A general misconception I've sensed is that value investors who aren't buying Buffett-type companies are usually lumped into a distressed turnaround category. Our investments are the proverbial one foot in a hole and one foot on a banana peel. A mistake or two away from a complete loss. I know I've been placed in this category many times, and I think many readers believe I'll buy anything as long as it's cheap. It might be a surprise to some, but that's not the case. I prefer to buy undervalued companies that don't run the risk of going out of business. Sure, the occasional good company at a cheap price might find its place into my portfolio, but more often it's an average company at an excellent price.
Enterprise Financial Services Group (EFSG) is a great example to show that not everything that's cheap is an attractive purchase. The company has a market cap of $5.7m against a book value of $18m. Their P/B ratio is 32%, and P/TBV is 44%. The bank is profitable and trades with a P/E of about 8x. The bank is undeniably cheap, they are trading at a low valuation of both earnings and their book value, both tangible and otherwise.
Purchasing a company at 44% of TBV should in theory give an investor a margin of safety. This is the buffer between their current market price, and an investors estimate of fair value. The concept of the margin of safety is to allow for investor mistakes and errors and still enable an investor to profit. In most cases a company at 44% of TBV and 6x earnings would indeed have a considerable margin of safety. But Enterprise Financial Services Group isn't a normal company, it's a bank, and in banking there are other factors that need to be considered as well.
Enterprise Bank is a small one branch bank located a few miles north of me in the suburbs of Pittsburgh. Their branch is fairly unique, it's a plain office building located next to a heavy equipment rental, and a kids play facility (giant inflatables, indoor playground). If it weren't for the tiny sign announcing their presence most people wouldn't even know it were a bank.
Enterprise Bank is a great example of potential pitfalls that can trip up a bank investor. The bank specializes in small business lending. The bank has $217m loans, of which $20m are for 1-4 family loans, typical single family mortgages. The rest of their loans are for commercial real estate and commercial ventures. The bank describes itself as a specialized lend for turnaround financing and startup financing, both categories of risky lending. For the risk the bank takes on their loans they earn comparatively low rates. Their yield on earning assets was 4.66% as of Q1 2014. This is much lower than I'd expect for a company that specializes in lending to borrowers whose future ability to repay loans is suspect.
The bank's funding isn't the more common low cost and stable consumer deposits, but rather wholesale funding via brokered CDs. The wholesale market is problematic for two reasons. The first is the funding costs are much higher than what could be achieved via a sticky retail deposit base. Enterprise Bank is paying .93% for their deposits. The average funding cost across all banks in the US was .31% as of the last quarter. Enterprise Bank is paying almost three times more for access to funds compare to the rest of the US banking industry.
The second reason that wholesale deposits are problematic is because they aren't sticky. Investors putting money into brokered CDs shop for the highest rate. When a bank's rates aren't competitive they have trouble attracting deposits. Banks relying on hot money for funding end up in a vicious cycle where they are continually fighting to attract consumers with higher rates, which are costly to the bank. The types of customers the bank attracts are not the ones a bank would want. These customers purchased the product for the rate, and when the bank's rate lags competitor's rates many customers cash in their CDs early and move their money. Wholesale deposits are not a cheap or stable funding source.
If the bank only had a poor deposit base, and a concentrated commercial loan portfolio then their valuation could be potentially attractive. While the commercial concentration and wholesale funding are not ideal those aspects alone don't merit a 70% discount to book value. What does merit such a discount is the quality of their loans.
Banks are highly levered companies, and with leverage comes risk. Enterprise Financial Services Group has a TE/TA (tangible equity/tangible assets) ratio of 5%. In layman terms this means the company is leveraged 20:1. The bank's Tier 1 capital ratio is 10.7% and total capital 11%. The bank's Tier 1 capital also includes their preferred stock as well as loan loss reserves. Note the difference between the holding company's leverage and the underlying bank's leverage.
The bank's holding company owns a real estate broker, a machinery rental company, an IT consulting firm, a CFO consulting practice, and an insurance brokerage as well as the bank. From a regulatory standpoint the underlying bank looks alright, although not ideal. The company doesn't break out the financials for their other businesses, but based on the bank and the holding company information we can surmise that their other companies don't have much in the way of assets, or earnings, but do have debt related to their operations.
Leverage can cut both ways for a bank, when times are good it can allow them to earn outsized profits. When the environment changes a small percentage of loans gone bad means shareholders can loser their investment.
Enterprise Bank reports that 5.29% of their loans are non-current, which is about $11.4m in nominal terms. The bank has $2.3m reserved for loan losses. All things considered their loan losses aren't terrible given that the bank is engaged in speculative venture stage and turnaround lending.
The company's absolute level of loan losses is concerning, but there's something a bit more subtle that's even more concerning. The company makes mention in their 2013 annual report of an accounting change that their regulator, the FDIC forced them to make. The change is that the bank is now forced to classify their loans after interest hasn't been paid after 90 days rather than wait for an impairment.
Banks are required to classify loans into different categories quarterly (or more frequently) based on the probability of repayment. Most loans are classified as satisfactory, this means the loan is current and interest is being paid. For most banks in the US if borrower fails to make a payment on a loan after 30 days the loan moves from current to non-current and is classified. Banks bucket loans into 30-90 days past due, 90 days past due, and non-accruing.
Enterprise Bank wasn't classifying loans until the bank had considered them impaired. In the past the bank would consider a loan performing until all hope was lost and they finally impaired it. Loans that hadn't paid interest for months might be considered current. It worries me that in the past the bank was only considering a loan classified when it was impaired.
The last item that the bank mentioned that helps justify their valuation is the impact of Basel III. The bank said they will be about 10% short on Basel III capital requirements. Instead of raising capital they suspended the dividend and instituted a pay freeze.
The fact that the bank is so close to capital inadequacy under Basel III, and that they had previously been lax in classifying loans is what made me pass on this bank as an investment. Maybe everything will go well in the future and this is a good value. But I don't invest based on rosy scenarios, I want to make sure companies I invest in can weather a storm or two, and a potentially bad storm. I'm not convinced that Enterprise Bank can weather a strong storm. So even though the bank is trading for a very low valuation this doesn't look like a safe investment to me.
Disclosure: No position
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