgage banking activity is seen as “exceptionally strong”. One of the attributes of Rurban that I like is that they hold onto the servicing rights of the mortgages they originate.  While these mortgage servicing rights (MSR’s) are not being valued very highly by the market, I expect that to change.

I was surprised to learn that Rurban will not revalue the MSR’s upward if (when) rates begin to rise or defaults begin to fall and, as a result, the valuation model used to put a value to the MSR begins to show increasing value.  As part of Note 1 to the financial statements the company wrote that “the valuation allowance is adjusted to reflect changes in the measurement of impairment after the initial measurement of impairment… Fair value in excess of the carrying amount of servicing assets for that stratum is not recognized.”

Rurban took a beat down because of the valuation adjustment that they had to make to the MSRs that they hold.  The valuation adjustment for the full year 2011 was $1,119,000.  That works out to 0.22 per share of before tax earnings.  Rurban reports the MSR adjumstent within its “core earnings” calculation, so it does not get ignored as is the case for some of the other mortgage servicers like PHH.  I’m not sure why they don’t “ex” it out of core earnings.  Its a somewhat bogus accounting requirement in my opinion.  If an asset can be adjusted up or down 25% in a single year is than you have to question the valuation period.

There has certainly been a move by the company to increase its MSR portfolio.  Below is a graph of the unpaid balance held by Rurban over the past 5 quarters.

Core earnings are increasing and not reflected in the stock price

If you ignore the effect of the valuation adjustment that Rurban has had to take on its MSR portfolio, and you look strictly at the company’s recurring core earnings, you quickly realize that the company’s stock price is not pricing in the full extent of its earnings generation or its earnings growth.

To come up with core earnings I have taken GAAP earnings and made the following adjustments:

• OREO impairments
• Goodwill impairments
• Provisions for loan losses
• Gains on securities
• MSR valuation adjustments

Earnings have been improving both because of loan and mortgage business growth as well as because of prudent management of costs.  Looking at the income statement I was struck by the degree of cost cutting that the company has done in the past 3 years.  Looking at salaries and employee benefits, they were reduced from $21M in 2009 to $18M in 2010 and to $14M in 2011.   Similarly, professional fees fell from almost $3M to less than $2M.  Even postage and delivery expenses fell, from $2.1M to $1.1M.

Going forward in 2012, Rurban is going to focus on growth in revenues.  I expect loan totals to increase along with originations.  I expect further increases to mortgage banking activity.  Both of these should drive further improvements in earnings.

Improving return on equity

In the chart below I am looking at core earnings return on equity, which ignores one time charges and MSR valuation adjustments.

Why doesn’t the market care?

It seems kind of crazy to me that a bank with a solid loan book, decent growth and with earnings that look set to top $1/share in 2012 can be trading at less than $4.  But I guess that is why the regional banking sector remains the trade of the decade.

Listening to the financial news for the last couple of weeks, I am starting to hear some positive comments made about the large money centre banks.  I think this is the first step in the healing process of investor sentiment towards the banking industry.  It may take some time yet, but at some point solid regional and community banks like Rurban are going to benefit from that change in sentiment.

Rurban trades at 4x core earnings and at about 60% of a tangible book value that is valuing their MSR portfolio at an extremely low level.  That just doesn’t seem sustainable to me.  As the cycle turns I would expect to see the company trade at a premium to book value and at a double digit earnings multiple. Both would suggest a share price over $10 per share.