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Three Community Banks worth keeping an eye on Part II: Shore Bancshares

I owned Shore Bancshares earlier this year but don’t own it now. It was one of four banks that I bought back in January when I jumped into the community bank sector whole heartedly. While the other 3 banks I bought worked out to various degrees, Shore did not, and I sold out shortly after the first quarter results came out for a small loss.

At the moment I’m out, but Shore is not forgotten. I continue to review the company’s results and look for an improvement that would justify an entry point. Looking at the second quarter, while the eventual value proposition is still there, the company doesn’t seem to have quite turned the corner just yet.

Shore operates 10 branches in Maryland and 3 branches in Delaware. The majority of its lending activities revolve around the commercial and residential real estate market in these regions.  Shore has a particularly high percentage of commercial real estate loans.  Of the company’s $819 million in loans at the end of the first quarter, $315 million were commercial real estate, while $309 million were residential real estate and another $114 million were construction loans.

The loan book has been hit by the downturn in the economy in Maryland. Maryland’s economy is not doing badly, but it is also not doing particularly well. The economy has pretty much mirrored the US as a whole. Below is an Economy.com table of the key economic regions in Maryland. The table denotes each area as either being in recession, being at risk, being in recovery, or expanding.

Another informative research piece on Maryland’s economy was put out by JP Morgan. One point made that I found of particular note (and that is illustrated in the chart below) is that Maryland (not surprisingly) derives a larger than average percentage of economic activity from government.

This would have to be considered a headwind to growth going forward. As one Baltimore economist put it:

We know the decline in federal government outlays has just begun,” said Anirban Basu, a Baltimore economist. “The economic outlook, I think, is pretty grim.”

The article goes on to point out that “because Maryland gets a disproportionate share of federal contracting dollars and other spending, it’s likely to feel a harder hit from any reductions [in government spending]”

To drill down a bit further to the counties Shore operates, (Talbot, Dorchester, Kent, Caroline, and Queen Anne’s), you can see from the following unemployment charts that each fairly closely mimics the experience of the US, with some improvement from the worst levels of 2009-2010, but still an elevated unemployment level.

Talbot

Dorchester

Kent

Caroline

Queen Anne’s

The economic malaise shows up in the impaired loan book. Shore has $33 million in impaired construction loans (28.9% of outstanding), $30.9 million in residential real estate loans (9.9% of outstanding) and $30.6 million in impaired commercial real estate loans (9.7% of outstanding).

The problem with Shore remains what it has been for the last few years. How much longer will economy lead to deterioration of the loan book deteriorate?

Company CEO W. Moorhead Vermilye did not paint a terribly encouraging picture in his second quarter comments:

“The operating environment remains tough as we are not yet seeing a meaningful upturn in the real estate related activities that drive the Delmarva economy. We continued to work diligently to resolve and dispose of problem loans, as reflected in a higher level of troubled debt restructurings this quarter,”

So those are the negatives, and why I am not ready to buy Shore just yet. The positives with Shore is its valuation is compelling in the event of a recovery.

The potential when Shore recovers

A great deal of the current problems are priced in the stock. Shore has a tangible book value of over $12 per share.  Its trading at less than half of book. The underlying earnings potential of the franchise remains strong; if you ignore the effect of all the onetime charges due to bad loans, the underlying banking business (ex provisions, one time charges, and gains) has been producing earnings at over a $1 per share clip for the last few quarters.

But even this may underestimate the earnings power of a stabilized Shore. Again excluding the onetime charges, ROA and ROE are solidly below where they were before the financial collapse. This suggests to me that once (or I guess if) the bank has its problem loans under control, they can embark on a cost reduction strategy to size the bank to the new level of business.

You can see the same influence if you look at the efficiency ratio, which has been hovering around 100% for the last six quarters.

Not quite there yet

One positive for the second quarter was that Shore did see a significant reduction in charge-offs.  Charges were cut to half of what they were in Q1, extending the previous downtrend that had been in place before Q1.

I would be more excited about this reduction in charge-offs if nonperforming assets had shown an improvement. Unfortunately they did not.

Until I begin to see a leveling off and ideally a drop in the non-performing assets, its difficult to make a move into the stock.

Other risks

Apart from the economic risks I already outlined and the presumed impact on the loan book, there really isn’t a lot else to worry about with the business. Reading through the risk factors of the recent 10-K was mostly an exercise in the plagiarisms of the standard banking risk fare:

  1. Concentrated Commercial real estate loans are being affected by the economic downturn
  2. Interest Rates falling
  3. The market value of their investment portfolio declining
  4. Competition
  5. Funding Sources
  6. Key Personnel

The only item of any concern is the one I’ve already highlighted.  Their loan portfolio, and in particular their commercial real estate portfolio, needs a strong economy to right itself.  Its really just a wait and watch until the bad loan book stabilizes.

Waiting on my hands

The reason I am reluctant to buy Shore is because until they start to see a sustained downward trend on their nonperforming loans, the company remains at risk for panic. We saw that panic back last fall when the stock fell into the mid-$4s. It could happen again with the right confluence of European and US financial worries. Rightly or wrongly, the stock will likely remain range bound until the book turns around, and we won’t begin to see that until at best October, when the next quarterly is released. I, before then, the stock dropped another 15%, which would put it in the $4.50 range, I would be tempted to buy. Absent that, I will wait patiently on my hands.

Three Community Banks worth keeping an eye on: Part I

For those of you new to this blog, I have been investing in community banks since early 2011.  I described my foray into the sector in this post,  almost a year ago today.  To reiterate:

I got introduced to the idea of buying regional banks stocks about 6 months ago.  Two separate catalysts piqued my interest in the idea:

  1. Last summer I read the David Einhorn book, “You Can Fool Some of the People All of the Time”.  In that book, which is about a fraudulent business development company called Allied Capital, Einhorn spends a chapter outlining his investment philosophies.  One of the ideas he puts forth is investing in mutual holding companies.   Seth Klaman has been another proponent of investing in MHC’s.
  2. Tim Melvin’s trade of the decade.  Melvin, a fairly well known value investor, believes that the small regional bank stocks have been beaten up well beyond what is justified and that their recovery represents the trade of the decade.

I’ve had some good luck investing in community banks over the last year.   Some have turned out extremely well (Rurban Financial (RBNF) and Community Bankers Trust (BTC) have been more than doubles).  Others have been less prolific (Oneida Financial (ONFC),  Home Federal Bancorp of Louisiana (HFBL), Shore Bancshares (SHBI), Atlantic Coast Financial (ACFC)) but generally I have gotten out of with either a small loss or a small gain.  One of my biggest mistakes has been a lack of patience; indeed if I had held onto Oneida and Home Federal, I would have seen 20% gains from my purchases last year.

Community banks are simple businesses.  It makes them easy to compare and evaluate, and relatively straightforward to project into the future.  A community bank income statement generally looks like this:

Banks earn interest on the loans they make and the securities they buy.  The extent to which the interest earned exceeds the interest paid on funding (for community banks the vast majority of funding is deposits) is the banks margin, called the net interest margin.  With only a few other wrinkles, such as revenues received from originating and servicing mortgages, or in some cases from running insurance or investment wings, the degree to which the net interest margin exceeds the expenses associated with running a bank (called non-interest expense) is the profit of the bank.

How I’ve made money on the banks

There are plenty of solid banking franchises  trading at reasonably cheap prices.  You can probably make 10-15% per year by buying well run banks with low levels of nonperforming assets and reasonable return on assets and equity, and socking them away.

This was how I started with my own banking investments.  The first three banks I bought were Oritani Financial Corp (ORIT) Oneida Financial (ONFC), Home Federal Bancorp of Louisiana (HFBL).  Each is a solid franchise, each has a low level of loan losses, and each trades at or near tangible book value with decent returns on assets and equity.  I’m sure each will continue to go higher over the long run.

But I am always in the pursuit of the best returns and those are usually found a little further up the risk ladder.   One of the basic premises of my investing strategy is that while the price of risk is ultimately assigned by the market, the perceived quantity of risk involved varies, and can be reduced by research, critical thinking and sweat.

Going further up the risk ladder meant looking at banks that most investors would shun.  I studied the banks that had been hit the hardest by the financial crisis.  While a bank with non-performing loans above 3% is generally considered of questionable quality, I started looking at banks with 8-10% non-performing assets.  While banks with return on assets of 1% and return on equity of 10% might be thought to be worth considering, I looked at banks with negative returns, shrinking assets and dwindling equity.

This tact has proven to be fruitful.  Three stocks that I have bought have resulted in above average returns.  Two of them, Rurban Financial (RBNF) and Community Bankers Trust (BTC) have been in the neighborhood of a double so far.  The third, Bank of Commerce Holdings (BOCH) returned a quick 30% before I took the position off, though I am looking at adding it back at the right level.

My one regret has been not to have taken more positions in banks.  To give a couple of examples of banks I looked at but just couldn’t get comfortable with, First Financial Northwest (FFNW) has doubled from $4 to $8 in the last year and a half, while Heartland Financial (HTLF) has nearly doubled since last fall.

But even with some of the moves we’ve seen I think there is still more to come.  As the economy recovers banks should see improvements to their loan book and strengthening margins on the securities they buy.  And I continue to believe that the banks most likely to outperform will be those that were hit hard during the recession but that managed to survive.

3 Banks I’m Looking at

I have my eye on a number of banks that meet these criteria.   There are 3 in particular that I have been looking at this weekend.  While I am not quite ready to pull the trigger on any of the three, I am getting close, and I think the ultimate upside once they work through their books of problem loans is a multiple of the current share price.  I am going to look at each one individually in the upcoming 3 posts.

  1. Shore Bancshares (SHBI)
  2. Premierwest Bancorp (PRWT)
  3. United Community Bancorp (UCBI)

Next up will be a post on Shore Bancshares shortly.

The OceanaGold Gamble

I first bought OceanaGold at $1.80 at the end of May.  I originally bought it strictly as a trade.

The price subsequently moved up and I added to the position twice, first at $1.98, and later at $2.14.  You’ve heard me say it before – do more of what’s working and less of what doesn’t.

Well sometimes that backfires.   When gold got pummeled in mid-June, my position in OceanaGold got hammered back below $2.   It happened so quickly that I did not have time to react, and I ended up losing all of my profits and a little more on top of that.

Such is the difficulty of owning a trading stock with a secular thesis.

From that time until this week OceanaGold didn’t do much of anything.  It sat in the 1.80’s, would briefly rise into the 1.90’s but never for more than a few days.  I held, not wanting to sell near the low without justification and not having the time to do the work I needed to do to get that conviction.   But over the weekend (last weekend), I stepped through their recent reports and presentations, made a few runs at their numbers, and I decided I might just stick this one out.

Two reasons to stick it out

OceanaGold had a terrible first quarter.  Costs were up and above $1000 per ounce.  Production was down over 20%.  The mines that it is currently operating in New Zealand have been struggling with costs pressures for some time now.  But the first quarter was particularly bad.

Part of the bet I was making when I bought OceanaGold at $1.80 was that the first quarter was an aberration.  And, having stepped through that first quarter in some detail now, while I don’t expect costs to drop back to pre-2011 levels, I do find it plausible they they fall back into the low $900’s an ounce.  Similarly, production could easily return to 60,000 ounces plus per quarter.  The progress made in its second quarter earnings release on Thursday suggests this just may be in the process of playing out (note that I wrote most of this post before the Q2 earnings were released so I won’t be talking in detail about them).

The other part of the bet on OceanaGold is the expectation that the company will be reevaluated for the better once the Didipio project begins to produce substantial ounces.  Because of the by-product credits from copper production, Didipio will produce gold at negative cash costs for the first couple of years.

Let”s step through this two-pronged thesis in more detail.

Production Costs should come down

Productions costs on a per ounce basis were bad in the first quarter and they have been rising for some time now.

When you look closely at the rise in production costs over the last number of quarters you can attribute the rise to essentially 3 factors:

  1. Rise of the New Zealand Dollar
  2. Fewer Ounces produced
  3. Changes in the amount of the total costs that can be amortized as pre-stripping

I was quite astonished by just how much of the company’s costs increases could be attributed to these 3 factors.  In fact all of it.  If you look at the total operating costs in New Zealand dollars over the last few years, including costs that were amortized as pre-stripping, they are remarkably flat.

Note that I did this work before the Q2 earnings release so it is not included in the chart.

What the chart illustrates is that this a story of a company dealing with cost pressures due to their local currency appreciating and the natural evolution of the mine plan with changing grades and changing strip ratio.

Looking ahead, I don’t expect much further appreciation of the New Zealand dollar.  With a global slowdown at hand, it seems reasonable to expect the NZD to weaken against the US dollar.  The fewer ounces produced has been a function of various issues that occurred in Q1.  There were issues at the Macraes open pit, at Fraser underground and at Reefton.  The good news is that it appears the company made progress on all fronts in Q2 (production in Q2 was 55,000 ounces versus a little over 50,000 ounces in Q1) and expects production back to normal (which would be around 60,000 ounces per quarter) by Q3.  As the above chart of total costs  indicates, costs per ounce are primarily a function of ounces produced.  A return to 60,000 ounces per quarter would show a drop in costs to about $900 per ounce.

Didipio

The other part of the bet on OceanaGold is the expectation that the company will be re-evaluated once the Didipio project begins to produce ounces. Because of the by-product credits from copper production, Didipio will produce gold at negative cash costs for the first few years and over the life of the mine cash costs will be substantially lower than the existing New Zealand operations.  This is going to dramatically bring down corporate cash costs.  I expect that analysts will be more inclined to give OceanaGold an average mid-tier multiple once their cash costs settle in-line with other mid-tier producers.

In the table below I have estimated the impact of Didipio on corporate cash costs in 2013 and 2014.

By way of analogy, consider Agnico Eagle.  In the first quarter (again I wrote most of this post before second quarter numbers were out) Agnico recorded cash costs of $594/oz.  Agnico’s largest mine in terms of gold production for the quarter was Meadowbank, which produced 79,000 ounces for the quarter.   Meadowbank produced those ounces at costs of $1,020 per ounce.  Taken alone, Meadowbank would be a high cost producer and receive a low multiple.  But Agnico offsets the high costs at Meadowbank with costs of $278/oz at Pinos Altos and $216/oz at LaRonde.

Looking at the latest BMO report on Agnico Eagle, I note that the company gets a cash flow multiple of 10x.  This compares to OceanaGold at 4x cash flow excluding Didipio and 2x cash flow including it.

Clearly, there is room for an upside re-evaluation.

Gold Price

The last factor that is going to determine the future direction of the share price is the price of gold.  I have some thoughts there, but I am not going to go into them in detail here.  Suffice it to say that this is the piece of the puzzle that I am least confident about.  Its unfortunate that I am so uncertain about whether gold will continue to rise or whether it will stall out and potentially fall.  Because given the other factors at hand, OceanaGold would seem to be a good place to build a large position at today’s prices.

 

Week 55: Skittish

Portfolio Performance

Portfolio Composition

Click here for last two weeks of trades.

Portfolio Summary

I have reluctantly added some risk over the last couple of weeks  My cash position is down to $27,839 from $35,893 two weeks ago, which is a drop to 23% of total assets in my tracking portfolio.

The stocks I have bought have been added because I believe they are cheap.  I think that there is a reasonable chance that they will be worth significantly more over time.  But I do not add them with complete conviction.

The problem remains Europe.  And I remain wary of when the next shoe will drop.    Until Friday, the market had forgotten about Europe for the time being, but we have seen this happen before, and always with the same ending. Europe comes back and again trumps all else.  With Spanish yields rising to a new high on Friday (7.267%)  I am already questioning whether I have made a mistake by purchasing rather than selling stock.  I have already considered an about face.

You can see just how skittish I am by looking at how many trades I am second guessing myself on.  Three times in the last two weeks I bought a position only to sell it later the same day.  These weren’t planned “trades”.  I don’t play the day-trade game.  These were cases where I took the position and couldn’t handle the weight of it, and decided to sell instead of worrying about whether I had made a mistake by buying.

I am typically not so wishy-washy.  That the market has me going through convulsions speaks volumes to the uncertainty that exists at the moment.

As for the stocks I bought, those that I kept that is, I am confident that I got them at a decent price which, in the absence of more macro-malaise, will lead to eventual profits.  More on the individual position updates in the post below:

Company Updates

Radian Group (RDN), MGIC (MTG), MBIA (MBI): here

Arcan Resources (ARN): here

Phillips 66 (PSX):  here

 

Week 55 Update: The Insurers

The Insurers

I added to all 3 of my insurers in the last two weeks; Radian Group, MGIC, and MBIA.  Regarding Radian and MGIC, while the data this week was mixed, I still am of the mind that the worst of housing is behind us.  While I’m not ready to jump into home builders or lumber stocks or anything else that is dependent on a robust recovery in prices or demand, I am willing to make a bet on mortgage insurance companies that need things to just stop getting worse.   The insurers need prices to stop falling and defaults to continue to slow.  I am inclined (albeit skittishly) to believe that will happen.

The housing data this week, while not great, supported that thesis.  The market focused on the month over month decline in existing home sales (down 5.4%), but year over year the trend is still to higher sales (4.5%).  The trend, while not robustly bullish, appears to be of a bottoming nature.

Perhaps more importantly, inventory continues to decline and the year over year number is down a somewhat startling 24.4%.

Total housing inventory at the end June fell another 3.2 percent to 2.39 million existing homes available for sale, which represents a 6.6-month supply4 at the current sales pace, up from a 6.4-month supply in May. Listed inventory is 24.4 percent below a year ago when there was a 9.1-month supply.

Bill Mcbride (of CalculatedRisk) pointed out in a recent post that it is really the inventory number that we should be focusing on:

I can’t emphasize enough – what matters the most in the NAR’s existing home sales report is inventory; what matters the most in the new home sales report next week is sales. It is active inventory that impacts prices (although the “shadow” inventory will keep prices from rising). Those looking at the number of existing home sales for a recovery in housing are looking at the wrong number. For existing home sales, look at inventory first.

Meanwhile the monoline insurers (Radian and MGIC) are writing more  new business and this is some of the best business they have every written.  I have already written about how strong lending standards are these days.  Below is the trend for New Insurance Written (NIW) for the first 7 months of this year.

The returns on the new business should be quite impressive.  Mark Devries, the analyst from Barclays that covers the insurers, was quoted in this Bloomberg article on expected returns:

Firms that stay in the business may benefit from a return on equity above 20 percent on new coverage as the exit of some rivals allows remaining insurers to boost prices, and tighter underwriting standards limit claims.

Meanwhile the old book continues to wind down.  The delinquency bucket for both insures continue to fall.

The insurers are like those movies you see where there is a big explosion and the movie star starts running and there is this big fire ball behind them and its gaining on them but the movie star keeps running and eventually the big fireball burns itself out.  These insurers are trying to outrun their legacy business by printing as much new business as they can to overcome the losses on the legacy.  I think when they hit that point that new gains outrun old losses is when they really move.

As for MBIA, the company is less dependent on any specific economic dynamic then they are on  the outcome of their court cases with Bank of America.  There are signs these cases could be coming to a head, but of course they might not.  Its really difficult to say when this will end and whether a settlement will be reached before a verdict.  When I tried to analyze the deal between Bank of America and Syncora earlier this week and the conclusion I came to was that you couldn’t extrapolate much of anything to MBIA.

Week 55 Update: Arcan Resource

I’ve owned Arcan before, but I have always had trouble holding onto it.  I think that in the aggregate I have probably lost a few dollars on the stock.  Yet here I am again to take another stab at it.

Arcan is an excellent example of why I follow the rules of:

  1. Never add to a losing position
  2. Do more of what’s working and less of what isn’t

With Arcan, I eventually sold out for good on March 23rd at $4.75.  At the time there wasn’t anything in particular that you could pinpoint that would suggest the stock was about to fall by more than two-thirds.  But what concerned me was that the stock wasn’t doing what it should be doing if things were going well. That is, it wasn’t going up.

And then there was the CAPEX.  My skittishness with Arcan and most other oil juniors has always been based on their level of capital expenditures in relation to their cash flow.   As I outlined in this post back in February, Arcan has been spending multiples more money than its been taking in.  You can’t just keep doing that forever.  It will work as long as the market sees you as a “growth stock”, but as soon as that music stops, well so do your funding sources.

Arcan has gotten themselves in over their head with funding and now they are going to have difficulty meeting their growth expectations.  The near-term outlook for the company is not terribly clear.

So why buy?  Well the stock is off 75% from its highs.  I think its all price in.

As well the company appears to be changing (perhaps by necessity) its spendthrift ways.  President, Doug Penner, said the following in the first quarter press release:

“I am excited about implementing Arcan’s next stage of development.  Having expanded rapidly in our first nine years of operation, we are maturing as a company, ensuring that our continued growth also delivers value for our shareholders over time. We are focused on reducing down‐time, operating costs and G&A expenses as we work to bring our capital spending more in line with our cash flow. We are also looking at all of our assets  strategically, and we will consider divesting non‐core assets as opportunities arise.”

Of course, with reduced spending will come reduced growth, and that is one of the reasons the stock has been decimated.  At $1.50 per share, which is about what it cost me on average to buy a position, we are getting awful close to the value stock territory.  The company has a $7+ NPV of its reserves.   Their production numbers haven’t been stellar, but they are showing stability and they should be getting past the initial flush declines and into more stable exponential declines on most of their wells.  AS well, the company should begin to benefit from the infrastructure spending of the last year, as the pipeline from Ethel brings down operating costs and we begin to see the fruits of the waterflood at Ethel in the second half of this year.   As I pointed out in that same article earlier this year, there is a clear difference between the Ethel decline curves and that of Deer Mountain Unit, where there is waterflood.

Arcan is simply a bet that the stock has gone down too far.  A move back to $2 would be a 35% gain and I could see it happening with nothing more than a bit of improved sentiment.

Week 55 Update: Phillips 66

I have actually owned Phillips 66 (PSX) for a while now, just not in the account I track online. Phillips 66 is a spin-off from Conoco Phillips.  The company has 3 lines of business:

  1. Refining
  2. Midstream
  3. Chemicals

I originally came across the idea of Phillips 66 after reading a Barrons article that was posted on the Investorvillage.com BRY board.  Phillips was a recommended pick of Meryl Witmer.  The thesis outlined by Witmer was as follows:

Phillips’ 50% of PCChem could earn $1.30 a share this year. These earnings deserve to be valued at a 10 multiple, or $13 a share. The midstream segment owns and operates natural-gas processing facilities and fractionation plants, and a large and valuable natural-gas pipeline system. It also owns 50% of a master limited partnership. It should have free cash flow of $1.20 to $1.30 a share and about a dollar in earnings once it finishes up a couple of projects. It is worth 17 times free cash flow, or more than $20 a share…

So at $35 you get the refining business for free.

My original purchase a few weeks ago was somewhat vindicated after Warren Buffett noted in a Bloomberg interview that his company had bought a large position recently.

The interesting thing about Phillips is that they stand to benefit from the increased liquids production in North America.  Below is an excerpt from the company’s CEO at the Citigroup Global Energy Conference:

If you think about natural gas at kind of $2 a day and ethane that was 30 cents and going down I think the last time I looked at it. But ethane at 30 cents is about $5 a million BTUs. So we capture the upgrade from the wellhead at $2 to 5 bucks through the midstream business and then the petchems really pick up at $5 and go to essentially the crude level, which is what the rest of the world competes on when they’re buying naphtha. Think about that at $17 to $18. And while we don’t know exactly where that rent is going to get captured through that chain, by the ownership in DCP and CPChem, we benefit all the way through that chain in the ownership in capturing that margin upgrade. So we really like that position that we have there.

The thing that makes Phillips interesting is that, as was implied by the Meryl Witmer analysis in Barrons, based on the valuation of the company, investors seem to be treating the company as a refiner, when really only a third of the company’s business is refining.   Moreover, as the company pointed out at another conference recently, this time put on by UBS, the other two-thirds of the business, midstream and chemicals, have return on capital metric north of 20%.

My only problem with Phillips is finding a price to buy in at.  I bought into it in other accounts at under $32.  It pains me now to buy at $35-$36.  Perhaps we will get a further pullback, though after the Buffett endorsement I kind of doubt it.