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Posts from the ‘Shore Bancshares’ Category

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.

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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.

Regional bank earnings round-up

Over the course of last week four of the five regional banks in my portfolio reported first quarter earnings.  Since that time I have been busy reviewing those earnings and drawing conclusions on whether the stocks should remain owned, or be punted out for other opportunities.  Below I will go through my analysis and thoughts on each of these banks.

Rurban Financial (Ticker: RBNF)

Rurban Financial reported earnings last Tuesday.  Rurban does not have a particularly troubling loan book, and while they do have some non-banking related problems (such a legacy data processing business that does not appear to be doing very well) they are mostly set to generate strong earnings going forward.  So when I look at Rurban’s results, I focus on what they were able to earn.

Earnings per share came in at 20 cents.  Because Rurban has a  large mortgage servicing portfolio they are subject to big swings in earnings due to the GAAP valuation adjustments that they have to take on their portfolio of mortgage servicing rights.  While these adjustments are GAAP requirements, they tell us nothing about the business and tend to obscure the true earnings of the business.  Thus, I like to look at a “core” earnings number that eliminates the valuation adjustments as well as any other one time charges and the loan loss provisions.  Core earnings came in at 19 cents.  Core earnings for the past 5 quarters are shown below:

I’m not too worried about the decline in earnings quarter over quarter because a lot of it is seasonal.  Rurban sold a lot less mortgages in Q1 2012 than it did in Q4 2011 and that is just the seasonal nature of that business.  For some reason a lot of markets in the US experience high mortgage demand in Q4, and low demand in Q1.  In most Canadian markets it is the opposite of that, with Q4 being the slowest of the four quarters.

Another contributor to lower earnings was reduced revenues from the RDSI data processing subsidiary.  RDSI provides data processing services for banks across the Midwest. RDSI lost $1.4M in 2011 and doesn’t appear to be doing any better in 2012.  Its a strange situation because the big cause of the loss in Q1 were writedowns related to Rurban’s own bank deciding not to use RDSI for their banking related data processing needs.  Clearly they are cutting ties (winding down?) and maybe that will be for the best in the long run.  Below are revenues from RDSI less intercompany over the last 5 quarters.  Its become small enough that going forward it should cease to be the drag on earnings that it has been.  And that’s a good thing.

Mortgage revenue at Rurban continued to be strong; Rurban generated $1.2M in origination volumes in Q1 versus $420K in the same quarter last year.   As I already mentioned originations are always down in Q1 versus Q4, so that number was a decline from $1.5M in the previous quarter.   The year over year growth in origination led to further growth in their servicing business, which was up by another $20MM in terms of unpaid balance sequentially.  Nonaccrual assets continue to fall, down to $6.5M from $8M in the fourth quarter of last year.  And the company continues to rein in cost, witness by another drop in non-interest expense.   Negatives for the quarter were pretty much the same as those I saw elsewhere in the banking sector.  They are getting squeezed on interest margins (down from 4.07% to 3.64%), and loan growth was pretty flat quarter on quarter.

Overall Rurban announced pretty solid results and they are continuing to move towards their potential $1 per share of earnings.  There is still work to be been, ROA remained poor at 0.60%, but that is why the stock trades at only 2/3 of book value, and why the opportunity for further price appreciation remains.  I have been very happy to see the shares move up as they have over the last week.

Shore Bancshares (Ticker: SHBI)

Shore had a tough quarter.  While I had been hoping  that the company’s loan book was on the mend, the first quarter results showed that there is still some work to be done.

The loan book deteriorated over the quarter.  The company had to put aside provisions for credit losses of $8.4M, which was way up from $4M in Q4 and $6.4M in Q1 2011. Nonperforming assets rose to 8.1%.  I had been hoping that nonperforming assets had peaked in Q3 and would continue to roll over in Q1.  Unfortunately not.

The company said that the rise in nonperforming loans resulted mainly from one relationship. 50% of the $9.1M in charge-offs were related to a single large real estate borrower.

If you can get past the loan book (and I wish they could get past their loan book), there were some positives for the quarter.  While deposits increased 4.2% on a year-over-year basis and, notably, core noninterest-bearing deposits were up 17.4% year-over-year, so the company’s borrowing base continues to move towards lower cost loans.

If you look at Shore’s eventual earnings poential, if they could stop taking massive writedowns every quarter, it remains strong.  Earnings ignoring the provisions were $0.39 per share.  Over the previous twleve months Shore has put together earnings of $1.50 per share if you ex out the loan losses.  So the potential is certainly there.  Unfortunately loan book stabilization appears to be a bit further off then I had anticipated.

I’m not sure what to do with Shore.  I am tempted to cut it and run.  I originally got the idea from Tim Melvin of Real Money.   He described the investment as a 5 year hold and a 3 to 5 bagger.  Given that the bank trades at about 1/2 of tangible book value and that it used to be a $25 stock before the collapse of 2008, and you can see where he is coming from.  However I am not quite as patient as Mr Melvin.  I like stories that are in the process of turning it around, not just with the potential to turn things around at some point.  I haven’t sold out of the stock yet, but I have an itchy trigger finger.

Community Bankers Trust (Ticker: BTC)

BTC’s earnings are always obscured by the effect of the indemnification asset that the company carries as a result of an agreement to take over a failing bank, SFSB, back in 2009.  The indemnification asset is an accounting tool that accounts for the FDIC guarantee that BTC received when they took over the SFSB loan portfolio.  Unfortunately, the accounting of the asset it such that when there is better than expected performance in the SFSB portfolio, the company has to amortize the indemnification asset on their income statement.  The size of these amortizations is extremely large relative to earnings.  In Q1 the amortization was $1.9M versus net income of $0.9M.

I always ex-out the effect of the indemnification asset when I look at BTC’s earnings.  The asset says nothing about their cash generation and earnings ability.  In fact it actually works in reverse to that underlying ability.

Ignoring the indemnification asset and a few other small one time gains and losses, BTC earned 13 cents in the quarter.  On this core earnings metric BTC has earned 52 cents over the prior twleve month, which means it remains an incredibly cheap stock trading at a little over 4x earnings.  Looking at the same sort of “core” earnings number that I did for Rurban, you can see that the bank is consistently been pulling in 10-15 cents of earnings a quarter for the last 4 quarters.

BTC has done an excellent job of pulling itself back from the brink of bad loan losses, and this continued in Q1.  Nonperforming loans on its non-covered portfolio (non-covered refers to loans not covered by the FDIC loss sharing agreement) decreased 13% or $4M quarter over quarter.  Nonperforming assets have fallen from a high of 9.7% of total assets in the second quarter of last year to 6.9% of assets in the most recent quarter.

Meanwhile the company grew its loan book marginally in Q1, which is traditionally a slow time of the year for loan growth for the company and a quarter where their loan book shrank last year.   It is also interesting to note that unlike most of their competitors, BTC managed to maintain a flat net interest margin in the quarter, at 4%.

I really like the turnaround that is taking place at BTC.  Having bought the stock at a little over a $1, I am sitting on a double already.  Yet I have no plans to sell.  BTC was a $3.50 stock as recently as the beginning of 2010 and was a $7 stock before the financial crisis hit in 2008.  I don’t see any reason why they can’t return to a level somewhere between those two numbers.

Bank of Commerce Holdings (Ticker: BOCH)

I learned about Bank of Commerce Holdings from a BNN Market Call with Benj Gallander, the Contrarian Investor guy.  He had BOCH as a top pick and I was looking for regional banks at the time so I took a look at the stock and bought some at $3.25.  Watching Market Call is a hit and miss time investment, you can sit there and watch episode after episode and get nothing out of it, but every once in a while there will be a gem.  BOCH was one of those gems.

Bank of Commerce Holdings is steady as she goes.  I’m not quite sure how they have done it, but BOCH has managed to keep nonperforming assets at reasonable levels (2.45% in Q1 which was down from 2.68% in Q4 2011) while operating in one of the hardest hit real estate markets (Sacramento).  To be fair they also operate in a second market, Redding California, which didn’t have quite as bad of a housing decline.

The company has been consistently reporting return on assets (ROA) of 1% and return on equity (ROE) of 8-9% for the last 3 quarters.

Much like Rurban, the first quarter seasonally has lower mortgage banking revenues than does the fourth quarter so I am not concerned about the decline in ROE and ROA sequentially.  Mortgage banking is a big part of Bank of Commerce Holdings banking business so they are subject to these seasonal effects.  What is more relevant is the trend in mortgage banking revenues.  They have climbed substantially from $2.5M in Q1 2011 to $5M in Q1 2012.

Bank of Commerce Holdings earned 35 cents per share in 2011 and 31 cents per share in 2010.  I would expect them to earn over 40 cents per share in 2012.  BOCH is not going to be a shooting star type of a performer.  Its not going to double in a year.  But the company is consistently profitable and consistently adding to shareholder value.  There is also the chance for them to raise ROE above 10% and ROA above 1% by increasing their operational efficiencies.  I hope to see this occur over the next year as the economy improves and opportunities present themselves.   I think it is reasonable to expect the stock to trade to the $5.50 range by the end of 2012.  That is good enough for me.

Jumping into another Mortgage Servicer

On Tuesday the financials broke out and that breat out has continued through the week. A quick look at the KRE shows that the trend has been up since the end of December and that the move this week took them decisively above the July-August levels just before the break down occurred.

Along with the plain vanilla regionals, a number of the mortgage specialists that I have leaned towards are showing strength. Newcastle Investments continues to move higher. PHH Corp is flirting with $15. I’m pleased that these stocks are responding so well; as they continue to do so I will continue to add to my positions.

As it is I have bought the breakout over the last few days by buying a new bank and a new mortgage originator/servicer. On Wednesday I initiated a position in Shore Bancshares.The bank is trading at about 1/2 of book value and looks to be slowly turning around its admittedly elevated delinquent loan book.  And just yesterday I initiated a new position in a recent IPO called Nationstar Mortgage Holdings.

Nationstar Mortgage Holdings

I have been stepping through the Prospectus on Nationstar. It is available here .

I’m pretty excited about the company. I have been looking for another pure play on the mortgage servicing rights thesis. Newcastle is not a bad way to go, and PHH Corp looks good, but Nationstar looks like another cheap alternative to get leverage to an early turn in the US housing market and to the pricing disconnect of mortgage servicing rights.It appears to be trading at about 17x last year’s earnings (ex the MSR adjustments), and I expect that with the growing servicing portfolio (they have grown at a 70% rate for the last 3 years), and with deals like the one they are doing with Newcastle, that those earnings are going to go up substantially.

The company has been privately owned by Fortress Investment Group (another company I want to look at), which is a private equity firm. Fortress is the same firm that is involved with Newcastle.  Apparently someone at Fortress is seeing the same thing I see in the mortgage servicing right business.

Fortress did the IPO of Nationstar at $14 but interestingly will remain a large majority shareholder at 81%. I have no doubt that Fortress made the IPO because of the opportunity they see to capitalize on the mortgage servicing industry.

Newcastle Investments

And since we are speaking about mortgage servicing, yesterday Newcastle also made the predictable announcement that they would raise their dividend from 15 cents to 20 cents for the first quarter.  I find it kinda fascinating how the stock jumps on these dividends increases.  They also left the door open for further increases and further investment into MSR’s.

Kenneth M. Riis, Newcastle’s CEO commented, “I am pleased to announce our second common dividend increase since it was reinstated in the second quarter of 2011. Our ability to increase our dividend is a result of deploying capital at attractive returns and improving our overall operating results. As we complete new investments, we expect our operating results and cash flows to improve further.”

I don’t know if there will be another share offering but I don’t really see any other way for Newcastle to “complete new investments”. Any offering could mean a short term down draft in the shares. But with an investment opportunity like mortgage servicing provides right now, I would argue that raising capital is a good thing over the long run.

Remember that the MSR’s that Newcastle has invested in thus far are expected to return 20% IRR based on the expectation that 20% of those loans will refinance or default every year. That’s the base case. Yet we are in a period where refinancing and defaults could begin to fall substantially, which would drive up the IRR of the servicing. In my opinion the potential for an IRR far beyond the base case is significant.

The current Opportunity in Mortgage Servicing Rights

I’m going to say it again.  MSR’s are a HUGE market disconnect right now.  The disconnect is being brought about by a combination of regulatory changes that have made MSR’s unnattractive from the Tier I capital perspective and from a legacy business of bad loans that many of the banks are stuck with.  The result is that most of the biggest players traditionally in the MSR industry are stepping back and some (Bank of America for example) are getting out completely.  This has left the industry undercapitalized, which has resulted in a collapse of pricing of mortgage servicing rights.  The rights have traditionally traded for 4-6x their coupon; today they are trading at less than 2x.  Newcastle has done its recent deals at around 2x.  And this mispricing has happened at a time when the industry fundamentals for servicing have never been better.  Loan quality is high because standards have become very tight, and with rates so low the potential for significant refinancings has dwindled.

No one else seems to be noticing this. I feel like a loan wolf.  Nevertheless I remain convinced that this is a great opportunity.

In the mean time I will continue to take advantage of the silence and keep adding to Newcastle, to PHH, and now to Nationstar.