Sunday, December 15, 2013

Versailles Financial, almost too good to be true

Illiquid community bank stocks are possibly some of the most neglected securities in the market.  Many investors won't consider making a bank investment, and further, not many bank investors are willing to venture into the dark reaches of the unlisted and illiquid stock world.  It's at the junction of these criteria (unlisted, illiquid, bank) that some of the best deals of the market can be found, Versailles Financial (VERF) is a perfect example.

Community banks can be scary to some investors, a few bad loans and the whole ship is sunk, especially with a small bank.  A few bad loans at a larger bank and no one notices.  A few bad loans, years worth of bad decisions, and bad management and the country's citizens will bail you out at a large bank, unfortunately (or fortunately) there is no one backstopping community banks.  I would prefer a bank with management making intelligent lending decisions resulting in few if any losses.

Versailles Financial is the holding company of Versailles Saving and Loan, a single branch bank located in Vesailles Ohio founded in the 1800s.  The company shares its name with the royal and well known palace in France.  Versailles Financial is neither well known, or anything of note.  Versailles Ohio is a city with a population of 2,687 people.  I grew up in Northern Ohio, and we used to joke places like Versailles had more cows than people, the joke was funny because it was often true.  The bank's link to agriculture is most evident with that fact that 16% of its loan book is for farmland.

The investment case for the bank is fairly simple, the company's current market cap is $5.9m against a tangible book value of $9.8m.  In other words they're selling for 57% of TBV.  The bank is also profitable, and has been for the last nine years, sailing through the financial crisis without a loss.  They're over capitalized as well with an 35% tier one capital ratio.  The company's nine year earning summary is shown below:


The company isn't generating record earnings which can mostly be attributed to the lack of scale the bank has with only one branch.  A bank's branch network is what works to gather deposits and generate new loan volume for the bank.  With only one branch deposit and loan growth can both be constricted, which is the case for Versailles Financial.

One item worth noting on the income summary above is the lack of provision for loan losses.  A bank's safety is derived from its balance sheet.  A bank's value is also derived from its balance sheet.  If a bank has a history of dodgy loans then it's worth discounting their loan book when valuing them with the expectation that the future might look similar to the past.  Versailles Financial's lending history has been absolutely pristine with a very small amount of loan loss provisions, and an even smaller amount of charge-offs and non performing assets.  As of the most recent quarter the bank had zero non performing loans, no loans past due, and no OREO holdings.  Sit and consider that for just one minute, every single loan that Versailles has made is paying on time, the company has zero bad loans, not even one tiny mistake by a junior lending officer, none.  Granted this could change quickly, but given their lending history I'm fairly confident in their lending ability.

A cynic might read the above paragraph and think that they are cooking the books.  I would argue the opposite.  Recently bank regulators have been coming down hard on community banks in the area of charge-offs forcing them to realize them early.  Because of this the income statements of small banks have been prematurely depressed.  The large banks aren't dealing with this, regulators have allowed them to post-pone charging off loans that haven't paid in over six months; extend and pretend is alive and well at our largest banks.

An astute reader might wonder why this bank hasn't sold yet, they appear to be a prime candidate.  Single branch banks make perfect acquisition targets, there are many costs that can be removed quickly, such as the duplicate CEO and CFO, where the savings flow straight to the bottom line.  In the case of Versailles the retirement of the CEO and CFO alone would most likely double earnings.

The bank was founded as a mutual in the 1800s and IPO'ed in 2006.  Mutual conversions are restricted from selling themselves anytime before the three year anniversary of their IPO.  The timing for Versailles wasn't that good, their three year anniversary fell in the beginning of 2009, not an ideal time to sell a bank.  Since 2009 the bank M&A market has been soft, especially for many smaller banks like Versailles, it's hard to get a deal done for a $48m (assets) bank, there just isn't much interest in that market size.

While size is a potential negative I'm comfortable investing in a small bank with pristine credit quality at 57% of TBV.  When the bank IPO'ed a reasonable valuation would have been 1.2x TBV, at this point even if the bank traded up to TBV shareholders would be satisfied.  Until the market realizes what a deal Versailles is I will continue to hold the stock and let management do what they do best, make high quality loans and collect interest.

It's worth mentioning that this is an extremely illiquid stock, it trades by appointment on occasion.  It took a few months for my initial order to fill.  Patience is rewarded with a stock like this.

Disclosure: Long VERF

11 comments:

  1. Hi Nate,

    I noticed that VERF has not submitted their financials to the SEC in about a year and their financials are actually a challenge to find on the companies website although I was able to find them. I was just wondering what list you were searching through when you stumbled upon these guys. I'm sure you were doing a P/B screen but just curious how you find such off the radar tiny companies. They don't even show up on yahoo finance if you look at the whole savings and loan industry under the "industry browser". Any help you can provide would be appreciated. Thanks.

    - Michael

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    1. Michael,

      I use CompleteBankData.com to screen and look at financials for banks and holding companies. The site has financials on all non-filing banks as well as all filings banks.

      Nate

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  2. What makes banks such a lucrative business is the ability to use other people's money in a regulated 10 to 1 ratio. A typical bank should be able to earn 13% ROTE with little risks, aside from bank runs.

    Versailles is obviously not utilizing the potential of the business and you should look into it as why. My guess would be that there isn't enough of a market demand for their business since they are geographically restricted and hence the massive discount. Even with this massive discount the investment return on annual profits appear to be 4.1%, of course it'll be a lot higher if they get taken out for a massive premium. In that case you are just betting on someone offering a high take out price and who knows how long that will take. The opportunity costs here are real if the take out thesis takes more than 3 years.

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    1. I actually strongly disagree with this. As a depositor, I trust banks with high capital ratios far more than those levered to the hilt - ie 10%. Indeed, in a free-banking system, such banks SHOULD attract deposits, and be able to pay lower rates on such deposits than more levered banks. Such banks also earn lower returns on equity - because they have so much equity than more levered banks. So those banks share prices, per dollar of equity, should be lower. I don't mind as a depositor, and some owners don't mind either (see CFNB).

      The problem with a bank like Versailles though, is, I like their business model but because they earn so little ($100-200K) really they have to trade at a bigger discount to equity for me as a shareholder.

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    2. You would only care about the bank’s leverage as a depositor if the FDIC isn’t going to cover your losses in the event of a bank run. Also being leveraged to 10% is quite conservative. Many banks outside the US have 3-5% equity cushions so they have inflexible balance sheets to weather a slight storm.

      I view the mega banks in the US as utility companies with strong sticky deposits to fund their operations. Of course when it comes to leverage you have to trust management since a mistake can lead to a zero on your investment, but the Feds will backstop the top 4 banks… everyone else are on their own which could explain why some decide to have higher equity cushions. Regardless you want to seek banks with high ROA (1.5%+) since that’s a sign that management is doing something right. Low ROA even at a discount is the equivalent to a cigar butt. You can make money but the frictional costs adds up over time!

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    3. I agree with you but it's a tough call and a bad system overall, b/c the "top 4 banks" have achieved too big to fail status because of an unwillingness to let depositors lose money (at least via default, yet not by inflation); the 10% capital ratio is applied across the board, even to banks without the ROA/earnings power to sustain such a ratio with the same degree of depositor safety. As a result I think you have a lot of distortions in a fractional banking, government backstopped banking system.

      But we agree that banks like this, which don't really make any money at all, do nothing for shareholders. Nate is basically betting that the stock price will at some point, for some (in my humble opinion) reason, reach some arbitrary number like 0.8 or 1. But what if it doesn't? Then you're stuck with a bank that isn't making any money and probably never will.

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  3. Nate,

    Nice post. I have owned this one for about 18 months. The price was under 50% of TBV when I bought it.

    My conclusion was the same as yours that the price was just too cheap. But, it remains a very small part of my portfolio because I think the wait to realized full value could be quite long.

    In my view, the management and board are operating the bank more as conservators of a local institution that they wish to maintain, not as stewards on behalf of shareholders. The bank has been ridiculously overcapitalized since the IPO, and there has been no effort to do anything about it 4+ years. With management and the board owning over 25% of the stock, it seems unlikely that much will change anytime soon.

    I think 1.2X book would be a real stretch for this bank, given its lack of growth and limited profitability even if you eliminated the cost of the CEO/CFO and the public company cost. I would willingly take 0.8X book for my shares and call it a day.

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    1. Greg,

      My cost basis is similar to yours, it sounds like we have a similar approach. Versailles is a tiny position, microscopic in a sense. I buy banks like this in bulk, I have 25% of my portfolio set aside for banks, cheap ones like this I just buy a tiny stake and call it a day. All of my tiny stakes do add up to a significant amount of money at some point.

      I would probably take 80-90% of BV if there were some liquidity to get out.

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  4. Would bank interest accrued to depositors once paid and gone through the income statement be transferred into the balance sheet under deposits?

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  5. You don't have a problem with their non-interest expense being so high? If you take their noninterest expense as a cost of gathering deposits, I find that the net interest margin looks a lot more modest. Given that, I feel this bank should trade for a substantial discount to book.

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  6. Most of that is a function of their being a single branch bank. Fees like data processing, and legal are higher as a proportion because they're at one location. If they expanded those fees would be spread across a larger deposit base.

    To an acquirer (private market value) these are redundant fees. An acquiring bank isn't going to pay double the data processing fees, or double the legal fees.

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