Description

Bridge Bank (BBNK) is a cheap, easy-to-understand, highly profitable, fast growing (all organic), and undiscovered Silicon Valley commercial bank (with limited exposure to real estate) run by a veteran management group. One particular catalyst over the next year, in addition to the likelihood of continued strong core operating results, is the potential acquisition of one or two major competitors (Comerica or Greater Bay Bancorp— legitimate rumors abound) which would likely create significant customer and employee dislocation, allowing BBNK an opportunity to gain market share and accelerate its already high growth. (The banking industry is replete with stories of small banks taking advantage of merger dislocation in their markets.) A second catalyst would be a secondary offering that would improve the limited liquidity of the stock (averages 7K shares per day, and management is aware of the discount it is causing). The stock trades at 12.9 times my 2007 estimate of $1.55, making it very inexpensive relative to high performing banks that trade near 20 times and many sub-par banks that trade at 14+ times. It also trades at a very low 2.6 times book value despite a 20% ROE. With the help of one or two disruptive mergers in its markets, I think BBNK can double in two years and triple in the next five.

Key Highlights of Bridge Bank

• 6.7% net interest margin, which puts it easily in the top 1% of banks in the country. Its business model, particularly its success at gathering core deposits, has made it immune to the shape of the yield curve.
• Excellent profitability, with a 1.4% ROA, up from 1.2% YOY and a 20% ROE, up from 16% YOY
• Loan growth of 20% YOY and core deposit growth of 19% YOY
• EPS growth of 55% YOY
• Superb credit quality—no charge-offs in 2006.
• Experienced management group coming from Bank of America, Silicon Valley Bank, Comerica, and Greater Bay. They continue to be highly successful in recruiting key employees from other competitors.
• Limited competition—industry consolidation has limited the field to a couple of bureaucratic mega-banks (Bank of America, Wells) and a handful of large regional banks (and two of the largest—Greater Bay Bancorp and Comerica— are poorly run).

Excellent Balance Sheet Characteristics

A bank’s balance sheet drives its earnings (loans are booked as assets and produce interest revenue; deposits are booked as liabilities on which it must pay interest) and BBNK’s balance sheet is one of the best in the country, with low cost core deposits (i.e. no cd’s) making up 77% of their total funding base (vs. less than 50% at most banks) and loans spread across a diversified commercial base. Below is a quick snapshot of their earning assets and funding costs and the rates they charge and pay:

As you can see, their assets are mostly high yielding adjustable rate loans. On the funding side, you can see that the vast majority comes from low-rate savings and non-interest bearing demand accounts. This favorable asset/funding mix is what has allowed the net interest margin to remain stable at its very high rate of 6.7%. (The net interest margin, or NIM, roughly approximates the difference betweens asset yields and deposit costs. Most banks have NIMs of 3-5%.) Their ability to rapidly grow core deposits while the broad banking industry has seen shrinkage over the last year is truly remarkable (customers are switching into more interest rate sensitive products like cd’s). While management has been talking down expectations for the NIM, I would not be surprised to see it stabilize or even rise from the current level.

Good additional information on BBNK is available in their August investor presentation, which can be found at the following link: http://ofccolo.snl.com/cache/1500011013.pdf  It is short (19 slides) and definitely worth spending a couple minutes flipping through. Page 13 gives a great visual break-down of the balance sheet, specifically the loan portfolio. You will note that real estate based loans make up only 38% of loans (construction loans at 19%, land development loans at 6% and commercial real estate loans at 13%) vs. 50%+ at many California commercial banks. Below is a quick breakdown of BBNK’s loan portfolio as of Q3/06:

All-Star Management Team

Despite BBNK’s small size, it has a veteran leadership team with decades of experience at very large, sophisticated financial institutions including Bank of America, Comerica, and Silicon Valley Bank. (Pages 7 and 8 of the presentation have a great break-out.). In particular, three recent recruits from Silicon Valley Bank (SIVB) stand out. Jeannie Kao was a top executive within their import/export trade finance operations, a very profitable and growing niche business, and is now leading it for BBNK. Mike Field, who was with SIVB almost from the beginning, is now leading BBNK’s efforts to serve technology companies and their relatively specialized deposit/cash management needs. Paul Gibson, hired in early November, will be heading their technology practice on the east coast, out of Reston, VA. (SIVB is a somewhat legendary bank in the Bay Area that has carved out a profitable niche serving technology companies—the stock has been a 10+ bagger in the last 12 years, although the growth has slowed more recently.) BBNK’s ability to recruit all-stars will remain a key competitive advantage.

Silicon Valley Is Booming, And BBNK Is Levered To Silicon Valley

While Google continues to be the poster child of Silicon Valley’s resurgence since the dot-com bust, many other start-ups have also been doing well (i.e. YouTube and SunPower) and several other older companies have been experiencing a renaissance (like Apple and HP). Given Stanford University’s key roll as an incubator and the entrepreneurial spirit engrained in the region, the beneficial cycle is likely to continue. While some banks can thrive in poor economic environments (M&T Bank, based in chronically recessionary upstate NY, is a great example), most banks do much better in regions of the country that have strong economic growth. While there is much concern about the real estate market in California, technology innovation, entrepreneurship and solid population growth in the Silicon Valley area will likely limit any real estate softness in the area. Additionally, the 49ers’ increasingly likely move from San Francisco to Santa Clara will create hundreds of millions, if not billions  of dollars in infrastructure spending and support an already tight employment market. As one piece of evidence of the Valley’s resilience, look how seamlessly it absorbed the dot-com bust and the billions in destroyed wealth and the out-migration of thousands of employees. It barely registered and banks in the region did not report any serious sort of asset quality problems. While I am not arguing that Silicon Valley is recession-proof, I do think it is more immune than most other regions of the country. Incidentally, the Wall Street Journal had a very interesting article (October 5, 2006, page B1) highlighting Silicon Valley’s unique economy and its ability to continue attracting businesses and entrepreneurs from across the country.

Recent Results Are Very Good

Q3/06 EPS of $0.34 was up 55% compared to the $0.22 reported a year ago and up 17% vs. Q2/06’s $0.29 (which was understated by $0.02). Revenue was up 30% YOY and 5.2% from Q2/06 (21% annualized). The net interest margin was 6.73%, up slightly from 6.67% a year ago, but down a sharp 31 basis points from Q2/06. While this decline looks initially alarming, the reason for the decline is actually good. BBNK has been very successful in gathering low cost deposits. Rather than investing them in imprudent loans, it chose to invest the deposits in highly liquid, short term securities yielding around 5.3% (see the growth in Fed Funds assets in the table up above). Since the Fed Funds rate of 5.25% is lower than BBNK’s existing margin of 6.73%, the addition of these assets mathematically brings the margin down. However, this isn’t a concern because the earnings generated from such assets are riskless and can easily be deployed into higher yielding loans. The key result to look at is dollars of net interest income, which grew from $9.3M in Q2 to $10.1M in Q3. That is growth of 9% despite a 30 basis point drop in the margin, and to repeat, it wasn’t achieved by making risky loans, as many others banks do (if you are interested in a beautiful example of this, check out FBTX, a small Texas bank that is making foolish construction loans in Colorado, Arizona and New Jersey); it was done the hard way—by gathering low cost deposits and investing them in riskless assets.

Loan growth has slowed down from a 20%+ clip earlier in 2006 to only 7% annualized in Q3/06. The slow-down is entirely understandable given real estate and recession concerns, but the continued strong employment numbers, a stable housing market in Silicon Valley, a robust M&A, IPO, and VC market, and a surging stock market are likely to encourage more business expansion shortly. Management has described the lending environment as “cautiously optimistic.” Additionally, BBNK’s proven ability to continue hiring away key talent will allow it to grow in a flat market.

The balance sheet is also very solid, with tangible equity to assets most recently at 7.2% (many banks run at 5-7%) and the loan loss reserve ratio at 1.39% (many banks have dropped this to near 1.00% in the last 5 years). Asset quality is excellent. They do have two non-performing loans totaling $2.6M, but neither has incurred any charge-offs, and the larger of the two credits ($2.3M) is an SBA loan with excess real estate collateral and has likely already been favorably resolved or will be so in Q1/07.

It is important to note that these impressive revenue and earnings growth numbers aren’t distorted by any one-timers or competitor M&A activity. They are being achieved through strong organic growth centered around recruiting top talent and gaining profitable customers. Given BBNK’s small size, recent success, ability to attract key talent, their growing brand recognition, and the economic strength of Silicon Valley, I see no reason why revenue and EPS growth can’t continue at 20%+ for several years.

Valuation

At $20, the stock trades at 12.9 times my 2007 estimate of $1.55, which does not currently include the impact of any potential competitor M&A activity. (In such a scenario, I think they could do $1.60 and be set up for a superb 2008.) Tangible book value at year end 2006 will likely be $7.80, putting price to tangible book at under 2.6 times (on which it is earning a high 20% ROE). Many high-performing banks trade at PEs of 20 and P/TB ratios near 4.0. Such a valuation would put BBNK at over $30, or up 50%+ within the next year.

Catalyst