XENITH BANKSHARES INC XBKS
October 03, 2011 - 1:23am EST by
september
2011 2012
Price: 3.50 EPS $0.00 $0.00
Shares Out. (in M): 10 P/E 0.0x 0.0x
Market Cap (in $M): 36 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 36 TEV/EBIT 0.0x 0.0x

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Description

This was my write up for admission.  It is a small company, but offers 2-3x upside over the next several years without requiring much imagination.  Not much has changed except that when I pasted my write up, some of the lines became double spaced.  Housekeeping note, I updated my tables to included the recent preferred share issuance.

Xenith Bankshares (XBKS)

Shares outstanding: 10,446,928

Price: $3.50/share

Market Capitalization: $36,564,248

Tangible Book Value: $50,771,000

Pro forma TBV: $56,771,000

Xenith Bankshares is losing money, acquiring multiple banks and recently completed a share offering.  The surrounding factors have resulted in very little attention paid to the punctuated equilibrium type shift in the bank’s balance sheet and competitive environment.  The bank faces a lot less competition today than it did several years ago, is well capitalized, and has experienced managers.  Since the bank started life in late 2009, it has shown that it will emerge as a high quality commercial bank by writing conservative loans, gathering low cost demand deposits, and achieving wide net interest margins.  The recent acquisitions have given the bank the scale to start breaking even, if not show profitability, as well as remove competitors.  

Xenith Bankshares is a midmarket and small business focused commercial bank in Virginia focused on the Richmond, Washington D.C., and Norfolk metropolitan areas.  It began life in 2008, but it wasn’t until December 2009 with the acquisition of Suffolk Bank that actual banking began.  The bank is approaching the critical mass to start reporting profits. As a commercial lender with a clean balance sheet and experienced management, Xenith should be able to produce strong results in coming years. 

 

Xenith

VBB

Paragon

Pro Forma

Loans

180,675

59,200

59,000

298,875

Total Assets

296,976

93,000

77,000

466,976

Deposits

201,951

77,000

76,000

354,951

Total Liabilities

232,156

87,000

77,000

396,156

Equity

64,820

6,000

-

70,820

Goodwill

14,049

-

-

14,049

Tangible Equity

50,771

6,000

-

56,771

Tangible Equity/Assets

17.10%

-

-

12.16% 

Thesis

An investment in Xenith is essentially a wager that management will succeed in making the bank profitable and achieving at least a 1% return on assets with a 10% tangible leverage ratio for a 10% return on equity.  Xenith has 5 years before its margin of safety in the discount of market price relative to tangible book value erodes.  

Recent transactions have given it the scale to break even within the next 2 quarters, if not report profits.  At 65% of tangible book value, Xenith only needs to earn a 1% ROA with a 10% leverage ratio for the value of an investment at today’s price to compound at 15% due to the discount.  Bigger numbers can be entertained by increasing the ROA and leverage ratio – perhaps an “optimal” commercial bank can earn a 1.5% ROA with only an 8 or 9% leverage ratio, but conservative assumptions are enough to indicate how undervalued Xenith is.  There is a lot of upside relative to the minimal risk posed by purchasing Xenith at 65% of TBV with a loan portfolio unburdened by a lot nonperforming loans or real estate owned and location in the relatively healthy and diverse Virginia economy. 

 2008-2009

In 2008, Bank Cap Partners, a bank focused PE firm, and a team of Virginia businessmen/bankers put up $35 and $5 million respectively to start a de novo commercial midmarket bank in Virginia in addition to raising another $8m from other investors.  The plan was to exploit the gap left between the customer service oriented small community banks and the large balance sheets of major banks to offer commercial loans to midmarket businesses.  Instead of a branch network, the plan was to develop relationships with technology and personalized service.  Their focus was on the metropolitan areas of Richmond and northern Virginia, which account for 70% of Virginia’s economic output and have witnessed waves of bank mergers and failures over the past 20 years. 

The best laid schemes of mice and men often go awry.  In 2008, the ability to open up a de novo bank was hampered by the regulatory infrastructure being overburdened with more pressing problems.  Xenith, at the time just a charter-less pile of capital prepared to start banking, looked to Suffolk Bank, located in southern Virginia outside of Norfolk.  Suffolk Bank started in 2003 and had three branches.  Suffolk was just a bland commercial real estate lender funded with time deposits, but allowed Xenith to start business. Xenith merged with Suffolk, massively recapitalizing it to set the stage for growth as a business lender per its original plan.  Xenith had its infrastructure set up in Richmond, while Suffolk offered a footprint in southern Virginia.  The bank set up an office in Tysons Corner in northern Virginia to serve that area. 

2010

In 2010, the bank continued to grow.  The bank focused on non-time core deposits, generating loan growth, and continuing to execute on its plan. 

The bank started 2010 with essentially all of its deposits being time deposits ($103m out of $125m).  By the end of 2010, the bank had $101m in time deposits of out $175m.  This is evidence that the bank is developing relationships with customers and not focused on showing short-term deposit growth with low quality time deposits.  The loan balance grew from $113m to $151m from the beginning to end of 2010.  A strategy focused on cultivating low cost deposits before aggressively lending is preferable to quickly growing the loan book at the expense of interest rate risk on the deposit side and credit risk on the loan side.

The bank has $3.2m in nonperforming assets, all of which were acquired from the predecessor.  A legacy loan participation from Suffolk Bank totaling $15m for hotel loans.  This portion of the loan portfolio has been underperforming and the main issue on the bank’s balance sheet.  It consists of 13 total participations, and $1.5m of the total is non-performing. This is not life threatening, but worth pointing out since this type of lending not indicative of the current management’s approach.  The bank has already provisioned losses for NPAs.

In November, the bank announced that it was going to issue additional shares to fund expansion.  This caused the share price to steadily fall.  They wanted to raise up to $42m in an offering, which is a huge amount for a company that had a $30m market capitalization at the time.  Unlike many de novo banks, Xenith’s focus on larger commercial loans means that more capital is necessary to support a loan book that is both diversified and large relative to the individual loans.  There was not enough interest and so the plan was shelved, but the damage was done in terms of looming dilution. 

2011

The bank did not complete its share offering until April at a price of $4.25/share, raising $15m for the bank.  Management and Bank Cap Partners participated in the offering and some executives have purchased additional shares at recent prices.  While some might balk at the strategy or issuing shares to expand “unprofitable” lending, this move proved prudent.  It has allowed the bank to take advantage of several opportunities that emerged in recent months. 

To rewind for a moment, when the bank started in 2009, a local Richmond paper covered the company (link).  The article covered Xenith’s strategy and mentioned some of its competitors with similar approaches.  The two banks mentioned as pursuing a similar strategy in the Richmond area were Virginia Business Bank (VBB) and Paragon Commercial Bank, which opened their Richmond offices in 2005-2006.  Due to the point in the credit cycle, it was practically impossible to have a positive outcome with a de novo bank in 2006, and so both encountered problems in recent years.

In July, Xenith announced that it was acquiring the deposits and performing loans from Paragon’s Richmond branch and it was taking over VBB from the FDIC.  This is where the opportunity becomes interesting, because the transactions are complicated on the face of it and the surrounding details translucent. 

In an apt demonstration of evolution by punctuated equilibrium, Xenith bank is the sole survivor in its niche with a strong capital base.  These transactions should give Xenith the scale necessary for profitability as well as reduce their competition for future business.  Both are manageable in size, give Xenith the scale approach profitability, and match the lending demographics and geography.  In addition, by taking out 2 direct competitors, Xenith is in a better position to gather low cost deposits of the businesses it lends to as a contingency of the overall relationship with customers.  This will boost the net interest margin on the acquired assets as well as Xenith’s in coming quarters.

The benefits are plentiful:

-       non dilutive accretion to operating income

-       non dilutive accretion to equity (VBB only)

-       removal of two direct competitors in Richmond area

o   increased leverage to develop deposit relationship with borrowers

-       increased scale to drive bank to profitability

Paragon Acquisition

Paragon Commercial Bank is a commercial bank from North Carolina.  They expanded into Virginia in the prior decade, but losses are forcing them to retrench and focus just on their NC operations.  The details of the transaction are limited in terms of types of loans or deposits, but it is not impossible to understand the impact on Xenith’s balance sheet.

 

Xenith

Paragon

Pro Forma

Loans

180,675

59,000

239,675

Total Assets

296,976

77,000

373,976

Deposits

201,951

76,000

277,951

Total Liabilities

232,156

77,000

309,156

Equity

64,820

-

64,820

Goodwill

14,049

-

14,049

Tangible Equity

50,771

-

50,771

Tangible Equity/Assets

17.10%

-

13.58%

Xenith did not acquire any of the Paragon’s non-performing loans.  They chose which loans they wanted to take on their books and they are all in the area with which management is familiar.  The deposit premium was equivalent to the asset discount in dollar terms, and the difference between assets and liabilities was made up by a cash contribution from Paragon.  Xenith announced that all of Paragon’s Richmond staff would be kept, but they are being consolidated into Xenith’s office space. 

Paragon is a privately held commercial bank primarily based in North Carolina with $1 billion in assets, so it is difficult to assign what are the yields on the loans or deposits or the salaries of the personnel since those acquired are just a fraction of much larger organization.  According to the press release, the acquired deposits were described as primarily non-time “core” deposits. Using Paragon’s percentage figures for the whole organization based on the 6/30/11 call report – 4.63% interest-earning asset yield, 1.97% interest bearing liability yield, and 1.86% non interest expense to assets ratio - the annualized earnings impact is from the acquired assets and liabilities are calculated as:

 

Contribution

Yield

Interest Income

 2,732

4.63%

Interest Expense

 1,497

1.97%

Net Interest Income

 1,235

2.09%

Noninterest Expense

 1,432

 

Pretax Income

 (198)


Noninterest income was negligible at Paragon as a whole, but the earnings as a result of the acquisition are likely to be positive since occupancy costs will become redundant and interest expense is likely overstated (calculated as a % of assets).  There are also marginal costs such as IT systems that don’t need duplication, which on the whole are negligible, but would put the acquisition in the black since the implied loss is just $198,000.  The noninterest expense is calculated as a percentage of acquired assets, which almost certainly is inaccurate.  Since their 10 employees are being incorporated into existing Xenith space and infrastructure, $143k/person seems rather steep.  If the interest expense is overstated since Paragon’s overall interest expense is skewed towards time deposits, it would also result in a positive pretax income figure.  It serves as a basis for estimation.

Virginia Business Bank Transaction

Virginia Business Bank (VBB) has been a struggling commercial bank in Richmond over the past several years.  They opened in 2006, which like Paragon, practically invited failure due to the point in the credit cycle.  VBB struggled to raise additional capital and stem losses as the economy entered recession and was taken over by the FDIC.  Xenith agreed to acquire the bank without a loss share agreement (LSA) stating that they were familiar with the local businesses to which VBB lent.  In exchange though, the FDIC was willing to let Xenith acquire the bank with a high asset discount relative to performing assets, in effect increasing Xenith’s equity.

 

Xenith

VBB

Pro Forma

Loans

180,675

59,200

239,875

Gross Loans

 

70,000

 

Cash

19,278

13,500

32,778

FDIC Cash Contribution

-

17,800

-

OREO

0

2,500

2,500

Total Assets

296,976

93,000

389,976

Deposits

201,951

77,000

278,951

Total Liabilities

232,156

87,000

319,156

Equity

64,820

-

70,820

Goodwill

14,049

-

14,049

Tangible Equity

50,771

-

56,771

Tangible Equity/Assets

17.10%

-

14.56%

This deal is unattractive and hard to follow at first glance because the gross value of the assets acquired is all that was stated in the initial press releases on the VBB acquisition, while the asset discount is only disclosed 8-K filing in which the press release is an exhibit.  In addition, it is necessary to use regulatory filings to understand what exactly was acquired.  The assets that will appear on Xenith’s balance sheet substantially differ from what one would be led to believe.

 

Actual

8-K/10-Q

VBB Call (6/30)*

Press Release

Loans

59,200

70,000

63,100

69,000

Cash

13,500

n/a

13,700

n/a

FDIC Cash

17,800

17,800

n/a

n/a

OREO

2,500

n/a

2,500

n/a

Asset Discount

 

-23,800

n/a

n/a

Total Assets

93,000

93,000

79,300

86,000

*loans adjusted net of nonaccruals

 

The company’s 7/29/11 press release on the acquisition:

"Xenith Bank acquires approximately $86 million in assets, including approximately $69 million in loans; and assumes $82 million in liabilities, including deposits of approximately $73 million."

From the company’s 6/30/11 10-Q, filed 8/12/11 (identical in 8-K filed on 8/4/11):

"Based upon a preliminary closing with the FDIC as of July 29, 2011, the Bank acquired total assets of approximately $93 million, including approximately $70 million in loans. The Bank also assumed liabilities of approximately $87 million, including approximately $77 million in deposits."

From the 6/30/11 Call Report, VBB had $69m in gross loans, $61.3m in loans net of $7.7m in past due and nonaccruals, $13.7m in cash, $2.5m in OREO, $83.5m in total assets, $73m in deposits, and $83.5m in total liabilities (payables and FHLB advances).  Of the $69m in gross loans, $56m are commercial and residential mortgages that have been seasoned, so it is not a cesspool of construction, development, or land loans that Xenith will be stuck sorting out.  These numbers have obviously shifted between the filing and July 29, but provide enough information as to what Xenith will look like going forward. The bank’s non-loan, non-REO assets were substantially cash, so the impact from the annualized run-rate operations in the worst-case scenario based on asset/liability yields and salaries from their 6/30/11 call report should contribute the following based on the figures in the “actual” column above:

 

Contribution

Yield

Interest Income

 3,078

5.20%

Interest Expense

 1,471

1.91%

Net Interest Income

 1,608

1.73%

Noninterest Expense

1,700

 

Pretax Income

 (92)


Instead of acquiring $93m in VBB’s assets, Xenith is really acquiring a total of $71.2m in clean assets from VBB comprised of cash and heavily discounted but performing loans plus $17.8m in cash from the FDIC.  Of the $93m in gross assets that Xenith reports acquiring, at least $31.3m is cash and around $59m is performing loans.  Xenith is getting an additional $7.7m in nonaccrual loans already marked down to zero, in which they gain from any recovery.  The total assets ($31.3m cash, $59.2m performing loans, $2.5m OREO) exceed the total liabilities ($87m) by $6m, which is essentially what the FDIC is paying Xenith to take on VBB. 

VBB, which was headquartered in Richmond, had 11 employees.  While the employees from Paragon’s Richmond branch are all staying with Xenith, no decision has been made about retaining VBB’s employees.  There are clear redundancies, but the relationships loan officers have developed at VBB might be considered important. Any employees would be consolidated into Xenith’s Richmond office, so salary and some additional computers and post it notes will be the only expenses.  The noninterest expense calculated above is simply VBB’s first 6 months of salary and benefits annualized according to their call report. 

VBB’s deposits are almost entirely time deposits.  This indicates that VBB was a low quality bank, if its failure wasn’t enough of an indication.  The benefit of taking out a low quality competitor in a market place is that a firm desperate to undercut others on price to generate business is no longer around.  While VBB’s loans were acquired at a steep discount, the deposits/liabilities get assumed at face value and are mostly high cost funding.  Xenith has proved competent at growing its core deposit balances though and interest rates are low, so while the initial deposit figures will look uglier, they should revert to lower cost and higher quality deposits over the next year.  Xenith can also leverage its lending relationship with former VBB customers to include deposits. 

Acquisition Risk

Bank transactions are notorious for under delivering.  Xenith is in a different situation from a risk/reward since it is not paying anything.  This is debatable if one wants to point to the share issuance at a discount to TBV, but this is shadowed by the opportunity cost were Xenith to a) pass on very cheap assets it is acquiring and b) open the potential of a new competitor entering the market/reduce its competition.  In fact, the equity part of the VBB transaction goes some way towards reducing the TBV/share dilution of the past offering.  There were other bidders for VBB, so the potential for new entrants is not a pure fantasy.  As the weak NIMs at both Paragon and VBB relative to Xenith show, there is room for improving the returns.  Xenith can also expand its own pre-transaction NIMs as well due to reduced competition. 

Xenith is only acquiring additional assets in the Richmond area.  Its existing presence, and clear redundancies from the acquired banks indicate that this will be a successful integration.  Xenith was initially started with the infrastructure to scale up and support a larger organization, so the increase in assets and expenses is factored in somewhat to the business plan.

When will the bank be profitable?

This is the crux of the investment opportunity.  The real answer is that it is hard to tell.  De novo banks typically take 2-3 years before showing profits and Xenith is really only one year in operation.  In the most recent quarter, Xenith lost $1m.  The bank has $56m in pro forma tangible capital compared to a market capitalization of $36m.  It can continue at its current run rate for over 5 years before the margin of safety in the bank’s liquidation value is at risk.  Results since management took over in December 2009 look like this (they don’t really tell much):

 

Quarter Ended

6/30/11

3/31/11

12/31/10

9/30/10

6/30/10

3/31/10

Net Interest Income*

 2,861

 2,766

 2,662

 2,326

 2,096

 1,515

Quarterly Growth

3.43%

3.91%

14.45%

10.97%

38.35%

 

Noninterest Expense

 3,482

 3,416

 2,962

 3,343

 3,647

 3,049

Net Income (Loss)

 (1,083)

 (1,474)

 (924)

 (1,950)

 (1,940)

 (1,102)

*pre provision (all nonaccruals result from before current management)

The recent transactions go a long way towards making Xenith profitable as will continued progress with the core operations.  Both transactions will be able to operate on Xenith’s existing infrastructure as Xenith’s Richmond and northern Virginia presence are based out of single offices and not branch networks. This creates a lot of operating leverage as Xenith reaches critical mass. 

Xenith’s operations so far have been indicative of a bank that will have high quality earnings when it reaches the proper scale.  The predecessor bank, on 9/30/10, had 85% of its deposits comprised of time deposits.  As of June 30, 2011, Xenith has 53% of its deposits as non-time core deposits, which is the proper direction for the bank to move.  In terms of protecting the TBV and margin of safety that stems from it, the slow bleed of drawing in funding before lending it out if preferable to the gaping wounds that would be caused by rapidly underwriting poor credit quality loans on the back of interest rate risk from time deposits. 

They appear to be offering a pretty high rate on money market accounts as the rate on demand and money market accounts was 0.90% as of 6/30/10.  Xenith pays higher rates the larger money market balances are (as of 8/28/11 check, 0.80% for $100-250k, 1.00% for $250k+).  If you enter an out of state zip code on their website to check the rates, they tell you they won't accept your deposits.  Xenith still has wide NIMs though, so the above average interest rate on money market accounts is only worrisome in isolation.  The interest rate can be interpreted as the bank developing relationships with businesses that will open up lending opportunities since the deposit balances are large.  They have let brokered deposits run off that were from its predecessor.  The removal of Paragon and VBB from the competitive landscape should allow Xenith room to possibly lower their own funding rates excluding the transactions.

Over the next year, Xenith will have an opportunity to reprice VBB’s deposits, which are entirely comprised of high yield time deposits – costing 1.91% as of 6/30/11.  Their interest yielding assets, which are entirely comprised of loans or deposits at other banks, earned 5.52% as of 6/30/11.  If Xenith were to roll over all the deposits and loans to their cost structure in addition to only keeping 6 of VBB’s 11 employees at $75k salaries, the contribution of the VBB transaction would look like this:

 

Contribution

Rate

Interest Income

 3,730

6.30%

Interest Expense

 853

0.98%

Net Interest Income

 2,877

 

Noninterest Expense

 450

 

Pretax Income

 2,427


Paragon offers even more room for margin expansion based on the extrapolation of their company wide yields to the assets and liabilities acquired – any error in the aforementioned projection of the earnings from the Paragon transactions are understating the earnings potential rather than overstating.  Xenith earned 6.30% on their loans and interest bearing liabilities yielded 0.98% as of June 30, 2011 compared to 4.63% on interest earning assets and 1.97% respectively for Paragon.  Xenith is mostly acquiring loans and cash from Paragon though, so the yield on interest earning assets acquired is higher in all probability due to an absence of a securities portfolio.  Xenith is keeping all of Paragon’s 10 Richmond employees.  Using salaries of $75k for all 10 is what comprises the noninterest expense since as previously stated, the staff is being incorporated into existing Xenith space. 

 

Contribution

Rate

Interest Income

 3,717

6.30%

Interest Expense

 745

0.98%

Net Interest Income

 2,972

 

Noninterest Expense

 750

 

Pretax Income

 2,222


These projected improvements would gradually occur over the next year or two as commercial loans are repaid or refinanced and time deposits reprice.  Management disclosed that most of the acquired deposits in the Paragon deal were non-time core deposits, so the original projected interest expense may already be closer to Xenith’s overall funding expenses. 

Even though Paragon and VBB have a poor relative underwriting history judging from the problems they’ve experienced, Xenith is acquiring only performing loans from Paragon and heavily discounted loans from VBB.  Even though credit standards are tighter now than 2006, the loan acquisitions give Xenith scale that would otherwise have to be achieved by rapidly underwriting loans.  A more seasoned loan portfolio puts Xenith in a stronger position to pass on lesser opportunities. 

De novo banks typically take 2-3 years to turn profitable.  Xenith started in December 2009, albeit by absorbing an existing bank.  Suffolk Bank, the acquired bank, was mediocre at best.  Its deposits were almost entirely time deposits and core operations were marginally profitable excluding provisions.  It’s last 10-Q before it was acquired by Xenith for 9/30/10 showed a net interest margin of 2.71% compared to Xenith’s current 4.35% NIM.  Suffolk has 3 branches, which result in high fixed costs relative to the business model Xenith is trying to execute.

The 3 branches inherited from Suffolk clearly don’t conform to the company’s strategy.  Consolidating them into a single location would reduce fixed costs, although Xenith is likely focused on growing loans and deposits for the time being.  There would be restructuring costs from severance and costs in terms of management’s distraction dealing with it.  This is essentially the cost of starting the bank, except it did not come in the usual form of expenses for getting a bank charter and investment banking fees for a share offering to raise capital. 

On a longer time frame, the bank should be quite profitable as a result of low costs.  Customers use check-scanning machines to deposit checks in their accounts and Xenith will ideally only have one location for each region it serves.  This keeps fixed costs lower and should result in a low efficiency ratio combined with the wide NIMs typical of commercial banking, which is ultimately a recipe for success. 

As with a bank that needs to grow its balance sheet, the focus should be on quality over quantity.  The bank has been disciplined by maintaining and 80% loan/deposit ratio.  Their focus has been on C&I and CRE lending.  There are no construction, land, or development loans.  The impression from the balance sheet and the stated strategy indicate that Xenith is a high quality lender that will be able to intelligently and effectively compete for commercial lending relationships.  There's no need to rush lending in a weak economy.

Valuation

There is a certain futility in projecting what type of returns Xenith will earn in the future and at what point.  The variety of factors put together such as lower competition, experienced management, a fortuitous geography, and the right idea indicate that Xenith will be capable of compounding book value at a high single digit or low teens clip.  To purchase it for $36m against a tangible book value of $56m seems like a good deal since things don’t need to pan out well to make money. 

The bank could continue to lose $6m/year for the next 2 years before turning profitable, at which point the market might pay 1x TBV for Xenith on the premise of impending profitability and an investor at today’s prices would still make 20%.  This seems quite unlikely considering the boost that the recent transactions will have combined with the progress the company has made so far. 

If the bank breaks even this year and then increases its return on equity 250 basis points per annum, it will have $63m in tangible equity at the end of year five.  If the market awards a 1.5x TBV book value on the assumption that Xenith will likely increase its ROE an additional 250 basis points until it reaches a 15% ROE, the business would be worth $95m.  A 10% discount rate implies a net present value of $59m, or 63% above current prices.  An investor would make 163% or 21.4% compounded.  Permutations of growth rates, exact quarter in which profitability is achieved, discount rates, and market multiples can all be toyed around with, but no calculation will be any closer to reality.   

You could also assume a 9% TBV leverage ratio on $56-63m in TBV, that is $622-700m in assets.  A 1% ROA for a commercial bank of the quality that XBKS is headed towards is conservative but would imply $6-7m in normalized earnings.  The current price is 5-6x normalized earnings.  The second we jack up the ROA to 1.2%, it's $7-8.5m in normalized earnings.  If they hit 1.5% ROA once the economy recovers down the line, we're whistling dixie.  You can assume an 8% leverage ratio and toy around with the ROA to your hearts content. Good things come to those who wait.

Tangible book value is 50% higher than the current market price.  As the market begins to understand the recent transactions, especially VBB, it should recognize that Xenith is approaching profitability in the near term and better positioned in the long term.  This should act as a short-term catalyst, although a 5 year investment time frame is far more appealing.

On the downside, Xenith seems to worth about 50% more.  On the upside, an investment at $3.50/share can lead to high teens to low twenties rate of compounding.

Management and Bank Cap Partners

Management is experienced and has a stake in the business.  Management and the board purchased additional shares in the April offering, somewhat unique for a share offering by a bank in the past several years.  There have been additional share purchases by management in August, including the CEO. 

The management team is comprised of several senior executives from Signet Bank, a Virginia bank that spun of Capital One in the mid 90s and was purchased in 1997 by First Union, one of the two banks that merged into Wachovia.  T. Gaylon Layfield, the CEO, was the Preisdent and COO of Signet.  Several other Xenith executives were in senior positions at Signet as well.  All executives have held senior positions are other banks, primarily in Virginia.  That they've grown C&I lending to a large part of the loan book (45%), a predonimantly relationship based form of lending, is a very positive sign that these guys know what they're doing, or at least the right people.

Most encouraging for a bank executive, the Regional President of the northern Virginia office is a golf course rater for Golf Week Magazine.  This is evidence that Xenith is a following the successful banking model of 3-6-3.  Borrow at 3%, lend at 6%, and out on the golf course by 3.

Below outlines direct ownership of shares, which excludes options.  Although the CEO owns shares worth more than his 2010 compensation, his compensation is likely depressed due to keeping expenses low in the ramp up phase.  There is a level of inside ownership for a $35m company that indicates management has some skin in the game.

Name

Position

Shares

Value @ $3.50

% of Company

Layfield

CEO

114,000

$399,000

1.09%

Cottrell

EVP, Chief Credit Officer

28,600

$100,100

0.27%

Osgood

EVP, CFO, CAO, Treasurer

48,500

$169,750

0.46%

Davis

EVP, Secretary

14,582

$51,037

0.14%

O'Flaherty

EVP

20,900

$73,150

0.20%

McDonald

Director

53,500

$187,250

0.51%

Gavant

Principal Accounting Officer

11,500

$40,250

0.11%

Garson

Director

35,982

$125,937

0.34%

Merrick

Director

35,400

$123,900

0.34%

Hanley

Director

12,000

$42,000

0.11%

Total

 

374,964

$1,312,374

3.59%

BCP

Bank Cap Partners

3,280,000

$11,480,000

31.40% 

Bank Cap Partners is a private equity firm focused on banking.  Bank Cap has investments in just 3 small banks.  Their strategy is to focus on the space in between the large banks and small banks.  It is essentially a repetition of Xenith’s mission, but they focus on de novo or recapitalizing existing banks and focusing them on commercial middle market companies and private banking clients.  Bank Cap seeks out management teams and provides a chunk of the capital.  While it does not entirely mitigate the risk of a large shareholder having control, Bank Cap’s ownership is on the same terms as other shareholders and their strategy is articulated and intelligent.

Recent Developments

This was written up a month ago.  Really the only thing that has changed is the $8.3m preferred stock issuance as part of the Treasury's Small Business Lending Fund.  I treat it as a liability, but it counts towards tier 1 capital (the bank has plenty already).  The interest rate is 1.53% even though the dividend is 1% due to the tax treatment.  This is higher than they would pay on a CD, but is a longer term source of funding without the abstract risk of rate shopping.  Interpret this as you will, but the bank is not short on capital, they are short on funding.  This could be interpreted as Xenith finding loans to underwrite.  The preferred is non dilutive and doesn't come with any strings attached.  The interest rate is contingent on how much small business lending Xenith does and that's pretty much all they do, so the rate should remain at 1%.

Risks

In November 2010, the bank wanted to raise an additional $42m.  They only managed to raise about $15m in their April 2011 offering.  If they were to issue shares at current prices, it would be quite dilutive to tangible book value.  If there is another offering and the share price doesn’t improve between now and when the market attaches a more rational valuation to the company, it would lower the projected returns.  Adjusted for the recent transactions, Xenith has a leverage ratio of 12%, so it still has capital to expand its loan book before issuing more shares to fund growth. 

There are the obvious risks such as an even weaker economy, continued competitive pressures from remaining banks coping with low interest rates, and general banking issues such as credit and interest rate risks.  The only way to protect against this is to purchase with a margin of safety, which appears to exist.

Conclusion

An investment in Xenith Bankshares (XBKS) at today’s price, $3.50/share or 65% of tangible book value, provides an investor with a wide margin of safety and asymmetric risk/reward due to the growth runway that Xenith is on for the next decade.  A clearly articulated strategy of focusing on a service oriented midmarket commercial bank with a low cost infrastructure is a strategic framework that is reinforced by the presence of Bank Cap partners and should provide a rational guide for the bank’s development. 

Catalyst

Time and the release of Q-10 for quarter ended Sept. 30, 2011.
    sort by    

    Description

    This was my write up for admission.  It is a small company, but offers 2-3x upside over the next several years without requiring much imagination.  Not much has changed except that when I pasted my write up, some of the lines became double spaced.  Housekeeping note, I updated my tables to included the recent preferred share issuance.

    Xenith Bankshares (XBKS)

    Shares outstanding: 10,446,928

    Price: $3.50/share

    Market Capitalization: $36,564,248

    Tangible Book Value: $50,771,000

    Pro forma TBV: $56,771,000

    Xenith Bankshares is losing money, acquiring multiple banks and recently completed a share offering.  The surrounding factors have resulted in very little attention paid to the punctuated equilibrium type shift in the bank’s balance sheet and competitive environment.  The bank faces a lot less competition today than it did several years ago, is well capitalized, and has experienced managers.  Since the bank started life in late 2009, it has shown that it will emerge as a high quality commercial bank by writing conservative loans, gathering low cost demand deposits, and achieving wide net interest margins.  The recent acquisitions have given the bank the scale to start breaking even, if not show profitability, as well as remove competitors.  

    Xenith Bankshares is a midmarket and small business focused commercial bank in Virginia focused on the Richmond, Washington D.C., and Norfolk metropolitan areas.  It began life in 2008, but it wasn’t until December 2009 with the acquisition of Suffolk Bank that actual banking began.  The bank is approaching the critical mass to start reporting profits. As a commercial lender with a clean balance sheet and experienced management, Xenith should be able to produce strong results in coming years. 

     

    Xenith

    VBB

    Paragon

    Pro Forma

    Loans

    180,675

    59,200

    59,000

    298,875

    Total Assets

    296,976

    93,000

    77,000

    466,976

    Deposits

    201,951

    77,000

    76,000

    354,951

    Total Liabilities

    232,156

    87,000

    77,000

    396,156

    Equity

    64,820

    6,000

    -

    70,820

    Goodwill

    14,049

    -

    -

    14,049

    Tangible Equity

    50,771

    6,000

    -

    56,771

    Tangible Equity/Assets

    17.10%

    -

    -

    12.16% 

    Thesis

    An investment in Xenith is essentially a wager that management will succeed in making the bank profitable and achieving at least a 1% return on assets with a 10% tangible leverage ratio for a 10% return on equity.  Xenith has 5 years before its margin of safety in the discount of market price relative to tangible book value erodes.  

    Recent transactions have given it the scale to break even within the next 2 quarters, if not report profits.  At 65% of tangible book value, Xenith only needs to earn a 1% ROA with a 10% leverage ratio for the value of an investment at today’s price to compound at 15% due to the discount.  Bigger numbers can be entertained by increasing the ROA and leverage ratio – perhaps an “optimal” commercial bank can earn a 1.5% ROA with only an 8 or 9% leverage ratio, but conservative assumptions are enough to indicate how undervalued Xenith is.  There is a lot of upside relative to the minimal risk posed by purchasing Xenith at 65% of TBV with a loan portfolio unburdened by a lot nonperforming loans or real estate owned and location in the relatively healthy and diverse Virginia economy. 

     2008-2009

    In 2008, Bank Cap Partners, a bank focused PE firm, and a team of Virginia businessmen/bankers put up $35 and $5 million respectively to start a de novo commercial midmarket bank in Virginia in addition to raising another $8m from other investors.  The plan was to exploit the gap left between the customer service oriented small community banks and the large balance sheets of major banks to offer commercial loans to midmarket businesses.  Instead of a branch network, the plan was to develop relationships with technology and personalized service.  Their focus was on the metropolitan areas of Richmond and northern Virginia, which account for 70% of Virginia’s economic output and have witnessed waves of bank mergers and failures over the past 20 years. 

    The best laid schemes of mice and men often go awry.  In 2008, the ability to open up a de novo bank was hampered by the regulatory infrastructure being overburdened with more pressing problems.  Xenith, at the time just a charter-less pile of capital prepared to start banking, looked to Suffolk Bank, located in southern Virginia outside of Norfolk.  Suffolk Bank started in 2003 and had three branches.  Suffolk was just a bland commercial real estate lender funded with time deposits, but allowed Xenith to start business. Xenith merged with Suffolk, massively recapitalizing it to set the stage for growth as a business lender per its original plan.  Xenith had its infrastructure set up in Richmond, while Suffolk offered a footprint in southern Virginia.  The bank set up an office in Tysons Corner in northern Virginia to serve that area. 

    2010

    In 2010, the bank continued to grow.  The bank focused on non-time core deposits, generating loan growth, and continuing to execute on its plan. 

    The bank started 2010 with essentially all of its deposits being time deposits ($103m out of $125m).  By the end of 2010, the bank had $101m in time deposits of out $175m.  This is evidence that the bank is developing relationships with customers and not focused on showing short-term deposit growth with low quality time deposits.  The loan balance grew from $113m to $151m from the beginning to end of 2010.  A strategy focused on cultivating low cost deposits before aggressively lending is preferable to quickly growing the loan book at the expense of interest rate risk on the deposit side and credit risk on the loan side.

    The bank has $3.2m in nonperforming assets, all of which were acquired from the predecessor.  A legacy loan participation from Suffolk Bank totaling $15m for hotel loans.  This portion of the loan portfolio has been underperforming and the main issue on the bank’s balance sheet.  It consists of 13 total participations, and $1.5m of the total is non-performing. This is not life threatening, but worth pointing out since this type of lending not indicative of the current management’s approach.  The bank has already provisioned losses for NPAs.

    In November, the bank announced that it was going to issue additional shares to fund expansion.  This caused the share price to steadily fall.  They wanted to raise up to $42m in an offering, which is a huge amount for a company that had a $30m market capitalization at the time.  Unlike many de novo banks, Xenith’s focus on larger commercial loans means that more capital is necessary to support a loan book that is both diversified and large relative to the individual loans.  There was not enough interest and so the plan was shelved, but the damage was done in terms of looming dilution. 

    2011

    The bank did not complete its share offering until April at a price of $4.25/share, raising $15m for the bank.  Management and Bank Cap Partners participated in the offering and some executives have purchased additional shares at recent prices.  While some might balk at the strategy or issuing shares to expand “unprofitable” lending, this move proved prudent.  It has allowed the bank to take advantage of several opportunities that emerged in recent months. 

    To rewind for a moment, when the bank started in 2009, a local Richmond paper covered the company (link).  The article covered Xenith’s strategy and mentioned some of its competitors with similar approaches.  The two banks mentioned as pursuing a similar strategy in the Richmond area were Virginia Business Bank (VBB) and Paragon Commercial Bank, which opened their Richmond offices in 2005-2006.  Due to the point in the credit cycle, it was practically impossible to have a positive outcome with a de novo bank in 2006, and so both encountered problems in recent years.

    In July, Xenith announced that it was acquiring the deposits and performing loans from Paragon’s Richmond branch and it was taking over VBB from the FDIC.  This is where the opportunity becomes interesting, because the transactions are complicated on the face of it and the surrounding details translucent. 

    In an apt demonstration of evolution by punctuated equilibrium, Xenith bank is the sole survivor in its niche with a strong capital base.  These transactions should give Xenith the scale necessary for profitability as well as reduce their competition for future business.  Both are manageable in size, give Xenith the scale approach profitability, and match the lending demographics and geography.  In addition, by taking out 2 direct competitors, Xenith is in a better position to gather low cost deposits of the businesses it lends to as a contingency of the overall relationship with customers.  This will boost the net interest margin on the acquired assets as well as Xenith’s in coming quarters.

    The benefits are plentiful:

    -       non dilutive accretion to operating income

    -       non dilutive accretion to equity (VBB only)

    -       removal of two direct competitors in Richmond area

    o   increased leverage to develop deposit relationship with borrowers

    -       increased scale to drive bank to profitability

    Paragon Acquisition

    Paragon Commercial Bank is a commercial bank from North Carolina.  They expanded into Virginia in the prior decade, but losses are forcing them to retrench and focus just on their NC operations.  The details of the transaction are limited in terms of types of loans or deposits, but it is not impossible to understand the impact on Xenith’s balance sheet.

     

    Xenith

    Paragon

    Pro Forma

    Loans

    180,675

    59,000

    239,675

    Total Assets

    296,976

    77,000

    373,976

    Deposits

    201,951

    76,000

    277,951

    Total Liabilities

    232,156

    77,000

    309,156

    Equity

    64,820

    -

    64,820

    Goodwill

    14,049

    -

    14,049

    Tangible Equity

    50,771

    -

    50,771

    Tangible Equity/Assets

    17.10%

    -

    13.58%

    Xenith did not acquire any of the Paragon’s non-performing loans.  They chose which loans they wanted to take on their books and they are all in the area with which management is familiar.  The deposit premium was equivalent to the asset discount in dollar terms, and the difference between assets and liabilities was made up by a cash contribution from Paragon.  Xenith announced that all of Paragon’s Richmond staff would be kept, but they are being consolidated into Xenith’s office space. 

    Paragon is a privately held commercial bank primarily based in North Carolina with $1 billion in assets, so it is difficult to assign what are the yields on the loans or deposits or the salaries of the personnel since those acquired are just a fraction of much larger organization.  According to the press release, the acquired deposits were described as primarily non-time “core” deposits. Using Paragon’s percentage figures for the whole organization based on the 6/30/11 call report – 4.63% interest-earning asset yield, 1.97% interest bearing liability yield, and 1.86% non interest expense to assets ratio - the annualized earnings impact is from the acquired assets and liabilities are calculated as:

     

    Contribution

    Yield

    Interest Income

     2,732

    4.63%

    Interest Expense

     1,497

    1.97%

    Net Interest Income

     1,235

    2.09%

    Noninterest Expense

     1,432

     

    Pretax Income

     (198)


    Noninterest income was negligible at Paragon as a whole, but the earnings as a result of the acquisition are likely to be positive since occupancy costs will become redundant and interest expense is likely overstated (calculated as a % of assets).  There are also marginal costs such as IT systems that don’t need duplication, which on the whole are negligible, but would put the acquisition in the black since the implied loss is just $198,000.  The noninterest expense is calculated as a percentage of acquired assets, which almost certainly is inaccurate.  Since their 10 employees are being incorporated into existing Xenith space and infrastructure, $143k/person seems rather steep.  If the interest expense is overstated since Paragon’s overall interest expense is skewed towards time deposits, it would also result in a positive pretax income figure.  It serves as a basis for estimation.

    Virginia Business Bank Transaction

    Virginia Business Bank (VBB) has been a struggling commercial bank in Richmond over the past several years.  They opened in 2006, which like Paragon, practically invited failure due to the point in the credit cycle.  VBB struggled to raise additional capital and stem losses as the economy entered recession and was taken over by the FDIC.  Xenith agreed to acquire the bank without a loss share agreement (LSA) stating that they were familiar with the local businesses to which VBB lent.  In exchange though, the FDIC was willing to let Xenith acquire the bank with a high asset discount relative to performing assets, in effect increasing Xenith’s equity.

     

    Xenith

    VBB

    Pro Forma

    Loans

    180,675

    59,200

    239,875

    Gross Loans

     

    70,000

     

    Cash

    19,278

    13,500

    32,778

    FDIC Cash Contribution

    -

    17,800

    -

    OREO

    0

    2,500

    2,500

    Total Assets

    296,976

    93,000

    389,976

    Deposits

    201,951

    77,000

    278,951

    Total Liabilities

    232,156

    87,000

    319,156

    Equity

    64,820

    -

    70,820

    Goodwill

    14,049

    -

    14,049

    Tangible Equity

    50,771

    -

    56,771

    Tangible Equity/Assets

    17.10%

    -

    14.56%

    This deal is unattractive and hard to follow at first glance because the gross value of the assets acquired is all that was stated in the initial press releases on the VBB acquisition, while the asset discount is only disclosed 8-K filing in which the press release is an exhibit.  In addition, it is necessary to use regulatory filings to understand what exactly was acquired.  The assets that will appear on Xenith’s balance sheet substantially differ from what one would be led to believe.

     

    Actual

    8-K/10-Q

    VBB Call (6/30)*

    Press Release

    Loans

    59,200

    70,000

    63,100

    69,000

    Cash

    13,500

    n/a

    13,700

    n/a

    FDIC Cash

    17,800

    17,800

    n/a

    n/a

    OREO

    2,500

    n/a

    2,500

    n/a

    Asset Discount

     

    -23,800

    n/a

    n/a

    Total Assets

    93,000

    93,000

    79,300

    86,000

    *loans adjusted net of nonaccruals

     

    The company’s 7/29/11 press release on the acquisition:

    "Xenith Bank acquires approximately $86 million in assets, including approximately $69 million in loans; and assumes $82 million in liabilities, including deposits of approximately $73 million."

    From the company’s 6/30/11 10-Q, filed 8/12/11 (identical in 8-K filed on 8/4/11):

    "Based upon a preliminary closing with the FDIC as of July 29, 2011, the Bank acquired total assets of approximately $93 million, including approximately $70 million in loans. The Bank also assumed liabilities of approximately $87 million, including approximately $77 million in deposits."

    From the 6/30/11 Call Report, VBB had $69m in gross loans, $61.3m in loans net of $7.7m in past due and nonaccruals, $13.7m in cash, $2.5m in OREO, $83.5m in total assets, $73m in deposits, and $83.5m in total liabilities (payables and FHLB advances).  Of the $69m in gross loans, $56m are commercial and residential mortgages that have been seasoned, so it is not a cesspool of construction, development, or land loans that Xenith will be stuck sorting out.  These numbers have obviously shifted between the filing and July 29, but provide enough information as to what Xenith will look like going forward. The bank’s non-loan, non-REO assets were substantially cash, so the impact from the annualized run-rate operations in the worst-case scenario based on asset/liability yields and salaries from their 6/30/11 call report should contribute the following based on the figures in the “actual” column above:

     

    Contribution

    Yield

    Interest Income

     3,078

    5.20%

    Interest Expense

     1,471

    1.91%

    Net Interest Income

     1,608

    1.73%

    Noninterest Expense

    1,700

     

    Pretax Income

     (92)


    Instead of acquiring $93m in VBB’s assets, Xenith is really acquiring a total of $71.2m in clean assets from VBB comprised of cash and heavily discounted but performing loans plus $17.8m in cash from the FDIC.  Of the $93m in gross assets that Xenith reports acquiring, at least $31.3m is cash and around $59m is performing loans.  Xenith is getting an additional $7.7m in nonaccrual loans already marked down to zero, in which they gain from any recovery.  The total assets ($31.3m cash, $59.2m performing loans, $2.5m OREO) exceed the total liabilities ($87m) by $6m, which is essentially what the FDIC is paying Xenith to take on VBB. 

    VBB, which was headquartered in Richmond, had 11 employees.  While the employees from Paragon’s Richmond branch are all staying with Xenith, no decision has been made about retaining VBB’s employees.  There are clear redundancies, but the relationships loan officers have developed at VBB might be considered important. Any employees would be consolidated into Xenith’s Richmond office, so salary and some additional computers and post it notes will be the only expenses.  The noninterest expense calculated above is simply VBB’s first 6 months of salary and benefits annualized according to their call report. 

    VBB’s deposits are almost entirely time deposits.  This indicates that VBB was a low quality bank, if its failure wasn’t enough of an indication.  The benefit of taking out a low quality competitor in a market place is that a firm desperate to undercut others on price to generate business is no longer around.  While VBB’s loans were acquired at a steep discount, the deposits/liabilities get assumed at face value and are mostly high cost funding.  Xenith has proved competent at growing its core deposit balances though and interest rates are low, so while the initial deposit figures will look uglier, they should revert to lower cost and higher quality deposits over the next year.  Xenith can also leverage its lending relationship with former VBB customers to include deposits. 

    Acquisition Risk

    Bank transactions are notorious for under delivering.  Xenith is in a different situation from a risk/reward since it is not paying anything.  This is debatable if one wants to point to the share issuance at a discount to TBV, but this is shadowed by the opportunity cost were Xenith to a) pass on very cheap assets it is acquiring and b) open the potential of a new competitor entering the market/reduce its competition.  In fact, the equity part of the VBB transaction goes some way towards reducing the TBV/share dilution of the past offering.  There were other bidders for VBB, so the potential for new entrants is not a pure fantasy.  As the weak NIMs at both Paragon and VBB relative to Xenith show, there is room for improving the returns.  Xenith can also expand its own pre-transaction NIMs as well due to reduced competition. 

    Xenith is only acquiring additional assets in the Richmond area.  Its existing presence, and clear redundancies from the acquired banks indicate that this will be a successful integration.  Xenith was initially started with the infrastructure to scale up and support a larger organization, so the increase in assets and expenses is factored in somewhat to the business plan.

    When will the bank be profitable?

    This is the crux of the investment opportunity.  The real answer is that it is hard to tell.  De novo banks typically take 2-3 years before showing profits and Xenith is really only one year in operation.  In the most recent quarter, Xenith lost $1m.  The bank has $56m in pro forma tangible capital compared to a market capitalization of $36m.  It can continue at its current run rate for over 5 years before the margin of safety in the bank’s liquidation value is at risk.  Results since management took over in December 2009 look like this (they don’t really tell much):

     

    Quarter Ended

    6/30/11

    3/31/11

    12/31/10

    9/30/10

    6/30/10

    3/31/10

    Net Interest Income*

     2,861

     2,766

     2,662

     2,326

     2,096

     1,515

    Quarterly Growth

    3.43%

    3.91%

    14.45%

    10.97%

    38.35%

     

    Noninterest Expense

     3,482

     3,416

     2,962

     3,343

     3,647

     3,049

    Net Income (Loss)

     (1,083)

     (1,474)

     (924)

     (1,950)

     (1,940)

     (1,102)

    *pre provision (all nonaccruals result from before current management)

    The recent transactions go a long way towards making Xenith profitable as will continued progress with the core operations.  Both transactions will be able to operate on Xenith’s existing infrastructure as Xenith’s Richmond and northern Virginia presence are based out of single offices and not branch networks. This creates a lot of operating leverage as Xenith reaches critical mass. 

    Xenith’s operations so far have been indicative of a bank that will have high quality earnings when it reaches the proper scale.  The predecessor bank, on 9/30/10, had 85% of its deposits comprised of time deposits.  As of June 30, 2011, Xenith has 53% of its deposits as non-time core deposits, which is the proper direction for the bank to move.  In terms of protecting the TBV and margin of safety that stems from it, the slow bleed of drawing in funding before lending it out if preferable to the gaping wounds that would be caused by rapidly underwriting poor credit quality loans on the back of interest rate risk from time deposits. 

    They appear to be offering a pretty high rate on money market accounts as the rate on demand and money market accounts was 0.90% as of 6/30/10.  Xenith pays higher rates the larger money market balances are (as of 8/28/11 check, 0.80% for $100-250k, 1.00% for $250k+).  If you enter an out of state zip code on their website to check the rates, they tell you they won't accept your deposits.  Xenith still has wide NIMs though, so the above average interest rate on money market accounts is only worrisome in isolation.  The interest rate can be interpreted as the bank developing relationships with businesses that will open up lending opportunities since the deposit balances are large.  They have let brokered deposits run off that were from its predecessor.  The removal of Paragon and VBB from the competitive landscape should allow Xenith room to possibly lower their own funding rates excluding the transactions.

    Over the next year, Xenith will have an opportunity to reprice VBB’s deposits, which are entirely comprised of high yield time deposits – costing 1.91% as of 6/30/11.  Their interest yielding assets, which are entirely comprised of loans or deposits at other banks, earned 5.52% as of 6/30/11.  If Xenith were to roll over all the deposits and loans to their cost structure in addition to only keeping 6 of VBB’s 11 employees at $75k salaries, the contribution of the VBB transaction would look like this:

     

    Contribution

    Rate

    Interest Income

     3,730

    6.30%

    Interest Expense

     853

    0.98%

    Net Interest Income

     2,877

     

    Noninterest Expense

     450

     

    Pretax Income

     2,427


    Paragon offers even more room for margin expansion based on the extrapolation of their company wide yields to the assets and liabilities acquired – any error in the aforementioned projection of the earnings from the Paragon transactions are understating the earnings potential rather than overstating.  Xenith earned 6.30% on their loans and interest bearing liabilities yielded 0.98% as of June 30, 2011 compared to 4.63% on interest earning assets and 1.97% respectively for Paragon.  Xenith is mostly acquiring loans and cash from Paragon though, so the yield on interest earning assets acquired is higher in all probability due to an absence of a securities portfolio.  Xenith is keeping all of Paragon’s 10 Richmond employees.  Using salaries of $75k for all 10 is what comprises the noninterest expense since as previously stated, the staff is being incorporated into existing Xenith space. 

     

    Contribution

    Rate

    Interest Income

     3,717

    6.30%

    Interest Expense

     745

    0.98%

    Net Interest Income

     2,972

     

    Noninterest Expense

     750

     

    Pretax Income

     2,222


    These projected improvements would gradually occur over the next year or two as commercial loans are repaid or refinanced and time deposits reprice.  Management disclosed that most of the acquired deposits in the Paragon deal were non-time core deposits, so the original projected interest expense may already be closer to Xenith’s overall funding expenses. 

    Even though Paragon and VBB have a poor relative underwriting history judging from the problems they’ve experienced, Xenith is acquiring only performing loans from Paragon and heavily discounted loans from VBB.  Even though credit standards are tighter now than 2006, the loan acquisitions give Xenith scale that would otherwise have to be achieved by rapidly underwriting loans.  A more seasoned loan portfolio puts Xenith in a stronger position to pass on lesser opportunities. 

    De novo banks typically take 2-3 years to turn profitable.  Xenith started in December 2009, albeit by absorbing an existing bank.  Suffolk Bank, the acquired bank, was mediocre at best.  Its deposits were almost entirely time deposits and core operations were marginally profitable excluding provisions.  It’s last 10-Q before it was acquired by Xenith for 9/30/10 showed a net interest margin of 2.71% compared to Xenith’s current 4.35% NIM.  Suffolk has 3 branches, which result in high fixed costs relative to the business model Xenith is trying to execute.

    The 3 branches inherited from Suffolk clearly don’t conform to the company’s strategy.  Consolidating them into a single location would reduce fixed costs, although Xenith is likely focused on growing loans and deposits for the time being.  There would be restructuring costs from severance and costs in terms of management’s distraction dealing with it.  This is essentially the cost of starting the bank, except it did not come in the usual form of expenses for getting a bank charter and investment banking fees for a share offering to raise capital. 

    On a longer time frame, the bank should be quite profitable as a result of low costs.  Customers use check-scanning machines to deposit checks in their accounts and Xenith will ideally only have one location for each region it serves.  This keeps fixed costs lower and should result in a low efficiency ratio combined with the wide NIMs typical of commercial banking, which is ultimately a recipe for success. 

    As with a bank that needs to grow its balance sheet, the focus should be on quality over quantity.  The bank has been disciplined by maintaining and 80% loan/deposit ratio.  Their focus has been on C&I and CRE lending.  There are no construction, land, or development loans.  The impression from the balance sheet and the stated strategy indicate that Xenith is a high quality lender that will be able to intelligently and effectively compete for commercial lending relationships.  There's no need to rush lending in a weak economy.

    Valuation

    There is a certain futility in projecting what type of returns Xenith will earn in the future and at what point.  The variety of factors put together such as lower competition, experienced management, a fortuitous geography, and the right idea indicate that Xenith will be capable of compounding book value at a high single digit or low teens clip.  To purchase it for $36m against a tangible book value of $56m seems like a good deal since things don’t need to pan out well to make money. 

    The bank could continue to lose $6m/year for the next 2 years before turning profitable, at which point the market might pay 1x TBV for Xenith on the premise of impending profitability and an investor at today’s prices would still make 20%.  This seems quite unlikely considering the boost that the recent transactions will have combined with the progress the company has made so far. 

    If the bank breaks even this year and then increases its return on equity 250 basis points per annum, it will have $63m in tangible equity at the end of year five.  If the market awards a 1.5x TBV book value on the assumption that Xenith will likely increase its ROE an additional 250 basis points until it reaches a 15% ROE, the business would be worth $95m.  A 10% discount rate implies a net present value of $59m, or 63% above current prices.  An investor would make 163% or 21.4% compounded.  Permutations of growth rates, exact quarter in which profitability is achieved, discount rates, and market multiples can all be toyed around with, but no calculation will be any closer to reality.   

    You could also assume a 9% TBV leverage ratio on $56-63m in TBV, that is $622-700m in assets.  A 1% ROA for a commercial bank of the quality that XBKS is headed towards is conservative but would imply $6-7m in normalized earnings.  The current price is 5-6x normalized earnings.  The second we jack up the ROA to 1.2%, it's $7-8.5m in normalized earnings.  If they hit 1.5% ROA once the economy recovers down the line, we're whistling dixie.  You can assume an 8% leverage ratio and toy around with the ROA to your hearts content. Good things come to those who wait.

    Tangible book value is 50% higher than the current market price.  As the market begins to understand the recent transactions, especially VBB, it should recognize that Xenith is approaching profitability in the near term and better positioned in the long term.  This should act as a short-term catalyst, although a 5 year investment time frame is far more appealing.

    On the downside, Xenith seems to worth about 50% more.  On the upside, an investment at $3.50/share can lead to high teens to low twenties rate of compounding.

    Management and Bank Cap Partners

    Management is experienced and has a stake in the business.  Management and the board purchased additional shares in the April offering, somewhat unique for a share offering by a bank in the past several years.  There have been additional share purchases by management in August, including the CEO. 

    The management team is comprised of several senior executives from Signet Bank, a Virginia bank that spun of Capital One in the mid 90s and was purchased in 1997 by First Union, one of the two banks that merged into Wachovia.  T. Gaylon Layfield, the CEO, was the Preisdent and COO of Signet.  Several other Xenith executives were in senior positions at Signet as well.  All executives have held senior positions are other banks, primarily in Virginia.  That they've grown C&I lending to a large part of the loan book (45%), a predonimantly relationship based form of lending, is a very positive sign that these guys know what they're doing, or at least the right people.

    Most encouraging for a bank executive, the Regional President of the northern Virginia office is a golf course rater for Golf Week Magazine.  This is evidence that Xenith is a following the successful banking model of 3-6-3.  Borrow at 3%, lend at 6%, and out on the golf course by 3.

    Below outlines direct ownership of shares, which excludes options.  Although the CEO owns shares worth more than his 2010 compensation, his compensation is likely depressed due to keeping expenses low in the ramp up phase.  There is a level of inside ownership for a $35m company that indicates management has some skin in the game.

    Name

    Position

    Shares

    Value @ $3.50

    % of Company

    Layfield

    CEO

    114,000

    $399,000

    1.09%

    Cottrell

    EVP, Chief Credit Officer

    28,600

    $100,100

    0.27%

    Osgood

    EVP, CFO, CAO, Treasurer

    48,500

    $169,750

    0.46%

    Davis

    EVP, Secretary

    14,582

    $51,037

    0.14%

    O'Flaherty

    EVP

    20,900

    $73,150

    0.20%

    McDonald

    Director

    53,500

    $187,250

    0.51%

    Gavant

    Principal Accounting Officer

    11,500

    $40,250

    0.11%

    Garson

    Director

    35,982

    $125,937

    0.34%

    Merrick

    Director

    35,400

    $123,900

    0.34%

    Hanley

    Director

    12,000

    $42,000

    0.11%

    Total

     

    374,964

    $1,312,374

    3.59%

    BCP

    Bank Cap Partners

    3,280,000

    $11,480,000

    31.40% 

    Bank Cap Partners is a private equity firm focused on banking.  Bank Cap has investments in just 3 small banks.  Their strategy is to focus on the space in between the large banks and small banks.  It is essentially a repetition of Xenith’s mission, but they focus on de novo or recapitalizing existing banks and focusing them on commercial middle market companies and private banking clients.  Bank Cap seeks out management teams and provides a chunk of the capital.  While it does not entirely mitigate the risk of a large shareholder having control, Bank Cap’s ownership is on the same terms as other shareholders and their strategy is articulated and intelligent.

    Recent Developments

    This was written up a month ago.  Really the only thing that has changed is the $8.3m preferred stock issuance as part of the Treasury's Small Business Lending Fund.  I treat it as a liability, but it counts towards tier 1 capital (the bank has plenty already).  The interest rate is 1.53% even though the dividend is 1% due to the tax treatment.  This is higher than they would pay on a CD, but is a longer term source of funding without the abstract risk of rate shopping.  Interpret this as you will, but the bank is not short on capital, they are short on funding.  This could be interpreted as Xenith finding loans to underwrite.  The preferred is non dilutive and doesn't come with any strings attached.  The interest rate is contingent on how much small business lending Xenith does and that's pretty much all they do, so the rate should remain at 1%.

    Risks

    In November 2010, the bank wanted to raise an additional $42m.  They only managed to raise about $15m in their April 2011 offering.  If they were to issue shares at current prices, it would be quite dilutive to tangible book value.  If there is another offering and the share price doesn’t improve between now and when the market attaches a more rational valuation to the company, it would lower the projected returns.  Adjusted for the recent transactions, Xenith has a leverage ratio of 12%, so it still has capital to expand its loan book before issuing more shares to fund growth. 

    There are the obvious risks such as an even weaker economy, continued competitive pressures from remaining banks coping with low interest rates, and general banking issues such as credit and interest rate risks.  The only way to protect against this is to purchase with a margin of safety, which appears to exist.

    Conclusion

    An investment in Xenith Bankshares (XBKS) at today’s price, $3.50/share or 65% of tangible book value, provides an investor with a wide margin of safety and asymmetric risk/reward due to the growth runway that Xenith is on for the next decade.  A clearly articulated strategy of focusing on a service oriented midmarket commercial bank with a low cost infrastructure is a strategic framework that is reinforced by the presence of Bank Cap partners and should provide a rational guide for the bank’s development. 

    Catalyst

    Time and the release of Q-10 for quarter ended Sept. 30, 2011.
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