Friendly Hills Bank ($FHLB): "A Story of Two CEOs"

We did a post last month about the upcoming shareholder vote at Friendly Hills Bank (FHLB) regarding the proposed acquisition of three branches, all from Southern California Bancorp (BCAL). A Friendly Hills shareholder wrote in today with his analysis of the situation, which we are sharing below.

The key thing to understand is that the proposed acquisition is a "story of two CEOs": one CEO is buying three branches that the other CEO owns and wants to get rid of. 

What you worry about is an adverse selection problem: how can the buying CEO make sure that the price he's paying is low enough when he's buying an asset from someone who knows it better (asymmetric information problem) and wants to get rid of it. 

Is the Friendly Hills CEO familiar with one of the all-time most important economics papers, "The Market for Lemons"? Since the assets come with expense commitments, it is even possible that he should be getting paid to take them!

Friendly Hills BANK Story ... by Nate Tobik

Double Bottomline Corp. Reaches Definitive Agreement to Purchase Community Savings Bancorp, Inc. ($CCSB)

Press release yesterday: 

Double Bottomline Corp. ("DB") and Evan M. Stone have reached a definitive agreement with Community Savings Bancorp, Inc. (OTC: CCSB), and its wholly-owned subsidiary, Community Savings, a federal savings and loan association, to acquire Community Savings Bancorp, Inc. ("CCSB"), the registered savings and loan holding company for Community Savings. The aggregate merger consideration for the transaction is $9.5 million, subject to adjustment as provided in the definitive agreement. CCSB currently estimates that, without any adjustments, this will result in approximately $22.76 per share to the current holders of CCSB common stock. However, the estimated per share consideration may be subject to significant adjustment based on a variety of factors, including, but not limited to, transaction costs and whether the organization obtains CDFI status, as defined below. As a result, CCSB shareholders should not assume they will receive $22.76 per share upon closing of the transaction. Community Savings operates a full service location in Caldwell, Ohio. As of March 31, 2021, CCSB reported $59.58 million in total assets and total equity capital of $7.79 million. 

We wrote about Community Savings Bancorp in Issue 16 of the Oddball Stocks Newsletter (March 2017) when it was trading for $13.25. It had just de-mutualized at that point and was trading at a big discount to book value. Here was how Nate explained the idea in that Issue:

Following the conversion their equity to assets is about 18%, and their Tier 1 ratio should be about 40%. These are very high levels. The significant excess capital explains the paltry 0.2% return on equity (“ROE”). The bank barely ekes out a profit with a 97% efficiency ratio. The bank only has $32m in loans with the rest of their assets sitting in cash or investment securities. This is truly the epitome of a bank net-net if there ever was one.

Many people will think about all of this for a second and wonder why anyone would pay book value for this dog. After all, there are any number of people who believe that unless a bank can earn something like a 10% ROE they aren’t even worth book value. With that in mind, there are really a few reasons you might want to consider investing in this bank.

The first reason is that by consummating the conversion management took the first step towards realizing value, both for themselves and for shareholders. In most cases mutual banks convert either as a way to grow or as a way to cash out. There are banking regulations that prevent newly converted mutuals from selling within three years of their IPO date, but they are permitted to engage in value accretive actions before then. On the first anniversary of their IPO they can buy back stock, and on the second anniversary they can pay a dividend. Once the third anniversary rolls around they are afforded the opportunity, if they wish, to sell and cash out. The statistics on newly demutualized banks selling after the three year mark is encouraging. Over 80% of demutualized banks have been sold to another institution within five years of their IPO. If you’re looking to buy a bank hoping that it will be acquired at a tidy premium (ideally after you’ve made your purchase) then mutuals are fertile ground.

But what if the bank doesn’t want to sell? Remember that the 2 primary reasons to convert are to raise capital for growth or as a means of cashing out. So, if the bank isn’t going to sell and cash out, by process of elimination we are left with a growth strategy. With a larger asset base the bank is in a better position to make additional loans and grow, although it remains to be seen in Community Savings Bancorp’s case. This is because management hasn’t demonstrated any ability to grow beyond drifting up and down with the local economy.

The good news is that the bank’s management has skin in the game along with investors. They purchased 10% of the shares offered in the IPO for approximately $360k in the aggregate. This might seem like a nominal sum to many ritzy investors, but it is significant considering the CEO makes a base salary of $120k and got $20k in bonuses last year.

Community Savings never performed well as a bank, but what mattered in the end was purchasing at a big discount to tangible book value.

Shareholder Vote at Friendly Hills Bank ($FHLB)

Friendly Hills Bank is a small bank in Whittier, California (a city in Los Angeles County) that was founded as a community bank in 2006. The shares are OTC-listed (ticker FHLB) and trade for around $11, which is not much greater than the IPO price a decade and a half ago.

What caught our eye recently is that Friendly Hills is having a special meeting on June 22nd in order to hold a shareholder vote on a proposed acquisition of three branches from Bank of Southern California. The other thing that we noticed was a couple of smart bank investors (like @TimyanBankAlert) on Twitter mentioning Friendly Hills and the acquisition:

We follow @OurBank3 on Twitter, a bank investor account that has the motto: "The shareholders are the rightful owners. Management has a fiduciary responsibility. Proud #SHT member-Shareholders who Hate value Traps". So far we agree on banks wholeheartedly! So if this account has a beef with this proposed acquisition, we thought that we should dig a little deeper.

Let's first back up and understand Friendly Hills a little better. As of March 31, 2021, this is a bank with $214 million in assets, $127 million in loans, $171 million in deposits (L/D only 74%), and $20.7 million in shareholder equity (all tangible). In 2020, FHLB had comprehensive income of $1.4 million, which was a 7.4% return on equity and a 77 bps return on average assets for the year. However, for Q1 2021, the net income was only $240k which is a 4.7% annualized return on equity.

Unusually for a bank of this size, Friendly Hills is not a residential lender. Their loans are 70% commercial real estate and 30% commercial and industrial. The average interest coupon is 4.2%. Since their loans/deposits are so low, they have a significant amount of investment securities, more than half of which is of ten year or greater maturity. The bank is overcapitalized with Tier 1 RBC of 18.8%.

You can see the efficiency ratio trend for Friendly Hills as calculated by Complete Bank Data:

Book value per share for FHLB is $10.34 vs the recent trading price on May 27th of $10.95 per share, so it is trading for 106% of TBV. This is not exactly a screaming bargain when Oddball Stocks has recently written about a basket of small banks that are earning higher ROEs and trading for about 80 percent of tangible book.

Also, Friendly Hills management has a lackluster (at best) history of value creation. As you can see from a long term chart of the share price it has gone nowhere since the IPO. (And it has never paid a dividend.) The current president of the bank has been in place since the founding. We found an LA Times article from 2013 with his complaints about how small banks are over-regulated. 

It looks as though he and Friendly Hills stumbled right out of the gate after the bank was founded, losing a significant amount of money during the 2008 credit crisis. The bank originally raised about $17 million in equity, and by the end of 2010 the bank had accumulated a deficit of $5.2 million and was down to $11.8 million in equity ($7.29 per share). Even today, the bank has only $3 million of retained earnings since inception.

Now Friendly Hills wants to buy three branches from a local competitor (one each in Orange, Redlands, and Santa Fe Springs) for $1.17 million (plus assumption of the lease liabilities for the branches) that have $92 million in deposits. Here is what we wonder about with this proposed transaction:

  • Why does a bank with only 74% of its deposits lent want to buy more deposits? Don't they need loans and not deposits?
  • The pro-forma financials (disclosed on p34 of the special meeting proxy) show that in Q1 2021, these three branches would have been responsible for $432k of additional non-interest expense. So, in addition to the purchase price of $1.17 million, there is going to be commitment to a fixed overhead burden: lease payments, compensation, etc.
  • Are going to stick with their long-term securities portfolio strategy and term out / increase the tenor (time until maturity) of the $92 million that is coming in? It seems like this acquisition could result in pressure to earn back this incremental overhead burden by taking either more interest rate risk or more credit risk, plus more leverage from the additional $92 million of deposits on the existing equity base.
  • Is acquiring more branches really the right move for any bank in a country that is staggeringly over-branched (especially given changes in customer habits and technology)? Plus, is there an adverse selection problem in buying branches that a local competitor wants to get rid of? Is this an example of a smarter bank dumping an albatross on a bank that is "slow to realize their branch networks are a drag"?
  • Was there a better deal to be done here? If Friendly Hills shareholders turn this down, can Bank of Southern California really do just as well, or might the deal get sweetened?

We noticed in the proxy statement for the special meeting is that there is a significant outside shareholder who happens to be the largest shareholder of Friendly Hills. The officers and directors of FHLB as a group own 21.1% of the company, with the plurality of this held by the Chairman William Greenbeck and the CEO Jeffrey Ball. But the largest shareholder, Frank Kavanaugh in Newport Beach, owns 26.2%, which is more than all of the insiders combined. (The other shareholder disclosed in the proxy is AllianceBernstein which owns 9.6%.)

The 21% owned by management seems like good ownership skin in the game, but unfortunately a lot of this stock was essentially given to them and not purchased:

Stock Option Grants to Executive Officers
On December 31, 2018, we granted incentive stock options under the 2017 Equity Incentive Plan to our executive officers. We granted an option to Jeffrey K. Ball, President and Chief Executive Officer, to purchase shares in an amount equal to 2.5% of our issued and outstanding shares, or 50,000 shares, an option to our Chief Operating Officer, to purchase shares in an amount equal to 0.5% of our issued and outstanding shares, or 10,000 shares, an option to our Chief Financial Officer to purchase shares in an amount equal to 0.3% of our issued and outstanding shares, or 5,000 shares, and an option to our Chief Credit Officer to purchase shares in an amount equal to 0.3% of our issued and outstanding shares, or 5,000 shares.

The incentive stock options, which we granted to our executive officers in 2018, vest at the rate of 20% per year, beginning on December 31, 2019, which is one year after the date of grant. The options shall all remain exercisable, subject to earlier termination upon the happening of certain events, until December 31, 2028, ten years after the date of grant. The exercise price of the incentive stock options granted to our executive officers is $6.80 per share, which is equal to or in excess of the fair market value of the shares of our common stock on December 31, 2018, the time of the grant of such stock options. We did not grant any stock options or other stock awards to any of our executive officers in 2020.

Stock Option Grants to Directors
On December 31, 2018, we granted nonstatutory stock options to our non-employee directors under the 2017 Equity Incentive Plan. The nonstatutory stock options granted to our non-employee directors in the aggregate is equal to 4.5% of our issued and outstanding shares or 89,750 shares. The non-employee directors’ option grants vest at the rate of 20% per year, beginning on December 31, 2019, which is one year after the date of grant and the term of each of the option grants is ten years from the date of grant. The exercise price of the nonstatutory stock options granted to our non-employee directors is $6.80 per share, which is equal to or in excess of the fair market value of the shares of our common stock at the time of the grant of such stock options. We did not grant any stock options (or other stock awards) to our directors in 2020.
So that is really brutal from a shareholder perspective. The end of 2018, you may recall, was a big market crash. And how did FHLB insiders respond? Why, they gave themselves options to acquire 8.1% of the bank at 80 percent of tangible book value, and less than 70 percent of the IPO price a dozen years earlier.

Something else brutal about management is that FHLB has never bought back stock when it was cheap. The share count now is higher than it was a decade ago, even though the bank has excess capital and even though the stock had traded at big discounts to tangible book. After having been in business for a decade and a half under the same management, you get a pretty clear view that management doesn't allocate capital well (which should worry us about the branch acquisitions) and is opportunistic about transferring value to themselves (with the 2018 options grants).

We found that the largest shareholder Kavanaugh made a change in control filing with the Federal Reserve in December 2018 to acquire shares of FHLB. At the end of 2018, the shares had collapsed down to around $6-7, so this may have been a very astutely timed buy. (Yet notice that he, an outside shareholder, was paying cash for his stake, while the insiders were being granted cheap options.)

Really good things can happen for shareholders if someone with significant ownership skin in the game - that they paid for - comes in and pushes things in the direction of shareholder value maximization. This is "reading the tea leaves": remember how SouthFirst in Alabama was acquired last year? The only clues to long-suffering outside shareholder that things were moving in that direction were (a) unhappy minority shareholders with big ownership positions and (b) right before the sale, the termination of the golden parachutes for execs.

If you want to dig in further on Friendly Hills, we have uploaded some helpful documents on Scribd:

And if you like small banks and shareholder activism, be sure to try the Oddball Stocks Newsletter. We've been talking about almost nothing but small banks since last summer, and we are always very interested in shareholder activism and small bank activism.

Hanover Foods Quarterly Financials

We just received the latest quarterly financials from Hanover Foods.

Notice that between the end of fiscal second quarter (Nov 29, 2020) and the fiscal third quarter (Feb 28, 2021), the company bought back $1.26 million of stock. This is the first time that we have seen the company repurchase a significant amount of stock.

We would love to know the details about that repurchase and whether the company plans to do more repurchases at a fraction of book value and net current assets.

Hanover Foods 3rd Fiscal Quarter by Nate Tobik on Scribd

Bidding War for Sunnyside Bancorp ($SNNY)

We mentioned last month that "An Old Oddball Stocks Idea Ha[d] Its Day" with the sale of Sunnyside Bancorp, Inc. Today, a different buyer announced that it has a higher bid (20% premium) for Sunnyside.  

Rhodium BA Holdings LLC (“Rhodium”), a New York-based investor, which through its special purpose subsidiary OppCapital Associates LLC beneficially owns approximately 9.82% of the outstanding common shares of Sunnyside Bancorp, Inc. (OTCBB: SNNY) (“Sunnyside” or the “Company”), today sent a letter to the Company’s Board of Directors presenting a fully financed proposal to acquire Sunnyside for $18.50 per share in cash.

Over the past twelve months, Rhodium has privately approached the Company with multiple expressions of interest to acquire the Company on attractive terms, which were rejected without explanation by Sunnyside’s Board of Directors. Rhodium’s current offer represents a 23% premium to Sunnyside’s closing price on April 19, 2021, a 19% premium to the price offered by DLP Bancshares Inc. and a 50% premium to the Company’s unaffected share price on March 16, 2021 prior to the announcement of the DLP Bancshares Inc. offer. 

In its open letter to Sunnyside, Rhodium seems to be threatening to do a tender offer if their bid is rejected.

Third Amended Complaint Filed in Life Insurance Company of Alabama Shareholders' Lawsuit

Earlier, we mentioned that there was an Eleventh Circuit Court of Appeals ruling that was favorable to the minority shareholders suing Life Insurance Company of Alabama, which resulted in the federal court in Alabama ordering the shareholders to file file one final amended complaint against the company and its directors. That third amended complaint has now been filed, so we thought we would quote from some interesting sections:

  • In some cases, a large book value discount at an insurance company might indicate an asset quality problem, suggesting the company's assets were not worth their carrying values. However, LICOA's assets then and now consisted primarily of a rather “vanilla” corporate bond portfolio managed by outside advisers. The distress that the market price of the non-voting shares was (and is now) implying is managerial in nature. As discussed herein, it would ultimately be revealed that a group of relatives took legal control of LICOA by owning a majority of shares and have used and continue to use this control inequitably to the detriment of minority shareholders. Interestingly, during the pendency of this litigation, that discount seems to have widened and narrowed based on the market perception of Plaintiffs' likelihood of success in the litigation, indicating that it is indeed the inequitable conduct causing the distressed trading price of the non-voting shares.
  • The economic purpose of an insurance company, from a shareholder perspective, is to raise funds from policyholders and invest them at a profitable spread. Using borrowed money (“Float”) from the insurance customers as leverage and investing it in a bond portfolio ought to offer shareholders a higher return on their capital. But because the controlling shareholders of LICOA overpay themselves and otherwise waste money, the return on equity that minority shareholders receive is lower than the underlying yield on the bond portfolio. The minority shareholders bear all the risk of an insurance company's financial leverage (where the total assets are approximately three times the shareholder capital) but without the benefit of any increased return.
  • Causey’s husband Michael—who also works for LICOA—has had a similar social media presence, claiming to “Live in Alabama, but rarely there! Love traveling the globe in search of the best life has to offer...”. Like his wife, Mr. Causey also posted pictures of a lavish lifestyle of global travel and extravagance. The problem with the Causeys—and their family members who are also Director Defendants in this case—is that consistent with their social media profiles, their interests lie with funding and maintaining their lifestyles – not the interests of the shareholders of LICOA consistent with their fiduciary and statutory duties.
  • Even though Daugette is the Chairman of LICOA and his brothers-in law Lowe and Renfrow have subordinate titles, each year they are paid virtually the same amount. In 2019, LICOA began paying Causey a matching amount as well. For four executives of varying tenure, title, and seniority to receive virtually identical compensation shows that LICOA's compensation is not based on the market value of services rendered, but rather it is a de facto family dividend. The controlling shareholders have hired each other and split a disproportionate share of LICOA's profits according to a negotiated scheme amongst themselves. Tellingly, LICOA does not have any board minutes, compensation studies, or any documents whatsoever that explain how these nearly identical compensation levels were established.
  • After this litigation ensued—and after Terry Jacobs, whose family members are LICOA shareholders (“Jacobs Shareholders”), was disclosed as a witness and potential plaintiff—Defendants caused LICOA to purchase the Jacobs Shareholders’ shares at nearly three times the then-trading value of the LICOA shares (i.e., much closer to the book value). See Exhibit I. Near the same time, Director Daugette was purchasing the shares of other, uninformed shareholders at much lower prices, demonstrating how the Director Defendants game the system to keep share prices artificially low for their own oppressive repurchasing scheme, even though they know that the true value of the shares is much higher, as exhibited by the much higher price paid for the more knowledgeable Jacobs Shareholders' shares.
  • The Daugette, Renfrow, and Causey family members receive extravagant six figure salaries, some of which is for “no show” or “no work” jobs, and all of this excessive compensation is a de facto dividend that shareholders who are not family members do not receive. See Exhibit K. This compensation has been rising even as the company's profitability has deteriorated in recent years. See Exhibit L. As self-dealing transactions, these payments to insiders need to be entirely fair (both stemming from a fair process and resulting in a fair outcome). The burden of proof is on the Director Defendants to show that payments to these insiders are entirely fair, but since they run their business in a “Mafia Style” without written records, they will be unable to meet this burden.
  • The most egregious usurpation of a repurchase opportunity was committed by Daugette after the Lightfoot investigation and report. During the coronavirus chaos of 2020, Daugette personally bought shares from small shareholders for less than a quarter of tangible book value, while shortly thereafter he had LICOA pay three times as much for the Jacobs Shareholders' shares. If it was a good deal for LICOA to pay the Jacobs Shareholders $31.88 per LINSA share, then Daugette clearly usurped an even better opportunity from LICOA when he personally bought LINSA shares for prices as low as $10 per share – using LICOA resources such as employees, email accounts, and letterhead to conduct these personal purchases. After having his independent director patsies rubber-stamp his past misconduct with the Lightfoot straw-man investigation, he now feels emboldened to commit even more blatant abuses.

The entire Third Amended complaint is embedded below. The voluminous exhibits are in a second embed after that.

Licoa - Plaintiffs’ Third Amended Consolidated Complaint by Nate Tobik on Scribd

LICOA Third Complaint Exhibits by Nate Tobik on Scribd