I have a portion of my portfolio set aside specifically for cheap bank stocks. In the terms of some value investors my dedicated cheap bank portfolio might be considered a 'basket'. That is I buy tiny stakes in many banks if they meet certain criteria. I purchase larger positions in banks outside of this basket, but inside of it most positions are roughly the same size, about a quarter of a percent. No single bank is going to make or break the portfolio, but as a group I have a large exposure to undervalued banks. Sunnyside Bancorp (SNNY) is one of these banks.
Sunnyside Federal is a savings and loan that was established in 1930. The bank is located in Westchester County about 25 miles north of New York City. The bank's headquarters and only branch is located on Main Street of the quaint Irvington a few blocks from the Hudson River. They're also located near a number of country clubs, which should tell you something about the area they're located in. Westchester is the second wealthiest county in the State of New York with median home values of $533k and median household income of $81k.
The bank started as a mutual meaning the depositors owned the bank. The bank felt constrained by their mutual structure and in 2013 conducted an IPO. The IPO raised $7.9m with the sale of 793,500 shares at $10 per share. Depositors are given the first opportunity to purchase shares and with the completion of the IPO the shares now trade on the secondary market. The IPO proceeds plus their capital prior to the IPO gives them an equity value of ~$12m or $15.12 a share. Given that shares most recently traded at $9.45 this is an attractive stock at 63% of book value.
The bank's conversion from a mutual to a stock company was in an effort to pursue growth. The bank is as safe as they come with a 35% Tier 1 capital ratio and 13.7% Core capital ratio. They have a very small amount of non-performing assets, and OREO. Some small banks trade for less than book value because they have an asset quality problem, Sunnyside does not. Sunnyside has a growth problem.
As I said earlier the bank has a single branch. The common wisdom is that one branch banks are at a significant disadvantage because they can't spread costs between branches. In some cases this is true, but it's not a universal truth. Consider the Bank of Utica (BKUT) that has a single branch and close to $1b in assets and $770m in deposits. There are other one branch banks that have been able to grow to a large size as well.
The issue of scale in banking isn't related to the number of branches, rather it's related to asset size. A paper by the FDIC found that most economies of scale were reached when a bank hit $100m in assets, and became insignificant after $500m in assets.
The size of assets is critical for Sunnyside. With their current $40m in loans and $90m in assets they aren't making enough to keep the lights on. The bank has been reporting small quarterly losses for a while now.
The bank's management plans to put their excess capital to work by expanding their mortgage origination and SBA lending. Both mortgage origination and SBA lending are similar in that they're both relying on government guarantees and backing. With SBA lending a bank makes a loan to a business borrower where the government guarantees a portion of the loan reducing the risk for the bank. Mortgage origination is similar, a bank makes a loan to a borrower and then either sells the loan to a larger bank, or back to the government and keeps the servicing rights. The bank makes money servicing the loan plus earns an origination fee without tying up their balance sheet. This is a good strategy for a bank whose balance sheet doesn't have a lot of firepower, like Sunnyside.
Here is the bank's current lending mix:
The bank currently does almost no commercial or business lending other than residential business lending. This gives rise to the question of whether the bank has enough experience with business borrowers to tap into loan demand. If the bank can't generate SBA loans like they want they will need to find other routes for growth.
Fortunately the bank doesn't need to do much to become profitable. Their net interest margin, the measure of interest taken in minus interest paid out is below the industry average. Raising their NIM from the current 2.8% to the industry average of 3.37% would bring in an additional $521k in net interest income, and after taxes would be more than enough to propel the bank to sustained profitability.
I like investing in companies where small improvements in the company's operations can result in large financial improvements. It might seem outlandish for a tiny bank to raise their NIM by half a percent, but given all the bank's excess capital I don't think it's unreasonable.
If the bank is able to achieve profitability again there are a number of other catalysts for shareholder value. As a newly demutualized bank they are prohibited from buying back shares or paying a dividend until certain anniversaries are met. The company can buy back shares on the first anniversary from their IPO, pay a dividend on the second, and sell themselves after the third. One branch banks are great tuck-in acquisitions. The top management at Sunnyside makes a combined $514k in compensation, which given the area they're located in is reasonable. Yet if the bank were to sell and top management redundancies eliminated the acquiring bank would realize those savings in their earnings. This money losing bank is suddenly profitable without the top level salaries. If an acquirer were able to both remove management and raise the NIM to industry averages it could result in an additional $700k in earnings, or about $1 per share. So while investors see a tiny bank that's losing money a potential acquirer sees $1 per share in earnings or more depending on other cost savings.
As I was writing this post I read an article about the new football coach where I went to high school. He discussed his plan to turn the team around. He said the team had problems executing consistently and doing the small things right. If they could consistently get the small things right he believes they'll see success. That statement is appropriate for Sunnyside as well. It might seem crazy to invest in a money losing bank. At 63% of book value if management can consistently execute on the small things, and loan out some of their excess cash I have no doubt shareholders will be rewarded.
Disclosure: Long SNNY