I grew up on the edge of nothing, well it seemed like the edge of nothing; a few miles from the county line. The invisible county line was the border between corn fields, orchards and the encroaching suburbs. A scene replayed throughout the Midwest.
The Midwest can be described as a sea of fields broken up by small towns and occasionally larger cities. The Midwest is homogeneous, a small town in Ohio looks similar to a small town in Iowa. Omaha doesn't differ that much from Columbus or Indianapolis.
Under all of those seemingly endless fields lies one thing, a lot of tied up capital. Farming has enormous barriers to entry, the machines, the land, the labor. Take a minute and imagine starting a farm from scratch. You would need to spend a few million dollars to buy land, tractors, and plant seeds. Then you sit and wait and hope your crop grows before attempting to sell it into a speculative market. A farmer's input prices fluctuate as well as their final output price. When they purchase their inputs they have no idea if they'll be able to sell their product at a profit or loss. The scale of speculation that farmers undertake would make many traders blush.
While farming is speculative, one thing that's not speculative is selling services to farmers. This is the role that West End Indiana Bankshares (WEIN) finds themselves in. They are a small town Indiana bank located in Richmond. They provide banking services to farmers and the farming community. While the bank services the farming community they have very little direct farming exposure themselves.
What makes West End Indiana an interesting investment is they are trading for slightly less than book value and their shareholder register is filled with a slate of activist funds. Activist bank investors own 38.02% of the bank compared to the 11.46% that the Directors and Executives own.
Fundamentally West End Indiana is a quality small bank. They are small in the sense that they have a $27.5m market cap and only $263m in assets. But given their size the bank has impressive financial metrics.
The bank earns an above average 5.05% on their assets and pays .65% on their deposits, which is slightly below average. This enables them to earn a higher than normal net interest margin of 4.4%. The bank's ROE has increased from .84% in 2006 to their current 6.73%. What makes this rise even more incredible is that it's been a steady climb, straight through the crisis.
The bank has five branches, including limited service branches at the Richmond city schools with $2,000 in deposits. There are at least a few students at the school off to a good start saving!
I went to college in the area where West End Indiana operates. I've been through Liberty, where they have a branch countless times, as well as Richmond where they are located. It's amazing the amount of money the bank has considering the area, a very rural area filled with farms and small towns.
The reason the bank has a higher than average NIM is because they specialize in auto-lending. As shown in the picture below they have $75m in auto lending as of Q1 2015. Of the bank's total loans at the end of Q1 2015 36% were auto loans.
Sometimes auto lending has a negative connotation associated with it. Auto loans can go bad quickly if a borrower loses their job. Typically an auto loan is for an amount higher than what might be realized in a repo and sale situation. If a bank has a book of auto loans that go bad quickly they could face charge-offs as they sell a glut of used cars for a loss.
On the other hand an argument could be made that auto lending is safer than residential lending. A borrower needs a car to get to their job and make money for their payments, whereas it's easier to find shelter with family or friends if necessary.
The bank's loan portfolio summary is shown below:
When most investors think of a small rural bank they think of a savings and loan. A bank making loans to residential borrowers for their homes. West End Indiana doesn't follow that mold, they only have $64.7m in mortgages while the rest of their loans are auto and commercial. Bank management has clearly figured out the best way to maximize profit.
While maximizing profits the bank has also kept their asset quality in check. Non-performing assets as a percentage of assets peaked at 3.53% in 2013.
The bank was a mutual bank and demutualized in 2012. A demutualization is when a mutually owned bank raises money from depositors and outside investors as part of an IPO process. The proceeds from the IPO are generally used for growth. As you can see from the loan table above the bank was able to apply their funds from the IPO into growing their loans from $160m in 2012 to the current $203m.
When a bank demutualizes they are allowed to buy back shares after their first year public, pay a dividend after their second, and sell after their third. West End Indiana completed their demutualization in January of 2012, making them eligible to sell the bank at any time.
Often activist bank investors are attracted to bank's that are easy to sell. These activists will push for a sale and investors will realize a nice gain. Banks that are easy to sell usually have either a lot of costs that could be cut, or a nice niche franchise, such as West End Indiana's auto lending business.
When trying to determine if a bank is salable two things are worth considering, who would buy the bank, and what's the bank worth.
Let's look at who might want to buy West End Indiana. A new feature recently released in CompleteBankData.com is the ability to view deposit market share information. The following table shows the metro area ranking for West End Indiana's branches.
West End Indiana isn't much more than a bit player in the Cincinnati market. Cincinnati is ruled by heavyweights US Bank, Fifth Third and PNC. When looking at the overall deposit market share West End Indiana isn't more than a rounding error.
But a rounding error in Cincinnati is ok. West End Indiana isn't focused on the urban market, they are focused on rural customers across the border in Indiana. Most of their branches are un-classified, this means they operate outside of statistical metropolitan areas.
A bank looking to acquire a foothold in Cincinnati would have other better options for purchase. But a bank with experience in a rural area, that wants further exposure to rural Indiana might find West End Indiana a great acquisition.
The second question is what's the bank worth? The bank has a 66% efficiency ratio; this is a well run bank. Some small banks are acquired due to their value after costs are cut. It's not likely that enough costs could be cut at West End Indiana to make it valuable from this perspective. Instead of a cost cutting story West End Indiana looks more like a growth story in a niche market. The bank took the capital from their IPO and put it to work right away generating earnings. Earnings have grown at the bank from a $600k profit in 2012 to $1.4m in 2014. The bank earned $418k in the last quarter, and if earnings remain on track they could earn more than $1.6m in 2015.
What's limiting the bank's growth is they don't have enough capital. They have a very efficient auto and commercial lending platform with low losses. If they had more capital they could grow even quicker. This is where an acquirer could come in. A larger bank could acquire West End Indiana and inject more capital into their lending platform fueling growth. The acquiring bank might realize some cost savings from back office synergies, but I think the majority of the value would come from increased growth.
If a bank were to realize 10-15% in cost savings and growth with additional capital it's not unrealistic to value the bank in line with peers at 1.3x TBV. If the bank were to trade in line with peers it would mean a 40% gain for investors. Often times a niche lending franchise can merit a premium. With 38% of the company's shares owned by investors it's likely this bank will be sold, and probably be sold for at least 1.3x TBV if not more. If a quick sale doesn't materialize an investor will be left owning shares in a growing bank with a valuable niche lending business at less than book value. That's not a bad outcome either.
Disclosure: Long WEIN