Description
How about a regional bank trading at 18 times 2005 earnings and 2.5 times book value that is trading on takeover hype that is probably three years too early? Investors have greeted Jim Giancola’s appointment as CEO of Midwest Bank Holding (MBHI) with great enthusiasm. To a certain extent, it is understandable given his track record and charisma. After cobbling together a $7 billion regional bank in Evansville, Indiana (CNB Bankshares), he sold it to Bank One five years ago for a very handsome multiple of four times book and over 20 times earnings. While I do not doubt that MBHI will sell, I think the valuation still remains well ahead of itself, and the first quarter earnings release will demonstrate the true quarterly earnings run-rate to be near $0.20. (Consensus is $0.22).
History
MBHI was founded 30 years ago, went public in the early 90s, and for the most part was a successful regional bank until a few years ago. In 2000, Brad Leuke took over as CEO and basically ran the franchise into the ground. Notably, credit quality deteriorated significantly, accounting controls proved ineffective, and earnings became erratic because various trading strategies that were implemented proved to be volatile (not to mention inappropriate for a community bank). The result was a succession of auditors (Crowe Chizek, then KPMG, then McGladrey & Pullen, and now PWC), a Federal Reserve investigation and memorandum of understanding (MOU—which means the Fed is closely scrutinizing MBHI—still), and last year’s resignation of the CEO and chief investment officer.
Q1/05 Earnings
I have talked with three of the four sell side analysts and none really appeared to be properly on top of their earnings models. (In general, they were too aggressive on asset growth and did not include additional amortization expense related to the unwinding of a hedge.) To their credit, the company has been trading more on CEO Giancola’s charisma anyway. I believe the honeymoon is now over, however, and that core earnings will come to drive the stock more than some relatively far-off prospect of a sale. Following are my numbers for Q1/05 (and for you non-bank analysts out there I can provide more background and explanation if necessary) which excludes a $1.3M gain ($0.05 of EPS) related to the sale of its Fannie Mae equity securities in January, which it wrote down by $10M in December.
(1) Average securities: $835M
(2) Average loans: $1255M
Average earning assets: $2090M
(3) Net interest margin (NIM): 3.00 %
Net interest income: $15.5M
(4) Loan Loss Provision: $6M
Non-interest income: $3.1M
(5) Operating expense: $12.8M
Pre-tax income: $5.2M
(6) Tax at 28% rate: $1.5M
Net Income: $3.8M
(7) Diluted Shares: 18.44M
Q1/05 EPS: $0.20 (vs. consensus of $0.22)
In the interest of time, it will be helpful to have a copy of the February 28th press release with you as you go through my analysis:
(1) I arrive at my $835 figure by taking the average securities balance figure of $965.2M for the fourth quarter, subtracting $324M of agency securities that were sold in December, and adding the $195M in MBS that were bought in January. The company also prepaid $115M in FHLB (federal home loan bank) borrowings that was costing a very expensive 5.44% (prepayment penalty of $4.2M incurred in Q4/04). The result is a securities portfolio that shrinks by $130M but has a higher margin.
(2) Period end loans at the end of the fourth quarter were $1230M, and the company will be quick to point out that this translates to 7.8% growth from the third quarter, or 30% annualized. What they don’t tell you is that they did it by purchasing $10M in hybrid mortgages and substantially increasing the loan limits of its lending officers. While there was actually decent growth, a more realistic estimate of sustainable growth is 18% or so annually, or 4% on a sequential quarter basis. That leaves me with $1280M on a period end basis and $1255M for average loan balances for the first quarter. I think this is generous and provides room on the downside.
(3) Because of a purchase accounting adjustment, the net interest margin (NIM) for the fourth quarter was 3.14%. Excluding this one time item, the NIM would have been 2.74%, vs. 2.72% in the third quarter of 2004. With the substitution of the $324M in agency securities yielding a low 3.24% for higher yielding variable mortgages yielding 4.53% and the prepayment of the $115M in FHLB borrowings I calculate the positive NIM impact to be roughly 22 basis points. (My calculations: in the fourth quarter we had $324M of agency securities which generates annual net interest income of $10.4M (324*3.24%). The $115M in FHLB borrowings cost 5.44%, or $6.3M annually. The net contribution is $4.1M (10.4-6.3). Under the new scenario, the $195M in mortgages earn $8.8M annually. The difference is $4.7M, which divided by $2090 in earning assets equals 22 basis points of additional NIM expansion.) If we add this to the third quarter’s 2.72% and add another 4 basis points of “core” expansion (although this looking less likely given the results of banks that have already released Q1 earnings), we get a 3.00% NIM for the first quarter. Expansion beyond this will likely be tough throughout the remainder of the year, particularly given that 40% of the earning assets are still securities, which are earning a fixed rate of interest (versus loans which often float with prime or Libor). Most banks have a securities portfolio of under 30%.
(4) In general, loan loss provision expense is somewhat tricky to project for banks and is often subject to manipulation. I have been conservative in estimating only $0.6M, which is equal to the third quarter of 2004, the lowest of the year. Full year 2004 was $4.2M. MBHI does have a relatively high loan loss reserve ratio (LLRR) of 1.46% (many banks have seen this fall in the last couple of years from over 1.50% to less than 1.3%), but it also has a relatively high amount of non-performing loans that actually increased from $16.7M at the end of Q3/04 to $18.1M in Q4/04. One common metric for analyzing a bank’s reserve adequacy is comparing its LLR to NPLs, which gives you a coverage ratio. LLR/NPLS was equal to 182% at the end 2004. Many regional banks are well above 200%, which means MBHI only has limited flexibility in skimping on provisions, particularly if it is growing its loans aggressively and NPAs are not decreasing. If anything, MBHI’s provision expense will be higher than my $0.6M estimate.
Non-interest income excluding the volatile trading components which have been discontinued, have been very stable not to mention relatively small. It will be near $3.1M. Reported results will include the $1.3M gain on the FNM securities.
(5) Non-interest expenses include $6.8M of compensation (Q3/04 was high because of a severance package for the previous CEO) vs. $6.6M in the fourth quarter which is probably conservative as a result of several senior officers that have recently been hired. I have projected occupancy, professional, and “other” expenses to be in line with fourth quarter results. If anything, these will be higher, as the company is preparing for its Fed examination this summer and is still working on improving accounting controls. Additionally, there will be $0.45M related to the amortization of an unwound fair value hedge that will last for 8.5 years. Most analysts have not yet incorporated this into their projections. Strangely, however, although this is stated very clearly on the February 28th press release, there is not a word of it mentioned in the 10-K.
(6) The stated tax rate is fairly low at 28%. This should actually creep up over time.
(7) Diluted share count was 18.3M in the fourth quarter. CEO Giancola was granted 150K restricted shares (over $3M) on January 1st, which vests over 5 years.
In general, I have been very generous with my assumptions and can only get to $0.20 vs. consensus of $0.22.
Other Things of Interest:
(1) The company has been tight-lipped about its recent $100M mixed shelf offering (March 28th). This is somewhat confusing because MBHI does not appear to be under-capitalized with tangible equity to assets of 5.95% (many banks operate below 5.5%) and Tier 1 equity of a fairly comfortable 13%. They do have $20M in trust preferred securities (costing 10%) that they will likely redeem in June with a lower floating rate trust preferred. Their CFO said acquisitions will likely be part of MBHI’s longer term game plan, but I find it highly unlikely that the Fed would bless any M&A activity with its memorandum still in place. And even then, I think the investment community would greet any deal with a high degree of skepticism. I did speak with one person at Howe, Barnes, the boutique investment bank that took MBHI public and trades 40% of the stock, who mentioned an equity offering might be in the works. He was uncertain about this, however. I think the shelf only adds more risk and confusion to the story. Why buy MBHI now, if the company is going to sell stock shortly and flood the supply?
(2) There may be more restructuring charges coming down the pipeline. Its fixed interest rate securities portfolio still constitutes 40% of earning assets, and will quickly become a liability in a rising rate environment.
(3) In addition to his stock grants, Giancola has personally bought stock about 40K shares between November and February at prices between 20 and $22. Buying 40K stock is easy when the company has just granted you another 150K at no cost. He now owns about 1% of the company, a genuine stake. He’ll probably have a profit on the shares when he sells the bank in a few years, but in the meantime, I suspect he wants to do everything possible to support the stock price so he can conveniently raise equity to make some acquisitions or improve the balance sheet. I don’t think the market will cooperate.
(3) I am not big on technicals, but the stock is sitting precariously on an $18 floor. Next support is at $15, 17% below the current market. At that price, MBHI still trades at 16 times earnings and 2.0 times book.
Longer Term Secular Trends Favoring a Short Thesis on Banks:
Interest rates are rising and the yield curve is flattening, typically not a good thing for banks and financial services companies. We are finally seeing market sentiment turn negative towards regional banks.
A record number of new banks have sprouted in the last five years as a result of a favorable yield curve, rising real estate prices, and amazing credit quality; an abundance of competition will keep pricing on both deposits and loans somewhat cut-throat.
Final thought:
I have called the CFO at least half a dozen times in the last month trying to get clarity on the amortization expense related to the unwinding of the hedge. There may be a legitimate reason, but he returned my call when I first started researching the company a few months ago. Now he will not. It makes me very suspicious and more confident that the quarter’s results will not be good.
Catalyst
Q1/05 earnings miss which should be released on April 29th (tomorrow).