Opportunities in Community Bank Stocks

The United States has over 7,000 FDIC-insured banking institutions. Of these, most are community banks that serve a small geographic area. The Independent Community Bankers of America counts nearly 5,000 member banks, ranging from $3 million to $17 billion in assets.

A surprising number of these banks are traded over-the-counter. I have spent many laborious hours compiling a database of over 300 banks that report to shareholders, either through SEC filings or via statements posted on their own websites. I have another list of over 250 institutions that do not report publicly. I imagine that many of them are willing to provide statements to shareholders, or may at least mail an annual report. Whether reporting or not, investors can check out the financials of any FDIC-insured bank by looking up public call reports.

Many value investors categorically avoid all banks and financial institutions for several reasons. Bank balance sheets are opaque and asset valuations can be both subjective and pro-cyclical. By their very nature, banks are leveraged operations and are strongly affected by uncontrollable factors like the yield curve. Banks operate a carry trade, borrowing short and lending long. A bank’s capital structure is fundamentally unstable, depending on short-term deposits.

Community banks are less affected by some of these issues. Community banks generally do not use complex derivatives or engage in proprietary trading, practices many large banks have come to regret. Community banks can also benefit from local goodwill and brand value, many having served their local economies for decades. On the other hand, community banks have unique risks. Profit maximization may not be a chief concern for some of these banks; many are content to earn an ROE of 6-7% year after year. The fortunes of a community bank are tightly intertwined with the state of the local economy, as community banks lack the broad geographic diversification of their national competitors.

All that said, I believe there are attractive opportunities in the community bank sector. To begin my search, I set up a simple screen focused on modest valuation, conservative capital ratios, good profitability and high asset quality. I chose to include only dividend-paying banks, though there are many attractive institutions that do not pay dividends.

I used the Texas ratio to measure asset quality. The Texas ratio is a measurement of the total amount of a bank’s non-performing assets and loans and bank-owned real estate compared to a bank’s equity capital and loan loss reserves. Historically, banks have tended to fail around the time when these values become equal and the Texas ratio equals 100%. All of the banks I have chosen to profile have Texas ratios of less than 20%.

From the list that remained, I have chosen five banks to profile.

Malaga Financial Corp.

Ticker: MLGF

Malaga Financial Corp. operates Malaga Bank with five branches in the South Bay area of California. The bank was founded in 1985 and is 48%-owned by its board members. Malaga has seen impressive growth in earnings, book value and deposits since 2007, yet still trades at a P/E of 8.4 and a premium to book value of just 18%. Credit losses have been minimal and the Texas ratio is 0%. Core capital is a strong 9.77%. Malaga has a market cap of $96 million and yields 3.06%.

Home Loan Financial Corp.

Ticker: HLFN

Home Loan Financial Corp. owns the Home Loan Savings Bank. The bank has three branches in rural Conshocton County, Ohio, east of Columbus. The bank focuses on residential mortgages. Home Loan Financial has a generous dividend policy and yields 6.18%. The company is tiny, but a market capitalization of just $18.31 million against $19.60 million in equity capital. Trailing P/E is 9.0. The Texas ratio is a low 16.16% and the core capital ratio is a conservative 12.15%. Deposit growth has been slow, but the company has grown earnings rapidly via an expanding net interest margin and controlled loan losses.

Comunibanc Corp.

Ticker: CBCZ

Comunibanc Corp. owns the Henry County Bank. The Henry County Bank is another Ohio institution, operating six branches in northwest Ohio, southwest of Toledo. Comunibanc has grown its earnings at a healthy clip on the strength of high net interest margins and moderating loan losses. The company does not release quarterly reports, only an annual letter to shareholders on its website. Despite a healthy core capital ratio of 10.82% and a Texas ratio of 9.12%, Comunibanc trades at just 70% of book value and a P/E of 8.4. Comunibanc Corp. has a market capitalization of $18.18 million and yields 3.37%.

Farmers & Merchants Bank of Long Beach

Ticker: FMBL

FMLB is giant in the community bank arena, with $4.77 billion in assets and a market capitalization of $568.88 million. It has a giant stock price to match, currently around $4,345 per share. FMLB was founded over 100 years ago and operates 21 branches in the Long Beach/South Bay area of California. FMLB experienced elevated loan losses in 2008 and 2009, but these have since trailed off and the bank’s profits reached all time highs in the most recent four quarters. The company has been extraordinarily successful in attracting deposits, which grew at an annual rate of 14.17% since 2007. The bank is among the least leveraged around with a core capital ratio of 14.38%. Despite its low leverage, success in attracting deposits and low Texas ratio of 9.12%, FMLB trades at a P/E of 9.1 and at just 83% of book value. The stock yields 2.51%.

Independent Alliance Banks, Inc.

Ticker: IALB

Independent Alliance Banks owns two separate banks in the Fort Wayne, Indiana area, Markle Bank and Grabill Bank. Markle Bank has a Texas ratio of 6.32%, while Grabill’s ratio is 16.27%. IAB’s net income has stayed relatively steady in recent years, but the company has repurchased 9.6% of shares outstanding since 2007 and seems poised to continue that trend. Due in part to the repurchase program, the company managed to compound book value per share at 9.42% per year since 2007, even after paying generous dividends. While deposits have been growing at 5.21% annually, the company’s net loans outstanding have not grown at all, suggesting the bank has become more conservative or lacks opportunities for investment. IAB trades at a trailing P/E of 9.4 and a dividend yield of 4.31%.

All of these banks have one thing in common: they do business in areas with challenging local economies. The manufacturing bases of Ohio and Indiana have been in decline for many years, resulting in population loss and declining home values. Meanwhile, California is still feeling the after-effects of the housing bubble. Still, these banks have managed to grow and profit through the worst of the financial crisis and I wouldn’t bet against them.

Other broad economic trends make community banks look attractive. The number of US financial institutions has been in decline for many years, as larger institutions purchase smaller ones and gain access to new markets. Bank mergers typically offer attractive synergies, as business methods tend to be similar and integration expenses low. Furthermore, a tide of new regulations threatens to make business more difficult for smaller operators, which may cause them to seek acquirers.

Because it is difficult to fully understand the risks of any particular bank, I think a basket approach is called for. I think anyone who invests in a basket of these five banks (or any other reasonably-value, financially stable community banks) has a good chance of earning attractive returns over the next few years.

 

Disclosure: no position in any security mentioned.

 

 

Unilens Vision Inc. – UVIC

Unilens Vision designs, produces and sells specialty contact lenses. These lenses include torics, multifocals and other products for people with vision issues that rule out standard lenses. The eye care industry is highly competitive, but Unilens has managed to churn out steady profits and free cash flows over the last decade. The company was formerly headquartered in British Columbia with operations in Florida, but became a Delaware corporation in 2010.

Unilens Vision’s internal line of products is called “C-Vue.” The company’s sales of these lenses produces only a tiny operating profit, only barely enough to cover production costs and operating expenses in most years. The company’s real profits come from royalties on its multifocal soft contact lense technology, which was licensed to Bausch & Lomb in 2001. Unilens Vision receives royalties ranging from 2-5% on Bausch & Lomb’s sales of these lenses. The technology behind these lenses is patent-protected until November 2016. The company cautions that Bausch & Lomb is free to increase, decrease or even cease production and sales of these lenses at any time, and future royalties are completely beyond Unilens Vision’s control.

Unilens Vision’s revenues and operating profits peaked in 2009 and have since retreated modestly. Here’s a look at the past decade’s results.

Company sales (“C-Vue”) have remained largely steady since 2006, while royalties from Bausch & Lomb peaked in 2010 and have since retreated slightly. Unilens Vision seems incapable of producing organic growth in revenues and earnings. The company was awarded a new patent in November 2010, but conservative investors should not model growth into financial projections.

Operating earnings have ranged from approximately $2.2 to $3.1 million over the past five years. However, the company’s balance sheet has changed dramatically in the interim, which has had a huge effect on net income and cash flow, both in absolute and per share terms. A brief history lesson is needed. Prior to January of 2010, Unilens Vision was 48%-owned by a European company, Uniinvest Holding AG. Uniinvest Holding AG was put into liquidation and Unilens Vision seized upon the opportunity to repurchase this extremely large block of shares at a substantial discount to market value. To fund this transaction, Unilens Vision drew $6.0 million on a five-year term loan facility through Regions Bank. Shares outstanding fell from 4.558 million to 2.369 million.

Because of this transaction, Unilens Vision has been able to maintain earnings and free cash flow per share even in the face of gently declining revenues and the new interest expense associated with the debt.

Over the last six quarters, free cash flow and earnings per share have remained steady at around 60 cents per share on a trailing twelve month basis. However, the company’s share price has fallen by about 27% in the last 18 months.

The biggest factor in this decline is (in my opinion) the company’s dividend policy. Unilens Vision instituted a regular quarterly dividend in February 2007, at 7.5 cents per share. This amount was raised to 9 cents per share in August of the same year. All was well until April 2011, when the company announced it would cut its dividend in half. A look at the company’s stock chart reveals a precipitous decline beginning then. Typically, a company will only cut its dividend in response to severely challenging economic conditions combined with a poor free cash flow outlook. Companies that cut dividends are usually punished by investors, often rightly so.

In Unilens Vision’s case, however, the dividend cut was simply the result of a change in loan terms, not financial distress. In consideration for reduced principal payments and additional equipment financing from Regions Bank, Unilens Vision agreed to cap dividend payments at 4.5 cents per quarter, with higher amounts requiring the lender’s approval. In May 2012, Unilens replaced its Regions Bank term loan with one from Hancock Bank. The Hancock Bank loan has fewer restrictions on dividend payments. Under its terms, Unilens Vision can distribute up to 5 cents per quarter in the coming fiscal year, increasing to 7 cents per quarter the following year and 8 and 9 cents the years after that. A 5 cent per share quarterly dividend would still leave Unilens Vision with $1 million annually with which to pay down debt or make capital investments, assuming current free cash flow is maintained.

Since taking on debt in the share repurchase transaction, the company has reduced its principal value owed to $3.81 million. Market capitalization is $7.76 million and total enterprise value sits at just over $11.10 million. At current levels, the company trades at a very low EV/EBITDA and a very high free cash flow yield.

Unilens Vision’s modest valuation is earned in part. The company has not been successful in introducing profitable new products and is extremely dependent on Bausch & Lomb royalties. What’s more, the company’s balance sheet offers little protection. Shareholders’ equity actually went negative after the share repurchase, though it is being rebuilt rapidly as debt is paid down. Net debt to EBITDA is reasonable at 1.31 turns.

Still, the company’s extremely high free cash flow yield and willingness to return cash to shareholders makes the company attractive at current levels. I view the company as a good buy at any free cash flow yield of 13-14% or higher, or up to between $4.49 and $4.83.

 

Disclosure: I own no shares of Unilens Vision at the time of this writing, but I do have open orders to purchase.