SFB Bancorp - Too cheap to ignore, especially for activists

"Value is its own catalyst" is a common saying amongst value investors.  When a stock is marginally cheap investors need to pound the table, concoct 80 page power point presentations and create elegant narratives to sell the story.  When a stock has landed in value territory it's valuation is the story.  Such is the case with SFB Bancorp (SFBK) a bank in Tennessee that languished on the edge of the pink sheets until the discrepancy between the market price and book value became too great.  A fund discovered the stock and started to build a position.  The rest as they say is history.

I've talked about the idea with Colin, the Managing Director for Trondheim Capital numerous times. SFB Bancorp was an idea that appeared in the second issue of the Oddball Stocks Newsletter.  The full writeup sample is below.

I had the chance to interview Trondheim Capital and Meixler Investment Management about the bank, why this is a good investment, and what they wish to achieve.  Before getting into the interview I want to outline the investment case for SFB Bancorp in sentence or two.

Investment Snapshot

SFB Bancorp is a holding company for Security Federal Bank in Elizabethton, TN.  The bank has $60m in assets with a 41% Tier 1 ratio.  They have $37m in loans and $19m in cash and securities.  Equity is approximately $14.593m against a market cap of $12m. They trade for 82% of book value.  The bank is profitable and has been for years.  They never incurred a loss during the financial crisis and asset quality is pristine.

The bank's President embodies the community banker saying of "I know my bad loans by name."  I spoke with Carmella Price and asked about a non-performing loan and was given a list of the seizable assets such as a high end power boat that were negotiated as collateral for the loan.  Price certainly knew the bad loan by name, and was on top of the resolution.

The bank has a mediocre 5% return on equity, mainly due to their significant over capitalization.  If the bank were to use their capital to buyback shares, or extend credit it's feasible that they could earn over 10% on their equity without much effort.

Lastly, this isn't a cheap bank sitting on the sidelines waiting for someone to notice them.  As you'll see in the interview below a number of funds are already involved and working to close the valuation gap.


How did the bank come into being? 
It was founded in 1963 as a mutual. The founder's son (Bill Hampton) told me that his father (Peter Hampton) started it partially to generate more work for his law practice. I assume that means the title and escrow work. They demutualized and went public in May 1997. In 2003 they terminated the securities registration and moved to the pink sheets.

How can a bank so small survive?
Non-interest expenses were only $1.79 million in 2014. Of that, $1.064 million was compensation. They brought in $2.65 million in net interest income and non-interest income, so that leaves a respectable profit. East Tennessee is obviously a cheap part of the country from a compensation perspective.

When most investors look at SFBK their first thought is most likely "so many securities and not enough lending.." do you feel increased lending is what they need?
No. They say their market is too competitive and I believe them. Credit union competition always comes up. They have a culture of conservative lending which is one of the great things about them. They made money throughout the recent depression and bought back ten percent of outstanding shares in 2009.

Why are they so conservative?
That seems to be a part of the culture, inherited from the founder. I think it's admirable that they've let the loan book decline. It peaked in 2006! Hired help will grow for the sake of growth; an ownership mindset seems to result in conservatism at least with regard to credit risk. Now, interest rate risk and the idea of buying back stock instead of building a low-yielding bond portfolio is the area where we differ with management.

What's the ownership structure like?
The founder's son and family own about 25%. There's an ESOP that owns about 11%. The President of the bank subsidiary, Carmella Price, owns about 4%. Together that's 39% for what I call the insiders. Bill and Carmella are on the board with three directors who own less than 1% combined. Then there is Trondheim Capital, Meixler Investment Management, and a private investor named Jack Rubens. The three of us "outsiders" wrote a letter to management in July about capital allocation, and we informed them that our combined holdings were about a quarter of the company.

What's the opportunity for investors?
First, the bank is trading below book value even though it's profitable and overcapitalized. We estimate that the discount is close to 20%, but book value may understate both the liquidation and intrinsic values. Given the discount and overcapitalization, they should be buying back stock. At 12/31/14 equity was 23% of assets and Tier 1 was 41%.

Is there something better the bank can do with their excess cash?
Buy back stock below liquidation value, below tangible book value, below value as an acquisition target. Any of those ways that you look at it, repurchases below these intrinsic value would be a good use of surplus capital.

Are they a potential acquisition target? If so why? If not why not?
I think what we are seeing recently is that every bank is an acquisition target to an equal or larger size bank that wants to get economies of scale. I spoke with the founder of another bank in eastern Tennessee who already made one acquisition and wants to make more.

Is it possible to buy a significant stake?
There are shares offered in the open market. I'm surprised that micro cap investors aren't smarter about finding ways to buy stakes in tiny companies, the way Buffett used to do. In most states, companies are required to send a shareholder list to a shareholder. You could look for someone who owns the same quantity of shares you are looking to buy and make them an offer. I've never been offended by someone wanting to buy something I own.

In an ideal scenario what would you like to do at the bank?
At a minimum, we think that shares should be repurchased to close the gap between the share price and intrinsic value. This would reduce surplus capital, boost ROE, and reduce the interest rate risk if it was funded by selling some of the long duration treasury/muni paper. We also think that the significant shareholders who aren't insiders should have board representation.

Are you like most Wall Street activists who want to strip companies of their assets and leave the carcass to flail in the wind? (Security Federal Bank plays a vital role in their local community, is this something you'd keep?)
That criticism makes more sense with a non-financial company. With a bank that has surplus capital and too much lending competition, it's just so obvious that capital should be returned. Especially when shares are trading at a discount.

Can you walk us through why share buybacks are better than dividends or lending?
I actually found a compilation of all of the Buffett annual report comments on share repurchases and sent it to the President of the bank. It is so obvious that's what you need to do, provided that shares are below intrinsic value and that you have surplus capital, i.e. no investment opportunities that are superior to that. If you are a banker and you've sized up your lending market as being too competitive - which I perfectly respect - you are in the situation where you do not have a better use for the capital.

Is there a limit to what the bank can buy back?
Well, there's obviously a limit in terms of remaining well-capitalized and maybe another threshold of what the regulators are comfortable with. And obviously you want to stay within those limits. We are just talking about low hanging fruit here. See how much stock you can buy back at a huge discount using capital that's currently supporting fixed income instruments at one or two percent yields.

Have you talked to management about your ideas? What did they say?
As I mentioned, we sent a letter jointly with two other large outside shareholders about the repurchase idea. They sent a letter thanking us, saying that they are "in the process of updating the Company's strategic plan" and would be "discussing these topics and others with our financial advisors." Polite, but vague and non-committal.

What's managements plan for the bank?
That is not something they have wanted to share with us. It would be great to have a conversation with them where we compare the share repurchase plan with whatever plan that they have in mind and see which one results in higher IRR to shareholders, especially across a range of economic and interest rate scenarios. I think it would be tough to beat share repurchases at a discount.

Interested in learning more about banks? Buy my book The Bank Investor's Handbook (Kindle and paperback available)

Oddball Stocks Newsletter Investment Writeup

This writeup is from the July 2014 issue of the Oddball Stocks Newsletter, it's unaltered from the original publishing.

Disclosure: Long SFBK

1 comment:

  1. Nate, any suggestions on really great (think compounding-type) community banks out there? Those that put out an insightful shareholder's letter? Thinking of something like TYBT as an example.

    Also, do you know of any publicly available spreadsheet templates for modeling and quickly valuing a bank? Hoping to have something I can build out to see what drives the model, then modify for my own purposes.