Description

American River Bankshares ("Bankshares") is the holding company for American River Bank (ARB) and two other small banking subsidiaries.  It is a local business bank in the greater Sacramento, California region (10 locations in four counties).  It is in the middle of one of the more bombed out lending markets in the country, as high unemployment, massive resi-mortgage defaults, and a shrinking state government are all contributing to a "challenging" headwind, to say the least.

ARB has survived intact and with an improved competitive position.  Having done a good job avoiding large swaths of the carnage that felled (or staggered) many of its competitors, ARB is on the cusp of what I believe will be a secular organic growth opportunity.  This investment opportunity has the strong potential to be aided by the acquisition of at least one or two other banks via M&A..

This write-up simply aims to show that Bankshares is a well capitalized, reasonably well managed business, with an attractive franchise that - perhaps - is nearing the bottom of its cycle.  If true, I believe a purchase at or around today's prices would be a reasonable way to make an attractive return.  If I'm wrong, I think it is unlikely that a buyer gets blown up, creating a reasonably attractive risk/reward skew.

Given its geography, ARB did a good job avoiding the dregs of the 2004-2007 lending cycle.  Its CEO David Taber has become something of a cult-like figure amongst those of us looking at community banks (granted, we are probably overestimating his skill, on average).  ARB's core philosophy of restricting lending to investment properties and instead targeting owner occupied CRE led to massive loan outperformance versus peers.  They clearly have not hit 1.000 on this front, but the relative outperformance is enormous.

With $90 million of stated book and $73 million of tangible equity, Bankshares' 9.9 million shares at $6.40 imply a market cap of $63 million.  This puts AMRB at 87% of tangible book and 70% of stated book.  I believe this is an attractive entry point for a quality franchise with an improving competitive position that is likely near the bottom of its cycle.

Capital Position:

As of December 31^st, 2010, ARB had a leverage ratio of 11.9%, tier 1 capital ratio of 17.9% and a risk-based capital ratio of 19.2%.  Each of those is more conservative than the year prior period (11.7%, 16.0%, and 17.3% respectively).  The drastic overcapitalization is the result of a capital raise during 2009, though ARB would still be adequately capitalized without the additional equity.

Assets and Loan Losses:

ARB did not totally avoid the devastation to Sacto of course and has been leaking out losses and building on reserves quarter after quarter for the last several years.  As of December 31^st, they'd allowed for 2.19% of the loan portfolio ($7.6 million of losses) vs. 2.06% a year prior ($7.9 million).  This is net of chargeoffs in 2010 which were $7.7 million up from $6.5 million in 2009.

Portfolio Quality:

You can see that since Q3 2009 (and really since mid-2008), reserves, provisions and chargeoffs have ramped materially.  The loss reserve position is still approximately as large as it has been during the crisis as a percentage of the loan book (largely because the loan book is shrinking).  New provisions and chargeoffs both seem headed in the right direction (or at least no longer worsening).  Despite the shrinking loan book (and growing "investment" portfolio) leading to compressing NIM, AMRB managed to make a small profit during the year, basically hovering just a smidge above break for each quarter of 2010.

The long-term driver of any community bank is clearly the loan business.  For Bankshares' market, loan demand has dried to a trickle.  To give you some sense of how depressed loan demand is, read this quote from ARB's CFO on their recent conference call:

"In 2010, we booked about $35 million in new loans. That's down from $69 million in 2009. And just to give you some flavor on that, in 2006, our production was $218 million, 2007 it was $161 million.  So that $35 million that we booked in 2010, that's about 16% of the total that we actually booked in 2006."

As a result of the massive fall off in loan production, the loan portfolio itself has contracted from $376 million at the end of 2009 to $338 million at the end of 2010.

Here is Bankshares' consolidated loan portfolio and overall assets during the same period:

Assets:

The stability of the overall asset base has been driven by the influx of core deposits, though clearly the mix has worsened as incremental funds have been invested in securities rather than new loans over the same time frame:

Deposits:

This growth in core deposits (much of which has been non-interest bearing) has helped support what would otherwise even more severely compressed NIM by bringing down the cost of funding:

Yield Metrics:

What can be gleaned from the above is a common story today:

• The winner banks are growing their core deposits and drastically taking down their cost of funding;
• Yield on loans has managed to hold the line during the past year despite the sharp decline in LIBOR as banks are underwriting much more conservatively;
• The conservative underwriting stance combined with declining commercial and CRE loan demand is forcing the asset mix of many banks to change toward lower yielding "investment securities" (which in AMRB's case is 56% Ginnie Mae related, 32% Freddie and Fannie related, 10% munis and 2% FHLB stock). Yields on that blended pool are substantially lower (call it 2% based on the securities AMRB is targeting) than its loan portfolio (~6%). This asset shift is compressing NIM.

 There are many other details, including opportunities to acquire competitors (and therefore leverage the equity base) via FDIC assisted transactions or open bank M&A.  While assisted deals would seem to be a reasonable opportunity, management's view is that the opportunity may be limited in the coming year given the FDIC's current approach to the world.  That said, management states they are "absolutely" open to the idea of growing through acquisition.  Clearly regulatory costs and other costs (such as workout costs, servicing, etc.) have been on a one way train up and even modest increases in scale can be provide a substantial efficiency improvement.  It should be noted that despite AMRB's clearly well-capitalized stature (due to a capital raise in mid-2009), like most California-based banks, it continues to operate under a MoU from the FDIC which restricts its ability to do things like pay dividends or undertake M&A.  With regards to M&A, I believe strongly that the company would be able to secure a waiver for the right deal.  However, I expect they will continue to operate under a MoU until their credit trends have clearly stabilized.

 Here is a line of questioning from the recent quarterly conference call around M&A (MoE obviously means "merger of equals"):

<Q>: And just in general, [inaudible], do you expect to see MOEs or whole bank acquisitions like - what's the feeling up there, I mean...

<A - David Taber>: That's a great question [inaudible], and I appreciate you asking it. What I'm hearing from other CEOs in Northern California, there's a lot of chatter, many of the small banks that started in the last five, six, seven years, seeming to be at least open minded to some sort of merger with a larger, more established, more successful company. And the second part, the MOE, although I don't believe there is such a thing, but similarly sized banks leveraging their overhead is actually a strategy - not a strategy, but that is a conversation that some CEOs are starting to have. So, I wouldn't discount that - either of those things.

<Q>: Can you comment on this? I was told that the regulators are actually pushing banks with less than 500 million a year, or slightly above 500 million to actually consider MOEs like they are the driving force behind this. Something they want to see.

<A - David Taber>: I have heard the same thing, but I'm stunned by some things that investment bankers say.

<Q>: And would an MOE again impede...

<A - David Taber>: I think the real answer there is not so much from pressure, whether it's from a regulator or their investors, it really is from the knowledge that it is more expensive and more complicated to run a community bank with the changes in the overall regulatory environment, and that is getting folks to think about combinations in the best interest of [inaudible].

<Q>: Do you think we will see more MOEs in your area?

<A - David Taber>: I think that - I don't know if it's going to be in 2011 [inaudible]. You can't really predict that, but you certainly, over the next few years, everyone, at least that I have seen is predicting a drop, an overall drop in the number of banks. And there's only one way and that's going to be through mergers.

<Q>: And especially in your size, I would think?

<A - David Taber>: Correct.

RISKS:

• The primary risk is that banks in general (particularly sub-regional banks) are a giant value-trap; that loan growth does not reappear in any reasonable timeframe and the existing portfolio burns off unreplaced by quality commercial loans, but rather by low yielding government guaranteed loans.
  • Mitigant: In that world, I think paying 70% of book and 87% of tangible book doesn't get you killed but may not make you money. You basically are being compensated to wait a reasonable amount of time for lending to recover
• In a world where it turns out the fiscal and monetary stimulus of the past three years have done nothing but mask substantial underlying problems, many more banks are likely to fail. I think this is fairly likely, in fact
  • Mitigant: Barring something akin to a dollar collapse (which I definitely assign meaningful probability to), AMRB is actually poised to win in this environment. Certainly its share price may decline, but the competitive landscape would continue to improve and the opportunity for assisted deals by well capitalized banks with better than average loan portfolios might be tremendous

Basic Investment Opportunity:

Having attempted to establish that AMRB management as likely at some point to be able to generate some positive return for equity providers, I think it is fair to assess an investment in Bankshares based on an expectation that it is, at worst, a slightly below average bank over time.  I generally assume that well run banks should be able to earn a 12% ROE over time.  For AMRB, I clip that to 10% ROE potential and assume a slow, multi-year ramp back from 2010's nil return.

WARNING: Buying stocks may cause you to lose some or all of your money - especially this stock.  Don't buy this stock without doing your own research and even then, you should probably just invest in Treasuries and help fund the debt - that is a risk free investment whereas this investment entails substantial risk.  You are a fool to buy a stock based on a semi-anonymous internet write-up.  I may sell or buy this stock at any time without telling you about it.  Don't do drugs.

Catalyst

• Loan growth opportunities
• M&A transaction (either as a buyer or seller) or perception that small bank M&A is back, baby
• Provisioning improvements
• MoU removal