Shareholder Vote at Friendly Hills Bank ($FHLB)

Friendly Hills Bank is a small bank in Whittier, California (a city in Los Angeles County) that was founded as a community bank in 2006. The shares are OTC-listed (ticker FHLB) and trade for around $11, which is not much greater than the IPO price a decade and a half ago.

What caught our eye recently is that Friendly Hills is having a special meeting on June 22nd in order to hold a shareholder vote on a proposed acquisition of three branches from Bank of Southern California. The other thing that we noticed was a couple of smart bank investors (like @TimyanBankAlert) on Twitter mentioning Friendly Hills and the acquisition:

We follow @OurBank3 on Twitter, a bank investor account that has the motto: "The shareholders are the rightful owners. Management has a fiduciary responsibility. Proud #SHT member-Shareholders who Hate value Traps". So far we agree on banks wholeheartedly! So if this account has a beef with this proposed acquisition, we thought that we should dig a little deeper.

Let's first back up and understand Friendly Hills a little better. As of March 31, 2021, this is a bank with $214 million in assets, $127 million in loans, $171 million in deposits (L/D only 74%), and $20.7 million in shareholder equity (all tangible). In 2020, FHLB had comprehensive income of $1.4 million, which was a 7.4% return on equity and a 77 bps return on average assets for the year. However, for Q1 2021, the net income was only $240k which is a 4.7% annualized return on equity.

Unusually for a bank of this size, Friendly Hills is not a residential lender. Their loans are 70% commercial real estate and 30% commercial and industrial. The average interest coupon is 4.2%. Since their loans/deposits are so low, they have a significant amount of investment securities, more than half of which is of ten year or greater maturity. The bank is overcapitalized with Tier 1 RBC of 18.8%.

You can see the efficiency ratio trend for Friendly Hills as calculated by Complete Bank Data:

Book value per share for FHLB is $10.34 vs the recent trading price on May 27th of $10.95 per share, so it is trading for 106% of TBV. This is not exactly a screaming bargain when Oddball Stocks has recently written about a basket of small banks that are earning higher ROEs and trading for about 80 percent of tangible book.

Also, Friendly Hills management has a lackluster (at best) history of value creation. As you can see from a long term chart of the share price it has gone nowhere since the IPO. (And it has never paid a dividend.) The current president of the bank has been in place since the founding. We found an LA Times article from 2013 with his complaints about how small banks are over-regulated. 

It looks as though he and Friendly Hills stumbled right out of the gate after the bank was founded, losing a significant amount of money during the 2008 credit crisis. The bank originally raised about $17 million in equity, and by the end of 2010 the bank had accumulated a deficit of $5.2 million and was down to $11.8 million in equity ($7.29 per share). Even today, the bank has only $3 million of retained earnings since inception.

Now Friendly Hills wants to buy three branches from a local competitor (one each in Orange, Redlands, and Santa Fe Springs) for $1.17 million (plus assumption of the lease liabilities for the branches) that have $92 million in deposits. Here is what we wonder about with this proposed transaction:

  • Why does a bank with only 74% of its deposits lent want to buy more deposits? Don't they need loans and not deposits?
  • The pro-forma financials (disclosed on p34 of the special meeting proxy) show that in Q1 2021, these three branches would have been responsible for $432k of additional non-interest expense. So, in addition to the purchase price of $1.17 million, there is going to be commitment to a fixed overhead burden: lease payments, compensation, etc.
  • Are going to stick with their long-term securities portfolio strategy and term out / increase the tenor (time until maturity) of the $92 million that is coming in? It seems like this acquisition could result in pressure to earn back this incremental overhead burden by taking either more interest rate risk or more credit risk, plus more leverage from the additional $92 million of deposits on the existing equity base.
  • Is acquiring more branches really the right move for any bank in a country that is staggeringly over-branched (especially given changes in customer habits and technology)? Plus, is there an adverse selection problem in buying branches that a local competitor wants to get rid of? Is this an example of a smarter bank dumping an albatross on a bank that is "slow to realize their branch networks are a drag"?
  • Was there a better deal to be done here? If Friendly Hills shareholders turn this down, can Bank of Southern California really do just as well, or might the deal get sweetened?

We noticed in the proxy statement for the special meeting is that there is a significant outside shareholder who happens to be the largest shareholder of Friendly Hills. The officers and directors of FHLB as a group own 21.1% of the company, with the plurality of this held by the Chairman William Greenbeck and the CEO Jeffrey Ball. But the largest shareholder, Frank Kavanaugh in Newport Beach, owns 26.2%, which is more than all of the insiders combined. (The other shareholder disclosed in the proxy is AllianceBernstein which owns 9.6%.)

The 21% owned by management seems like good ownership skin in the game, but unfortunately a lot of this stock was essentially given to them and not purchased:

Stock Option Grants to Executive Officers
On December 31, 2018, we granted incentive stock options under the 2017 Equity Incentive Plan to our executive officers. We granted an option to Jeffrey K. Ball, President and Chief Executive Officer, to purchase shares in an amount equal to 2.5% of our issued and outstanding shares, or 50,000 shares, an option to our Chief Operating Officer, to purchase shares in an amount equal to 0.5% of our issued and outstanding shares, or 10,000 shares, an option to our Chief Financial Officer to purchase shares in an amount equal to 0.3% of our issued and outstanding shares, or 5,000 shares, and an option to our Chief Credit Officer to purchase shares in an amount equal to 0.3% of our issued and outstanding shares, or 5,000 shares.

The incentive stock options, which we granted to our executive officers in 2018, vest at the rate of 20% per year, beginning on December 31, 2019, which is one year after the date of grant. The options shall all remain exercisable, subject to earlier termination upon the happening of certain events, until December 31, 2028, ten years after the date of grant. The exercise price of the incentive stock options granted to our executive officers is $6.80 per share, which is equal to or in excess of the fair market value of the shares of our common stock on December 31, 2018, the time of the grant of such stock options. We did not grant any stock options or other stock awards to any of our executive officers in 2020.

Stock Option Grants to Directors
On December 31, 2018, we granted nonstatutory stock options to our non-employee directors under the 2017 Equity Incentive Plan. The nonstatutory stock options granted to our non-employee directors in the aggregate is equal to 4.5% of our issued and outstanding shares or 89,750 shares. The non-employee directors’ option grants vest at the rate of 20% per year, beginning on December 31, 2019, which is one year after the date of grant and the term of each of the option grants is ten years from the date of grant. The exercise price of the nonstatutory stock options granted to our non-employee directors is $6.80 per share, which is equal to or in excess of the fair market value of the shares of our common stock at the time of the grant of such stock options. We did not grant any stock options (or other stock awards) to our directors in 2020.
So that is really brutal from a shareholder perspective. The end of 2018, you may recall, was a big market crash. And how did FHLB insiders respond? Why, they gave themselves options to acquire 8.1% of the bank at 80 percent of tangible book value, and less than 70 percent of the IPO price a dozen years earlier.

Something else brutal about management is that FHLB has never bought back stock when it was cheap. The share count now is higher than it was a decade ago, even though the bank has excess capital and even though the stock had traded at big discounts to tangible book. After having been in business for a decade and a half under the same management, you get a pretty clear view that management doesn't allocate capital well (which should worry us about the branch acquisitions) and is opportunistic about transferring value to themselves (with the 2018 options grants).

We found that the largest shareholder Kavanaugh made a change in control filing with the Federal Reserve in December 2018 to acquire shares of FHLB. At the end of 2018, the shares had collapsed down to around $6-7, so this may have been a very astutely timed buy. (Yet notice that he, an outside shareholder, was paying cash for his stake, while the insiders were being granted cheap options.)

Really good things can happen for shareholders if someone with significant ownership skin in the game - that they paid for - comes in and pushes things in the direction of shareholder value maximization. This is "reading the tea leaves": remember how SouthFirst in Alabama was acquired last year? The only clues to long-suffering outside shareholder that things were moving in that direction were (a) unhappy minority shareholders with big ownership positions and (b) right before the sale, the termination of the golden parachutes for execs.

If you want to dig in further on Friendly Hills, we have uploaded some helpful documents on Scribd:

And if you like small banks and shareholder activism, be sure to try the Oddball Stocks Newsletter. We've been talking about almost nothing but small banks since last summer, and we are always very interested in shareholder activism and small bank activism.

Hanover Foods Quarterly Financials

We just received the latest quarterly financials from Hanover Foods.

Notice that between the end of fiscal second quarter (Nov 29, 2020) and the fiscal third quarter (Feb 28, 2021), the company bought back $1.26 million of stock. This is the first time that we have seen the company repurchase a significant amount of stock.

We would love to know the details about that repurchase and whether the company plans to do more repurchases at a fraction of book value and net current assets.

Hanover Foods 3rd Fiscal Quarter by Nate Tobik on Scribd