Is this bank a quadruple or a zero?

In the market risk equals reward, or so they say.  High risk equals a higher reward.  In the case of Enterprise Bank (EFSG) the bank's business model is low reward high risk, but for investors who are willing to wade through the muck this could be a high risk/extremely high reward stock.

I wrote about the bank a little over two and a half years ago.  They're located near where I live, and I've started to think about them again as one of my running routes takes me near their office.  I hesitate to use the term "branch" because they don't really have a branch, just an awkward office on a weird elbow bend next to pseudo-junkyard (heavy equipment graveyard rental), and an indoor playground for kids.

The bank is a niche lender, they specialize in lending to start-up businesses and small businesses with troubled business models in distress.  I know what you're thinking, this type of niche lending doesn't seem to fit well in a regulated industry especially when the firm is highly levered.  You're right, it doesn't, and why they're a bank mystifies me.

What has always intrigued me, and why I looked at them again is their valuation.  The bank has a tangible book value per share of $17.99 and a share price of $8.  The bank trades for 44% of tangible book value.  Incidentally this is the same price to tangible book ratio they traded at in 2014 when I last took a look at them.  Two and a half years into a historic small bank bull market and this stock's price is nearly unchanged along with it's valuation.  It's in situations like this that opportunity can exist, it doesn't always exist, but there is potential.

There is a lot to dislike about this bank.  It's easy to go overboard when looking at a bank still trading with a deeply distressed valuation.  I want to do them justice, this can work out very well for investors as you'll see, but you need to accept before buying in at this valuation.  Let's start by clearing the air with everything that's terrible about the bank.

First they are a small business lender and small businesses have a higher failure rate when compared to established business lending.  But if that weren't enough Enterprise Bank seeks out distressed small businesses.  The bank describes themselves in their annual report as lending to start-ups and small businesses in distress.  For the risk they're taking they aren't making that much money.  In the most recent quarter they had a net interest margin of 5%.  That's hardly compensation for the risk, and it's even worse when you realize they're a levered institution with the majority of their funding from the FHLB and brokered CDs.

Their business model is similar to someone driving a car very fast on an icy road.  There aren't any problems as long as the car stays straight and if the drives doesn't make any sudden movements, but the smallest nudge of the wheel can end in catastrophe.  To management's credit the bank has been traveling this icy road for a while without crashing, but that doesn't mean it's safe, or a crash isn't a wheel nudge away.

If anyone is looking for a good sleep aid I'd recommend reading the first 25 pages of their 2015 annual report.  To say it's unique or unusual discounts what it really is.  In the opening letter management summarizes the company's results then launches into a dissertation as to why they disagree with their regulators regarding revenue and income recognition.

Maybe I suffer from insomnia, or I enjoy the nitty gritty detail of bank regulatory disagreements, but whatever it is I charged through.  In the eyes of a bank regulator a loan is to be classified as "non-accrual" when the loan is more than 90 days past due.  A non-accrual loan can be considered in collection when the bank expects to turn their non-accrual loan into cash within 30 days.  The essence of the bank's argument is that they have a lot of non-accrual loans that they believe are in collection even though collection can take months or years for them.  The bank believes they shouldn't have to classify these loans and that any interest received on them should be recognized as income.

The bank believes they're a special case because they deal with distressed commercial borrowers and it's hard to sell commercial real estate.  My contention is it's hard to sell commercial real estate if the price is too high, or if the real estate holds little value.  It's very easy to sell commercial real estate in areas with strong commercial growth and limited space.  Incidentally those are two overriding traits of the area the bank is located in, yet somehow they were stuck with the dud properties.

It turns out the bank wasn't lending where they're located, a prosporous neighborhood (their current location withstanding) down the street from old money estates.  They were lending in distressed neighborhoods betting on a turnaround.  To make matters worse the bank happened to lend to almost all of the borrowers said neighborhood, and in 2008 when everyone ran for the exit Enterprise was left holding the bag.

The bank has dug themselves out of the pit they found themselves in, but this story illustrates some of the issues they face when selling property.  The properties are not prime commercial real estate.

Let's get back to their income argument with the regulator.  The bank argues that it should have $1m more in income that their regulator won't let it recognize because of accounting rules.  They claim they've received $1m in cash payments on non-accrual loans that hasn't been fully recognized on the income statement.  This is partially true, but also misleading.  On their regulatory financials this $1m in cash received has been applied to the balances of the loans.  The resulting loans are de-risked on the balance sheet, but does nothing for their income statement.  On their GAAP financials the bank has pushed through some of this interest income, but it's lumpy rather than consistent as the company would like.  This money didn't just disappear, it found its way onto the financial statements, just not where management would have liked to see it appear.

I find it noteworthy that so much ink was spilled describing this issue.  I could feel management's anger over the issue as I read their annual report.  They feel this is a hidden asset that shareholders should know about.  My sense is they might feel that if this $1m in income had been reported then they wouldn't be trading at the valuation they're trading at.  I'm guessing, but I don't think that's the reason for the low valuation.

The bank is operating in a very risky segment of the market.  They have a risky business model, and it's built on hot money funding.  For all of this risk the bank isn't printing profits.  They have capped their upside, but unlimited downside.  This is why they have a low valuation.

It isn't all bad news though.  The bank weathered the financial crisis and remains well-capitalized.  They paused the hunt for new business in order to ensure Basel III compliance.  The bank will remain compliant once Basel III is implemented and they don't expect any interruptions in their business.

What's even better is the opportunity set for investors if the bank does nothing other than work down their non-accrual loans and sell off their foreclosed real estate.  The bank has $10m in non-accrual loans, and at any other bank if those loans were brought current they'd continue to accrue interest and generate income.  In a traditional setting with a 5% NIM the bank would earn $500k in additional operating income if the $10m in non-accrual loans were current.  But given Enterprises specialty with investing in distressed and liquidating opportunities we can presume that the bank intends to collect and liquidate the $10m worth of troubled assets.  They also have $4m in foreclosed property on their balance sheet.  This means there is $14m worth of assets waiting to be realized once the bank can find buyers.  Let's discount these assets by 25% and say they ultimately collect $10m.  This is an overly conservative hair-cut, the bank has never charged off loans in an amount that's anywhere near this haircut.  The $10m collected would become equity and the bank's tangible equity would increase from $15.9m to $26m, which is $29.84 per share.

To summarize the opportunity, if the bank does nothing else related to banking, but instead focuses entirely on selling down their OREO portfolio and collecting on non-accrual loans they can almost double tangible book value per share for shareholders.

Beyond this the bank has worked to improve their operations.  Their return on equity is slightly over 7%, which is average for a bank their size.  The bank's efficiency ratio is in the 80s, and management noted in their letter they are working to lower it.  If the bank were to drop five to ten points of their efficiency ratio as well as work down bad assets investors could be looking at a tangible book value per share in the low to mid $30s.  That's attractive considering shares are at $8 right now.

I really like bank investments where the investment thesis rests on the company working off bad assets compared instead of needing to improve their internal operations.  It's easier to work off assets versus changing company culture, or changing morale.  In my newsletter I wrote about Summit Financial (SMMF), a bank that was in a similar position a few years ago, since then it's up over 150% as bad assets have dropped out of view.  Enterprise Bank has a worse starting point, but the appreciation potential is higher as well.

The risk to a situation like this is making sure the bank itself will stay strong and healthy long enough to work off the bad assets.  If the economy takes a dive before they can collect on their non-accrual loans and sell foreclosed properties then the bank will be in a bad situation.  New foreclosures and bad loans could swamp the bank's capital, especially given their focus on distressed assets.  In that situation the bank would be taken over by the FDIC and assets sold, ultimately to another bank that was stronger capitalized would realize those gains.

The reason this bank is trading at such a steep discount is because the market isn't sure whether they can work off their bad assets before the next crisis hits.  If they can this stock should quadruple or quintuple, if they can't then it's a zero.  Lottery ticket?  Perhaps..

Disclosure: No position

1 comment:

  1. I worry about companies selling their best assets first (ie little haircuts) and then suddenly distressed assets look better than they really are. Do you have any confidence that the bank is or isn't doing this?