Download A CASE White Paper

White Paper
February 2013
Emerald Financial Services Team
A CASE
for continuing investment opportunities in
community banks.
By Steven E. Russell, Esq.
3175 Oregon Pike, Leola, Pennsylvania 17540
Tel: 717-396-1116 • Fax: 717-556-8895
www.teamemerald.com
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Have Investors Missed Their Opportunity To Invest In
Community Banks?
Small cap bank stocks have continued their rise, up greater than 50%, from credit crisis lows reached on
October 3rd, 2011, the result of nine quarters of credit quality improvement, “better” capitalization, a
stabilized housing market, and a return to loan growth albeit slow loan growth.
While the operating environment has certainly improved since the fourth quarter of 2011 for small cap
banks, investors are now concerned that the “good” news has been priced in to the stock valuations.
As we enter the fourth quarter 2012 earnings season, investors are concerned that bank stocks have run
their course and that the sluggish economy, low interest rates, and net interest margin compression are
reasons to avoid the sector. The popular sentiment is that the shape of the yield curve will likely
contribute to net interest margin compression and EPS estimate reductions.
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We agree that if the domestic economy does not materially improve, low interest rates will likely persist
well into 2014. We view this as an opportunity for stock pickers to outperform as quality banks are
better positioned than others to manage through this challenging operating environment.
We believe that Emerald’s 10 Step Research Process enables us to pick winners in the type of bifurcated
market that exists in the bank sector today. We believe that we have and will continue to identify
attractively valued banks that have better growth prospects, lower deposit costs, liquidity deployment,
credit tailwinds and cost reduction capacity.
While buyers and sellers have yet to close the bid/ask spread enough to drive a “wave” in merger
activity. We have seen year over year growth in the number of mergers announced and consummated.
We believe that the continued regulatory burden will contribute to an increase in banks with less than
$1 billion in assets becoming willing sellers. As the anticipated merger activity takes place, we believe
we will see small cap bank and thrift valuations move towards historical levels.
Community Bank are Attractively Valued
Historically, bank stocks have been valued using either price to earnings (PE ratio) or price to tangible
book value (P/TBV) with investors relying on one more than the other depending on the operating
environment and where we are in the credit cycle.
Price to Earnings Ratio
In a normal operating environment, bank stocks can be valued on their price to earnings ratios (PE),
which is calculated by dividing a bank’s stock price by its earnings per share (which can be based on
trailing or forecasted earnings). The current price / next 12 months EPS multiple of small cap banks and
thrifts stands at 13.5x versus the one year, three year and five year averages of 14.2x, 15.2x and 15.7x,
respectively.
But the current operating environment is anything but “normal”. Earnings have been muted by
increased levels of provisioning, low loan to deposit ratios and excess capital being held by banks due to
regulatory pressures. Until provisioning, allowance for loan losses, and loan to deposit ratios return to
“normal” levels we place more emphasis on tangible book value metrics.
Price to Tangible Book Value (P/TBV)
Price to tangible book value is a more conservative valuation metric that measures the premium or the
discount bank stocks trade at relative to its tangible book value. TBV has become the de facto valuation
methodology during the recent credit crisis, as tangible common book value is often viewed as the
purest measure of GAAP capital and is the closest to regulatory capital measures. Banks currently trade
at 1.45x TBV, a significant discount to both their 1.7x P/TBV ten year historical average and 2.5x P/TBV
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twenty year historical average. We believe the current discount to historical levels provides an
attractive opportunity to invest in quality banks at bargain prices.
Home Prices Have Bottomed
Historically, real estate loans represent the largest community bank loan category, making up more than
sixty percent of their total loans. Real estate loans are broken down into three major categories: 1)
closed end residential real estate, which represents 22% of total loans; 2) revolving home equity, 6% of
total loans; and 3) commercial real estate which accounts for 40% of total loans and includes
construction, land development, and other land, as well as loans secured by farm land, multifamily
residential properties and non farm non residential properties.
With residential real estate related loans making up 28%+ of total loans at community banks historically,
we believe that an essential aspect to the rally we are witnessing in community bank stocks is the
stabilization of the housing market.
The Federal Government, via their move to launch the third round of quantitative easing, is targeting
the U.S. housing market. The Fed is hoping that by buying about $40 billion per month of mortgage
backed bonds they will further drive down long term interest rates. The goal is to attract more buyers
to the market by making mortgages even more affordable than the already historically low interest
rates. Obviously, with more buyers pushing up home prices the markets will continue to stabilize.
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As a result of the stabilized housing market, the theory is that demand for new home construction
would be stimulated, construction related employment numbers would improve and the stubbornly
high jobless rate would improve as well. In a nut shell, a stronger housing market fuels the economy
and a stronger economy bolsters confidence. Greater confidence fuels greater investment by local
business and this in turn strengthens the economy, helping to bring down unemployment and leads to
greater loan demand from business owners and from a more confident, employed and credit worthy
consumer.
Economy and Job Growth
GDP growth has trended close to 2% for 2012, but faced with a number of headwinds we believe growth
is likely to remain moderate in the near term. However, we believe that there is a natural process of
recovery that will occur with the recovery of the housing market which should provide some positive
momentum. Job growth remains key as job losses always endanger loan quality and growth on the
consumer as well as the commercial loan side.
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Despite the stabilization of the housing market economic headwinds, slow to no job growth and the
resulting low interest rate environment will continue to pressure net interest margins into 2013.
However, we believe that well managed banks will be able to differentiate themselves by maintaining a
flat to slightly down net interest margin while many of their peers see net interest margin drop at faster
rates.
A Flat NIM Can Be Achieved
A community bank’s revenue can be broken down into two major components, interest income and non
interest income. The first is interest income, which is revenue produced from extending loans to
borrowers and investing in other earning assets, such as securities. Net interest income is the dollar
difference between the interest earned on a bank’s earning assets, such as loans and securities, and the
funding cost of a bank’s liabilities which are simply the bank’s deposits. Net interest income is the
largest component of a community bank’s revenue, often accounting for 70%-80% of revenues at the
typical community bank.
Net interest income is driven by the amount of assets and spreads or net interest income. A community
bank’s net interest margin or NIM is a key profitability metric which is calculated by subtracting interest
expense from interest income divided by average earning assets. Recently, NIMs have remained flat
reflecting a combination of positive funding trends (lower deposit costs driven in part by growth in low
cost deposits and run off of higher cost CDs) and tightening loan spreads as stubbornly low interest rates
weigh on the sector.
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With the 10-year Treasury yield averages at 1.75% or lower, the yield is still very low and will continue to
contribute to margin headwinds but as we always say, “not all bank stocks are created equal.” Some
banks are better positioned than others to manage through the challenging operating environment.
There are a variety of reasons why certain banks have higher NIMs than others but the most common
reasons are a better mix of assets and/or lower funding costs. We are continuing to invest in
community banks that are generating attractive loan growth thus allowing them to improve the mix of
assets on their balance sheet. Asset yields are typically driven by the mix of assets and often a mix that
has a higher proportion of loans, which usually yield more than securities, will generate greater yields.
Higher yields may also result from a loan mix that is geared more towards higher yielding types of loans.
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Loan Growth
According to the Federal Reserve’s weekly H.8 release, loan growth is set to post its seventh consecutive
quarterly increase. Commercial and Industrial (C&I) growth has surged in December, which together
with continued strength in commercial real estate (CRE) balances, is signaling the strongest sequential
quarter growth in loans since the second quarter of 2010.
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Glut of Low Cost Deposits
In the present slow-growth economy, a solid low-cost core deposit base has become an increasingly
valuable commodity. During the housing ‘bubble” the excessive construction and mortgage lending was
often funded with alternative funding sources such as brokered deposits, Federal Home Loan Bank
(FHLB) advances, Fed funds purchased, and repurchase agreements which all contributed to higher cost
of funds at most banks. Lower funding costs at most banks have been easily achievable over the last 24
months as low cost or non interest bearing core deposits have been easily achieved without having to
increase expenses relative to gathering these deposits, such as branch expenses. The increase in
deposits reflects continued risk aversion among depositors and investors, in the face of economic
uncertainty arising from Europe, the fiscal cliff and the upcoming U.S. elections.
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Time deposits are at record lows as a percentage of total deposits and continue to fall as banks
substitute cheaper transaction accounts for time deposits. But banks still must find ways to put that
additional cash to work which is an increasingly difficult proposition, given the Federal Reserve's
intention to keep the long end of the yield curve low. The ongoing low interest rates will continue to
put downward pressure on net interest margins, forcing banks to squeeze every penny they can out of
operations and to focus more keenly on non interest income.
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As a resulted of the pressure on fees, many banks have developed new fee structures, i.e. the
elimination of free checking, and have acquired or are organically growing fee businesses such as trust
and wealth management services, cash management or mortgage origination platforms.
We believe mortgage banking will continue to figure prominently in non interest income as it is being
helped by the federal government through QE3 and HARP II. With rates at record lows, mortgage
refinancing activity will remain at increased levels for the next six months. We believe that as long as
rates remain around current levels and home prices remain stable a significant decrease in mortgage
banking fees seems unlikely.
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Lower Expenses Boosting Bottom Line
Non Interest Expense
Non interest expense, those expenses incurred that are unrelated to funding costs, typically represent
50% to 60% of total revenue. The largest portion is typically personnel expenses related to salaries and
other employee benefits. Our top performing banks are often willing to incur expenses in order to
continue feeding the growth pipeline but management teams at these banks are also well aware of
improving the efficiency ratio at their bank.
The efficiency ratio measures how efficiently a bank operates and can be calculated by dividing the non
interest expense by total revenue. Over the past three years we have seen efficiency ratios for the
industry increase given lower revenues and higher expenses related to higher credit and regulatory
expenses.
Despite credit remediation charges steadily declining, higher regulatory expenses related to Dodd Frank
have increased expenses by close to 5% on a pre tax basis for some institutions. When it comes to
expense management, community banks can be segregated into those that are actively implementing
expense rationalization programs and those that are managing costs down in a more gradual manner.
Lower Credit Related Expenses
According to the FDIC, aggregate industry credit losses in 2009 were the highest relative to pre-provision
earnings since the creation of the FDIC in the 1930s. As a result, loan loss provision expenses which are
the credit expense that flows through a bank’s income statement, have been elevated since 2008. From
2008 through 2010 banks generally were provisioning more than they were charging off. When a bank’s
provision expense exceeds its net charge offs in a given period, it signals that the bank is building its loan
loss reserve and points to increased charge offs in future periods. As evidenced by industry data from
the Federal Reserve, we believe that all of the loan categories reached an inflection point in delinquency
levels and net charge offs in early 2010. Credit costs have come down significantly for community banks
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and we believe that the trend is likely to continue. For the most part, we are seeing banks maintain
their allowance for loan losses at elevated levels but have seen provisioning levels on a quarterly basis
improve tremendously.
Banks that have addressed their credit quality early in the cycle have seen their earnings benefit from a
much lower provision expense and we believe we may have seen this trend play out. There are other
credit related expenses though that we think will reduce over the next twelve months thus helping the
bottom line such as a reduction in OREO expense.
Other real estate owned or OREO is property that has been acquired by banks through foreclosure.
When the real estate is secured, it is marked down to the current fair market value based on a third
party appraisal and the amount marked down is charged off. Any updated appraisals that result in a
write down or any gains or losses upon the sale of the real estate increases or decreases the valuation
allowance and is classified as OREO expenses. As we move further through the credit crisis we believe
that OREO expenses will continue to decrease thus helping the bottom line. However, we do believe
that credit leverage will generally begin to slow through the second half of 2013.
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The Long Awaited M&A Wave Will Arrive
Whole Bank Deals
We believe that deal activity will continue to increase in 2013 following a sharp increase in the number
of deals in 2012 to 231 from 172 in 2011, an increase of 34%. However, we believe that the majority of
deals in 2013 will focus on banks with less than $1 billion in assets that are faced with the challenges of
capital constraints, increased compliance costs, bank board fatigue and private equity investors looking
for an exit and/or banks with balance sheets that are poorly positioned for extended low rates.
Therefore, the more efficient firms buying the less efficient banks will primarily drive consolidation, in
our view. We believe that as the difficult regulatory and operating environment continues to weigh on
bank boards and management teams, potential sellers will become increasingly receptive to cash and
stock deals with consolidators that are viewed as partners of choice. To that end, we note that of the
7,181 FDIC insured institutions as of September 30, 2012, 6,522 or 91% had assets under $1 billion,
which in our view creates an abundance of opportunities for consolidation. Going back to 1990, the
highest amount of deals done in one year was approximately 4.4% of total banks compared to the
previous year which would translate to about 315 and we believe that to be the case in 2013. 315 deals
announced in 2013 would be a 36% year-over-year increase from 2012, slightly ahead of the 34%
increase seen in 2012, and we believe that to be a reasonable number.
FDIC Deals Will Pick-up
We believe the 2012 Presidential election slowed the pace of FDIC assisted deals, etc. The pace of FDIC
deals will increase tremendously in markets such as GA, FL, and IL, where the number of high Texas ratio
banks (>100%) with capital ratios below 3% remains extremely high. While bidding for these deals have
gotten more competitive and the winner rarely has a loss share agreement in place with the FDIC, if
properly bid with an appropriate loan mark, these deals remain financially attractive.
We believe that there are still many opportunities for FDIC assisted acquisitions to come. In fact there
are more than 700 banks still on the FDIC’s problem bank list, including a number of them operating
with negative capital levels or capital less than 2% and we believe that it is “inevitable” that these banks
will fail but the failures will come at a pace slightly below 2012. Thus, we believe that FDIC assisted
transactions remain a viable way for banks to expand.
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Emerald Financial Services Team
Kenneth G. Mertz II, CFA
President
Chief Investment Officer
Emerald Advisers, Inc.
Mr. Mertz is Chief Investment Officer and President of Emerald Advisers, Inc. and a Manager of the
Emerald Growth Fund and Emerald Banking & Finance Fund; Chief Investment Officer, PA State
Employees' Retirement System (1985-1992); Member, Association of Investment Management Research
(CFA Institute); past Trustee, PA State University Endowment Council (1998-2004); past Member,
Pennsylvania State University Research Foundation; Trustee, Evangelical Lutheran Church in America
Board of Pensions (Present); and past Chair, President, & Director of Central Pennsylvania Investment
Managers. Mr. Mertz has been quoted in The Wall Street Journal and in USA Today, and has served as
speaker at various investment seminars and programs across the country. He has been a guest on
CNBC's Mutual Fund Investor and has been interviewed several times on CNBC. Mr. Mertz graduated
from Millersville University with a B.A. in Economics.
Steven E. Russell, Esq.
Portfolio Manager
Senior Research Analyst
Emerald Advisers, Inc.
Mr. Russell is a Manager of the Emerald Banking & Finance Fund and a Senior Research Analyst for
Emerald Advisers, Inc. Prior to joining Emerald in 2005, Mr. Russell founded Greenwood Advisers, LLC, a
registered investment adviser. Previously, he served as Managing Director of iNetworks, LLC a private
equity firm located in Western Pennsylvania. Prior to joining iNetworks, LLC, Mr. Russell served as Senior
Vice President and Portfolio Manager of Emerald Advisers, Inc., where he served as Manager of the
Emerald Technology Fund and co-manager of the Emerald Select Banking Fund. He was also a Principal
and Founding Partner of Emerald Venture Capital. Mr. Russell served as Senior Private Equity Analyst for
the Pennsylvania Public School Employees' Retirement System (PSERS), where he administered PSERS'
$1.2 billion commitment of private investments, including leveraged buyouts, distressed investments,
mezzanine and growth equities. From 1996 to 1997, he administered PSERS' $400 million
Developmental Fund and $100 million Absolute Return Program. Mr. Russell serves on the Board of
Arbitrators for the National Association of Securities Dealers, and has appeared on CNBC, Bloomberg
Television and other investment oriented programs. He has been quoted in various international media,
including The Wall Street Journal, Smart Money Magazine, Bloomberg Business News, Dow Jones News
Service and Market Watch. Mr. Russell received both his JD and MBA degrees from Temple University
and a BA degree in Banking and Finance from Morehouse College. Mr. Russell is licensed to practice law
in the State of New Jersey and has passed the NASD Series 63 exam.
Joseph W. Garner
Director of Research
Portfolio Manager
Emerald Advisers, Inc.
Mr. Garner is Director of Research and a member of the Small Cap Portfolio Management team. He is
also a Manager of the Emerald Growth Fund. Mr. Garner's research efforts are focused on small and
mid-sized firms in the Business Services, Capital Goods, Consumer, Financial Services, and Technology
sectors. In 1997, he was named as a "Home-Run Hitter" by Institutional Investor magazine, and has
appeared on Bloomberg Television and CNBC. He also has been quoted in Fortune, Bloomberg Business
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News, USA Today, Dow Jones News Service, Standard & Poor's, MarketWatch, Investor's Business Daily,
Wall Street Journal, and other media. Mr. Garner served as President of the Millersville University
Foundation and previously served as Chair of the Board's Investment Committee. Prior to joining
Emerald in 1994, Mr. Garner was the Program Manager of the PA Economic Development Financing
Authority (PEDFA) and an Economic Development Analyst with the PA Department of Commerce's Office
of Technology Development. Mr. Garner received an MBA from the Katz Graduate School of Business,
University of Pittsburgh, and graduated magna cum laude with a BA in Economics from Millersville
University
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