Banks On Sale

My bank stock portfolio was comfortably in the black, with a solid 2.5% dividend yield at year-end. My have times changed.

Before I begin, I feel compelled to disclose that I am not a registered broker or financial advisor. I am not giving you investment advice.

At December 31, 2019, the SNL Bank & Thrift Index stood at 193% price/tangible book, 13.6x EPS, and a 2.63% dividend yield. Then Covid-19.

At April 14, 2020, I measured all banks and thrifts with total assets between $1 billion and $10 billion. Still community banks, and have decent trading volume for more efficient pricing. At the median, these banks had a market metric slash line (P/E, P/TB, Dividend Yield): 8.8x / 95% / 3.39%. But the differences among banks varied greatly. The greatest drop in market price was Marlin Business Services Corp., at 64%. At the other end of the spectrum, Community Bancshares in McArthur, Ohio GAINED 8%! Do they finance respirator production?

I should point out that Marlin Business Services has many subsidiaries, most of them finance companies, but one is a bank.

Statistics

On average there was a significant drop in valuations. But "on average" is a pesky phrase. What is the standard deviation? Recall from statistics class, which gave me math stress by the way, the closer the standard deviation is to zero, the lower the data variability and the more reliable the average is. The higher the standard deviation, the more variation there is in the data and the less accurate the average is. The standard deviation of stock price decline between December 31st and April 14th for the banks I measured was 11.8. Yikes!

That means, within the data, there is opportunity. And I hear about this opportunity from bankers that really, really want to buy back their stock at these valuation levels. But an abundance of caution because of the unknown, plus optics, is preventing them from doing so. 

Fear of the unknown and the gravitational pull that whispers in our ear to buy high, sell low may be holding back the rest of us. It is tempting to be as liquid as possible during this period of uncertainty. But it is the uncertainty that has otherwise healthy and profitable banks trading below book value. Some comfortably below book value.

First Quarter

Early earnings releases, primarily by the big banks may be fanning flames of fear. Citi announced a $7 billion provision for loan loss in 1Q, up from $2.1 billion the quarter prior. JPMorgan announced a 1Q provision of $8.3 billion from $1.4 billion. But $1.3 billion in assets MainStreet Bancshares in Fairfax, Virginia announced a provision of $350 thousand, down from $358 thousand the quarter prior. 

I think it likely though that most community banks will announce increases in provision, and some significant increases, due to early forbearance and payment deferment requests. And, as I said to a bank publication reporter yesterday, big banks take more of a macro-economic approach when assessing their loan portfolio. Community banks are more credit-by-credit. And that may not come to bare until the second quarter. 

Spreadsheets

And this is likely contributing to the wide variation in valuations we are seeing. The below two tables represent the top 10 price declines in banks with $1 billion to $10 billion in total assets from December 31st to April 14th.

Some of the above banks have stories. For example, at first glance, First Defiance looks compelling. A 1.50% ROA, 12.15% ROE, only 63 basis points non-performing assets/assets and a 9.58% tangible capital ratio. Even if NPAs spiked, they have a loan loss allowance as first defense and their capital was very good. Why in the heck did their stock drop 53% and now trades at a 6x earnings and a nearly 6% dividend yield?

Probably because they closed on a previously announced all-stock acquisition of a $2.9 billion in assets bank on January 31st. After their December 31st earnings, but before quarter end. And before the precipitous Covid induced bank stock decline. The deal value at January 31st was actually greater than at announcement! 

So there is uncertainty there, at least until FDEF announces 1Q earnings, which is not anticipated until April 28th. Even then it may not be clear because it would be challenging for FDEF to get their arms around the Covid impact to their own loan portfolio, let alone another, almost equally sized bank. Uncertainty equals discount.

And so it goes with many of the banks in the $1 billion to $10 billion in assets cohort. They have stories that are not easily analyzed by summary spreadsheet. Investors must look at loan types, non-performing loan trends, capital levels and trends, and percent of allowance to total loans. And, perhaps most importantly, management. Because good management rarely falls victim to bad circumstances over the long haul.

There are deals out there. You have to put in the work to find them.

~ Jeff

Uninteded Consequences of Executive Change in Control Provisions

You're a top performer at your bank and an executive from a competing bank wants you on their team. You recently got a new boss, and it isn't gelling. So the offer is timely.

You check out the competing bank. Do your due diligence. You respect their executives. Their numbers look good. Heck, you've lost a few deals to them. This bank deserves serious consideration for a job switch.

Hold on! You check their proxy statement. The CEO is 67. And he/she has a 2.99x change in control (CIC) contract. Nope. You're out. This bank's gonna sell so the CEO can pull the golden parachute rip chord. Why would they walk away with a gold watch when they can get paid for three years while sipping boat drinks in the Bahamas?

This hypothetical situation is an unintended consequence of executive CIC payments. The incentive gap between selling the bank and retiring while remaining independent is perceived as too big. 

Reasons for CIC Arrangements

There are legitimate reasons for change in control contracts. Meridian Compensation Partners, in their 2017 Study of Executive Change in Control Arrangements list the following reasons:

• Keep the Executive Neutral to Job Loss. The primary purpose for CIC arrangements is to keep senior executives focused on pursuing all corporate transaction opportunities that are in the best interest of shareholders, regardless of whether those transactions may result in their own job loss.

• Retain Key Talent. Corporate transaction activity may create uncertainty for critical executive talent. This uncertainty may create significant retention risk for a company. An executive with sufficient severance protection may be less likely to leave voluntarily to seek other employment in the face of transaction-related uncertainty.

• Maintain Competitive CIC Benefits. A majority of large public U.S. companies provide their senior executive officers with some level of CIC protection. Thus, companies provide CIC protection to attract and retain the top talent, especially in industry sectors undergoing substantial change or consolidation. 

Unintended Consequences

Aside from making it more difficult to get top performers to come to your bank when the CEO nears retirement, there are other unintended consequences. Other executives that may be retired in place (RIP) may hang on a little too long waiting for a buyer to come knocking and trigger their CIC payments. They are less likely to be making difficult decisions that will cause disruption yet might move your bank forward and position the bank for long-term success during this waiting period. 

Middle managers and high potential employees can read proxy statements too. Imagine the regional branch manager that wants to propose a change in hiring practices and development plans to turn branches into high performing sales and advisory centers. It will be difficult, but it is what customers are demanding. Should we do it? Nah, CEO is about to pull the chord. Multiply that perception several times over, and you have a bank that is losing pace with the market, making a sale a fait accompli. 

Shareholders celebrate the CEO's birthday too. I invest in bank stocks and have looked at a CEOs age on more than one occasion as a decision-point. This could artificially increase the valuation, making a sale more likely because the bank would have to earn its way into an inflated valuation. And shareholders may have bought in with the anticipation of a sale.

Development plans that help your high potential employees follow an executive track are shelved because of budget pressures. I am generally a cynic but most CEOs I know act in the very best interest of their bank. But what if, in the back of their mind where we rarely visit, they know that if they keep deferring the long and purposeful journey of developing multiple homegrown executives capable of becoming the next CEO, the board will opt to sell because there are little to no succession options. Under Jack Welsh, GE always had two or three people ready to go. Big company, I realize, but something to think about.

What To Do

What should you do about it? I asked a couple of executive recruiters and they didn't help me out. So I came up with one on my own. Unique, yes. A little out there, yes. Consistent with building a long and enduring business model, I believe yes.

Offer a Retirement Stock Plan (RSP) to ALL employees. Before you stop reading, let me describe it and run the numbers. One reason that institutional shareholders complain about CIC arrangements is because they put money in an executives pocket at the expense of shareholders. When a bank sells, the buyer assesses its value, then subtracts deal expenses. And a big deal expense is executive contracts.

But what if there was an incentive to stay and build the bank for the long-term, and retire? And instead of it only being available to executives, make it available to all employees that have been with you a minimum amount of years and retires.

This will put a premium on your talent management processes. Much like GE that shed 10% of its workforce each year using employee evaluations as the means to identify the 10%, a bank that implements an RSP must motivate high potential and otherwise good employees to stay, while having a process to improve or remove low performers so they don't hang on to get their RSP.

Math

It all comes down to a spreadsheet. Suppose Schmidlap National Bank, a $1.5 billion in asset bank, implements an RSP that pays 50% of a retiring employee's salary in Schmidlap stock if they retire after a certain age and have served between five and ten years at the bank. It would pay 100% of salary if they are there more than 10 years. Schmidlap can restrict the stock to protect against employees "retiring" and going to the competitor.

Here is what I think it would cost:

Many of the assumptions are aggressive, such as one executive retiring per year (at the average salary of all executives, including the CEO), and other employees retiring as a VP or AVP. If 5% of Schmidlap's 250 FTE employees retire annually, that's 13 per year at a $1.5 billion bank. That seems aggressive to me too. But I didn't want to undershoot the cost.

Based on my assumptions, this would cost Schmidlap $1.0 million per year and represent a 5% reduction in net income, and a 2.6% increase in operating expenses. I think banks can look hard within themselves to offset this cost with a mix of process improvements resulting in cost savings, and asset growth. My firm recently did a process review for a similar sized bank and made recommendations for $3 million in improvements, most of which were annual and recurring. We just taped a podcast with an emerging core processor that has 50% cost savings from your current core costs as a target. If half of the RSP was paid by growth, that would be $25 million in growth if it was added with a 2% incremental ROA.

I think the benefits would far exceed the costs. For one, it is a stock grant plan that adds to the bank's capital position to support growth. Second, it puts executives and employees on an even keel. It benefits both. Third, it reduces the incentive for the CEO and other executives to "pull the chord" and sell when they near retirement, which in turn helps the culture throughout the bank to manage it with an eye toward building a long-term future. It's a culture builder.

This doesn't mean the bank won't sell. If it hasn't earned its right to remain independent, that option remains on the table. And executives wouldn't be able to collect both a CIC and RSP at a sale event, in my opinion. Most states have laws that boards should consider all constituencies when making decisions: shareholders, customers, employees, and communities. An RSP would benefit all employees that gave a significant portion of their professional lives in service to the bank. 

What do you think? Any other ideas out there?

~ Jeff

Are Banks Overvalued?

The S&P 500 Bank Index is up 41% in one year. US Regional Banks' price-earnings multiple was 16.6x and price to tangible book value was over 2x (see chart). So are banks over-valued?

It depends. One way to compare is to look at the p/e ratio compared to the market. The S&P 500 p/e currently stands at 24.6x. So it looks like bank stocks are not overvalued.

But hold on. One ratio that can help us out is the PEG ratio. Remember that in Finance class? It's the p/e ratio divided by the earnings growth rate. According to Peter Lynch's iconic book One Up on Wall Street, a stock is fairly priced if its PEG ratio was 1. Meaning if it's p/e is 16.6x, like the US Regional Banks mentioned above, then the earnings growth rate should be 16.6%. I know I'm comparing a multiple to a growth percent. But, hey, I didn't invent the PEG ratio.

The challenge with banks' PEG ratio, as the chart shows, is that it is way over 1, by a factor of over 5 (5.7). I checked it against other industries in the Financial Services sector. Insurance brokerage has a PEG of 3.4. Specialty Finance: 0.4. The regional banks' PEG ratio, if I do the reverse math, implies that earnings are growing around 3% for the banks in that index. Which is very close to the 3-year annual net income growth for all FDIC insured banks.

So by the PEG ratio, banks would appear to be over-valued. Which may be true. But I want to bring up two mitigating points about banks:

1.  Banks are capital intensive. We must contemplate that implicit in their p/e ratio is some level of their tangible book value.

2.  Banks are not, in general, growth stocks long term. Risk management and the legions of regulators work in tandem to limit growth. 

Relating to 1, I did a data run of all banks and thrifts between $1 billion and $10 billion in total assets that were profitable. I checked their median p/e ratio. I then took their market cap and deducted their tangible common equity to deconstruct their p/e between tangible book and their market cap over tangible book (see chart). 

It is true that other industries can deconstruct p/e in this fashion. But would such an analysis of other industries equate 56% of an industry's p/e to it's tangible book value?

Even if we deducted tangible book from p/e, the industry PEG would still be 2.53 (7.6x / 3% growth), more than double Peter Lynch's prediction of fairly valued.

Which brings me to 2. How long can a company, a sector, and an industry grow faster than its markets? Certainly not forever. And for many, earning their p/e's means stoking growth either through acquisition, or greater risk taking. One is risky, and the other can be deadly. 

For these reasons, bankers may want to consider more moderate growth objectives, maximize earnings, and pay a larger portion of shareholder returns in dividends. 

What is your opinion on bank valuations?

~ Jeff

Note: I make no investment recommendations in my blog. I have a difficult time with my own portfolio. 

What Did a Trump Victory Do To Bank Stocks?

The S&P 500 futures plunged during November 8th's vote count when Donald Trump started pulling ahead. The nosedive gave the news media, who could hardly bare to report good news for Trump, some bad news to deliver. The market was betting a Trump win would be a disaster for equities.

But in a surprise turnaround, the next day when the dust settled and pundits were begrudgingly calling Mr. Trump President-elect, the market turned the tide. Traders were indecisive during the first 90 minutes of trading the next morning, and then came a buying spree that elevated the index to a gain of 1.43%. When things settled down, the final tally for November 9th was a 1.11% gain. So much for that Citi prognostication of an immediate 3%-5% haircut. How much do those analysts get paid?

But what happened with bank stocks? Surely there would be volatility with Trump's carping about over regulation. No industry suffered through more regulation since 2008 than the banking industry, right? And the Consumer Financial Protection Bureau, that reports to no one and has carte blanche to regulate institutions over $10 billion in assets, would surely not sit well in a Trump presidency.

Let's take a look. I analyzed the difference in stock prices of all publicly traded financial institutions that trade over 10,000 shares per day on US markets. I used October 31st as the base period, and the closing price on November 9th. Highlights can be found in the table below.

Disaster, averted.

In fact, the biggest loser in the systemically important >$50B category (SIFI) was a Canadian bank. Yes, I know they don't count towards our SIFIs, but still. A little humorous that a Canadian bank would suffer a decline. They are about to receive a significant amount of our celebrities! Looking further up the list for the next worst SIFI, I find National Bank of Canada, then Bank of Montreal. I had to go all the way to Huntington Bancshares to find a US-based SIFI. And they gained 2.9% from Halloween until November 9th!

I should note that three of our clients are in the Top 10 Gainers. I'm not trying to claim causation, just putting it out there.

The average stock price gain of all US publicly traded financial institutions between Halloween and November 9th was 4.2%. There was no catastrophe. No meteoric rise. Just another day at the office.

~ Jeff

Say It Ain't So Doug! Square 1 Bank Sells to PacWest

In the name of head scratchers, Square 1 Financial of Durham, NC, one of the most successful startup banks in a generation, is turning over the keys to PacWest, a California bank. The deal left me scratching my head, because at first glance it made little sense that a bank with Square 1's earnings trajectory would sell.

Niche banks are a growing part of our financial institutions landscape. I often cited Square 1 for their focus and success. In their own words, "Square 1 is a financial service company focused primarily on serving entrepreneurs and their investors." A bank with a focused strategy! Brings a tear of joy to my eye.

It had one banking office (in Durham), and twelve loan production offices located in key innovation hubs across the US. Its Chairman and CEO, Doug Bowers, was a 30-year BofA vet and more recently a member of a private equity firm. So the niche Square 1 adopted made sense.

But why sell Doug?

An industry reporter hypothesized that it was the price... 22x earnings, 262% of tangible book... c'mon?! But that was close to where Square 1 was trading at announcement. So there was no price premium. In fact, the below chart demonstrates that if Square 1 remained independent, their stock price would soar past the value received in this merger.

Like most projected performance, the devil's in the details. What I did was assume Square 1's 3-year compound annual growth rate in EPS (86%) linearly came down to earth to 12% by the end of the projection period, which is PacWest's 3-year EPS CAGR. I assumed PacWest's 12% would continue throughout the projection period. If all were true, it would have been more beneficial for Square 1 to go it alone. It is what I term "earning their right to remain independent."

So if future valuation wasn't the reason, then why? Perhaps they are receiving an outsized portion of the resulting bank than their current contribution. As I mentioned above, Square 1 did not receive a price premium from PacWest. So their pro forma ownership of PacWest is pretty much in line with their contribution (see table). Usually in a merger the seller receives a larger pro forma ownership stake because they receive a premium on their stock and they are relinquishing control. Not so, in this case.

So why did they sell? Here is what Bowers said in the press release: "Joining PacWest will be a terrific opportunity for our clients, employees, and stockholders. Square 1 offers PacWest a complementary line of business and significant core deposit growth. As part of PacWest, we will maintain our steadfast commitment to the entrepreneurial and venture communities, will be able to offer clients a wider array of products and will be well-positioned to continue to serve them through all stages of their growth."

That seems to tell us why PacWest bought Square 1, not why Square 1 sold to PacWest. So with Doug silent on the issue, here are my opinions on why one of my darling niche banks turned over the keys:

1. Institutional Ownership - Square 1 went public last March, raising $52 million at $18 per share from primarily institutional owners. The company was 70% institutionally owned with such names as Patriot Financial Partners, Castle Creek Capital, Endicott Opportunity Partners and other notables. Some had 5%-10% stakes, or about two million shares. Square 1 traded about 30,000-40,000 shares per day until around February 24th, when volumes soared (a fact that will not be lost on FINRA, although increased volumes prior to a merger announcement are not uncommon due to speculation). With such significant institutional ownership and relatively light normal trading volume, it would have been very difficult for those investors to lock in the trading gains experienced by Square 1 from November-February. How do you lock it in.... sell. Even if you are paid no premium. You can still lock in the price appreciation since you bought into the IPO.

2. Law of Large Numbers - As Square 1 grew larger, it would have to generate larger and larger amounts of business volume just to keep pace. For example, they had a $1.3 billion loan portfolio, the vast majority of which was commercial business loans. If 25% of that portfolio turned over every year, and I suspect it was more because business loans churn faster than commercial real estate loans, they would have to originate >$400 million of new/renewed loans per year to keep pace. Never mind growth. Which brings me to my third potential reason for selling...

3. Growth Trajectory - Square 1 was trading at 22x earnings when they sold. Banks their size typically trade around 13x-14x earnings. The premium was most likely the result of their balance sheet and earnings growth. Perhaps Doug and his senior management team were staring down the barrel of normalized growth. As investors began to recognize the slower growth, multiples would intuitively come down to the planet earth, suppressing stock price appreciation until the multiple normalized. That could have meant trading in a tight price range for a number of years. Why not lock in your tremendous gain since the IPO, and move on?

Square 1 was truly an extraordinary financial institution and I am sorry to see them go because I held them up as a premier example of how focused effort can lead to superior results.

If Doug Bowers and team were facing normalized growth and stock price appreciation, they could have decided to "cash cow" the bank, turning over a significant part of their earnings to investors in the form of dividends. In 2014, they enjoyed a 1.25% ROA and a 12.85% ROE. A great candidate for a cash cow. 

But alas that ship may have sailed when they backed up the truck to the institutional investor loading dock. They were numbers on a spreadsheet and were supposed to deliver the fund managers a big win. 

They did.

What else could Square 1 have done to satisfy their investors?

~ Jeff

Where will banks get their next dollar of capital?

Retained earnings.

I make a living helping financial institutions be as profitable as feasible. Why? To perpetuate their business model. This is how I feed my family.

But profits have been under pressure since 2008. First, FIs experienced pressure in their investment portfolios, purchasing Fannie Mae preferred's and other FIs trust preferred securities. Next, our over-exposure to construction and land development loans came to roost. Then commercial real estate fell under pressure as the economy teetered and rent roles declined.

Many banks had to replenish lost capital. The government stepped in to help, and taught us to ignore the guy/gal that knocks on our door and says "I'm from the government, I'm here to help." Absent or in concurrence with government-injected capital, FIs sought fresh capital.

But retail investors were nowhere to be found. This was one of the points made by Lisa Schultz of Stifel, Nicolaus, Weisel, an investment banking firm that specializes in FIs, at a recent Pennsylvania bankers conference.

Ms Schultz said retail investors were absent for all industries, not just FIs. She opined that they opt instead to invest in mutual funds, hedge funds, etc. Therefore, all of the action to attract capital was in the institutional market. I made this point in a past blog post, opining that the change in our shareholder base would be a significant factor driving future bank consolidation.

The change in shareholder focus, as presented by Ms. Schultz, is represented in the tables below. But this changing focus is from the institutional shareholder perspective... not the retail investor. The future investor will be concerned with quality growth that enhances shareholder value, combined with dividend policies that are mindful of capital preservation. I'm not sure how an FI will meet the 20%-30% capital appreciation, combined with sufficient liquidity, to meet "future", i.e. institutional, investor demand.

As if the shifting focus of the institutional investor wasn't challenging enough, what about the difference in what retail versus institutional investors value, and how they plan to exit their investment (see table below).

Tough luck finding your institutional investor at the local coffee shop bragging that they own stock in your institution. They could care less about how much resources your FI dedicated to the local food bank.

Here is what I think community FIs can do now to prepare for this shift in attitude:

1. Maximize retained earnings to reduce the need to visit the capital markets.

We have gotten a multi-year pass in generating profits because of the financial crisis and the subsequent teetering economy. Now it's time to cowboy up. How productive are your front line employees? How efficient is your back office? How well have you leveraged technology? Have you over-reached with your compliance program? If you don't have the answers, you better start looking for them.

2. Get a real investor relations program.

Investor relations is marketing. Marketing is much more than advertising. And your marketing message must be delivered long before you ever need capital. You must spin a story that gets locals excited about your bank. Yes, financial performance will play a significant role, but a supporting role to the story you tell about how your FI is a critical component to local communities. Retail investors may have shifted to investing in mutual funds, but the local community bank is probably one of few chances locals can invest in a company down the street.

3. If you must tap the institutional market, choose your partners carefully.

Ms. Schultz specifically addressed this issue in her presentation. Search for institutional investors that share your FIs objectives. Where did this fund invest? How long did it hold the investment? How did it exit?

4. Prepare for the exit strategy from the time of investment.

Receiving significant institutional investor dollars does not mean a fait accompli in terms of having to sell your FI so the investor can get out of the stock. However, if you don't plan for the investor's exit when they make their investment, the clock may run out when they are ready to go. Make evaluating strategic alternatives a regular part of your strategic planning, developing financial projections for a stretch case, base case, and stress case. See my post on this subject here. Also, make financial performance, investor relations, and stock trading liquidity a part of your strategy from the git go. If not, you'll find your FI might have up and went.

Where will your FI get it's next dollar of capital? I would like to know.

~ Jeff