The Bancorp (TBBK) is a branchless commercial bank headquartered in Wilmington, DE with a non-traditional strategy that should produce significant earnings growth over the next several years due to its leading position in one of the fastest growing areas in financial services, pre-paid stored value cards.  EPS should more than double from ~$0.60 in 2012 to ~$1.40 in 2014.  Earnings have been depressed primarily due to elevated investment spending in the pre-paid business and the low interest rate environment.  As the pre-paid business continues to grow the company should start experiencing operating leverage driving earnings growth.  Any pick up in rates would support even faster growth, although I am not anticipating this any time soon.  Applying a 12x multiple to estimated 2013 earnings power of ~$1.00/share generates a $12 near term price target with upside to both the EPS estimate and the multiple.  The stock currently trades ~1x tangible book (15x consensus 2012 eps), which should provide support barring a noticeable downtick in credit or a significant change in the regulatory environment surrounding pre-paid debit cards.  At current levels the potential reward is worth the risk.

Two points before I get into the story:

1.  TBBK has been written up twice before (2006 and 2010) but the opportunity has changed/grown enough to warrant a revisit.

2.  Betsy Cohen is the CEO and Daniel (one of her sons) is Chairman of the Board.  I realize the Cohens are a controversial family and lightning rods on this website.  I understand the issues and am comfortable with the risks.

 

Background
TBBK was founded in 2000 by Betsy Cohen (CEO), Frank Mastrangelo (President and COO) and a number of senior executives who had previously worked together at Jefferson Bank.  Betsy co-founded Jefferson Bank with William Lamb (current TBBK Board Member) in 1974 and sold it to Hudson United in 1999.  Frank was Senior Vice President and Chief Technology Officer at Jefferson Bank from 1995 until the sale.  The general strategy when TBBK was founded was to 1) essentially recreate the lending/asset side of Jefferson Bank serving the commercial needs of the Wilmington/Philadelphia area and 2) with Frank’s extensive knowledge and experience, be the deposit institution for financial services companies who want to provide a full array products to their customers but do not have all of the capabilities in house.  TBBK would be the bank behind the scenes providing the services and benefiting from the low cost deposits.  TBBK refers to this deposit generating strategy as affinity banking.  From their 10-k:

Nationally, we focus on providing our services to organizations with a pre-existing customer base who can use one or more selected banking services tailored to support or complement the services provided by these organizations to their customers. These services include private label banking; credit and debit card processing for merchants affiliated with independent service organizations; healthcare savings accounts for healthcare providers and third-party plan administrators; and prepaid cards, also known as stored value cards, for insurers, incentive plans, large retail chains and consumer service organizations. We typically provide these services under the name and through the facilities of each organization with whom we develop a relationship. We refer to this, generally, as affinity group banking.

The deposit strategy started with traditional community relationships over the internet and affinity banking; primarily HSAs, merchant processing and wealth management.  In 2007, TBBK purchased Stored Value Solutions (SVS) for $60.6 mm as an entree into the pre-paid stored value card business.  Similar to the other affinity banking businesses, this was viewed as a source of cheap deposits.  At the time of acquisition, SVS had ~4 mm stored value cards outstanding.

Quick aside:  The reloadable pre-paid stored value card business is, generally speaking, made up of marketers - Green Dot, NetSpend, Western Union, etc. and issuing banks - TBBK, Metabank (CASH), etc.  The marketers are customer facing.  They develop programs, partner with retailers, brand, market and sell the cards.  The issuing banks typically sign multi-year contracts with the marketers and also help develop the programs.  The issuing banks do all of the behind the scenes work managing deposits and transactions - they are more or less invisible to the customer.  A significant part of this work is creating the technology infrastructure that allows customers to make deposits and transact at hundreds/thousands of locations across the country.  The issuing banks, depending on how the contracts with the marketers are structured, make money through the cheap deposits lowering their funding costs and through some fee sharing.  Pre-paid stored value cards have been experiencing tremendous growth over the last several years.  The industry generally started with closed-loop gift cards and has evolved towards general purpose reloadable cards.  Mercator Advisory Group forecasts 42% CAGR in funds loaded through 2014.  NetSpend sizes a large portion of the available marget as the 60+ mm underbanked consumers in the US.  According to their Q4 2011 investor presentation, only 16% of the underbanked have ever used a general purpose reloadable card.  The number of underbanked should also grow as larger banks continue to shed unprofitable customers.  The market opportunity is there and is growing.  There are unquestionably regulatory risks especially given the new Consumer Financial Protection Bureau and the increased attention the industry is attracting.  However, pre-paid stored value cards offer a more cost effective alternative for a number of customers and the deposits are typically FDIC insured.

TBBK and Metabank (CASH) are the two leading issuing banks.  TBBK has issuing relationships with five of the top six program managers/marketers - Green Dot, NetSpend, Western Union, UniRush and AccountNow.  Metabank appears to have a similar sized business by deposits but earns more in non-interest income, although they also have some additional businesses included in their MPS segement so it isn't necessarily a direct comparison.  Metabank has been working under a cease and desist order since the fall of 2011 so they are currently unable to enter into new contracts.  Even with the inability to add new relationships, Metabank's stored value deposits have been growing 30%+, supporting underlying industry growth forecasts.

BIG PICTURE PLAN:  Structurally low cost deposits funding traditional loan/asset side driving higher net interest margin; branchless model and significant use of technology driving low efficiency ratio = high return bank.

WHAT HAS HAPPENED:  The credit crisis followed by prolonged period of low interest rates and weak loan demand.  Benefit of low cost deposits has been offset by declining yields on interest earning assets.  Weak loan demand has further pressured NIM as a larger portion of interest earning assets are in lower yielding securities.  Non-interest expenses have been high as TBBK has been investing in the pre-paid stored value card opportunity.  The result - weak loan growth and NIM, high efficiency ratio, slowly improving credit = low return bank.  This reality is not unique to TBBK as most banks are facing similar macroeconomic challenges especially when you add in the increased regulatory costs.  The primary opportunity with TBBK is the increasing non-interest income component of the story due to the growth in pre-paid stored value cards with the potential for meaningful operating leverage.

Analysis
Banks are pretty straightforward.  Gather deposits, make good loans and investments, generate non-interest income and manage your expenses.

Deposits
As of the 1Q2012, deposits ($mm) by source were as follows:

 

Community Bank                $358

Healthcare                         $435

Stored Value                   $2,119

Wealth Management          $544

Merchant Processing          $167

1031 Exchange                  $151

 

As you can see, ~56% of the $3.8 bn in deposits were sourced through the stored value card business.  Although this is a little misleading as there is some seasonality with the deposit balances, particularly with one of their customers, Higher One.  Management does not view the seasonal increases as core deposits and invests these seasonal balances in fed funds.  TBBK ended the relationship with Higher One as of the beginning of May of this year therefore we won't see as much seasonal volatility in the future and we should see a much smaller balance invested in fed funds.  In the first quarter average deposits were $3.8 bn with $1.7 bn invested in fed funds.  Subtracting the $1.7 bn from the $2.1 bn suggests ~$400 mm of core stored value deposits.  I realize you shouldn't mix averages with period end but the company doesn't report period end balances in the net interest table so that's the best information I have at this point.

 

TBBK generates the private label deposits through contractual relationships with customers; the contracts vary but most have an initial term of 3-5 years.  As of 1Q2012, share by remaining contractual term of existing deposits was as follows:

 

<1 year         40%

1 - 3 years    44%

3 - 5 years    16%

 

The company has retained 99% of maturing contracts over the last few years.  It doesn't make a lot of sense to make a change from the customers' perspective once TBBK develops the technological backbone and provides great service.  Why take the risk in changing your platform when it doesn't "cost" you much and the profitability of the underlying business is so great?  I realize this is not a deposit franchise in the traditional sense but one that should still have value in our ever changing financial services environment.

 

Deposits ($mm) by product:

 

Demand - non-interest             $2,442

Interest checking                        $802

Savings and Money Market         $500

Time                                              $19

Time >$100,000                            $11

 

The cost of deposits in 1Q2012 was 29 bps.  TBBK also uses a small amount of repos and subordinated debt so overall funding cost was 31 bps.  The average balances of core deposits (excluding those that are invested in fed funds) were $2.1 bn as of 1Q2012 and have been growing ~10% y-o-y.  Over the last few years the company has shifted the make-up of deposits from higher cost savings, money market and CDs to lower/no cost demand and checking.  Further they have paid down all of their short-term borrowings.  Not much of an opportunity to lower funding costs much further given the current deposit mix and historically low interest rates.  Any increase in rates will undoubtedly increase TBBK's funding costs but, given the shift over the last few years away from CDs and other higher cost deposits, the costs should remain structurally low.  Not much help right now but should be a benefit if rates increase.

 

Interest Earning Assets
Average interest earning assets in 1Q2012 were $3.9 bn broken down ($mm) as follows:

 

Loans                  $1,744

Investments          $466

Fed Funds           $1,699

 

Loans have compounded ~7% over the last three years while securities have compounded ~60% over the same period.  Reported yield on interest earning assets has fluctuated pretty dramatically over the last few years primarily due to the seasonality of some of the deposit relationships driving the investments in fed funds.  Eliminating the effect of the fed funds investments results in a pretty steadliy declining earnings yield from almost 6.00% in 2008 to the most recently reported 4.21% in 1Q2012.  This is due to 1) declining interest rates (pretty obvious) and 2) lower yielding investment securities making up a larger proportion of the assets.  

 

Loans ($mm) by category as of 1Q2012:

 

Commercial                            $446

Commercial Mortgage            $618

Construction                          $248

 

  Total Commercial               $1,312

 

Direct Lease Finance              $130

Residential Mortgage               $94

Consumer loans and other     $209

 

Unamortized costs                     $4

 

Total Loans                          $1,749

 

Total non-accrual loans were $24.9 mm as of 1Q2012; 1) construction - $10.4 mm (4.2% of category), 2) commercial mortgage - $3.6 mm (0.6%), 3) commercial - $6.0 mm (1.3%), 4) consumer - $0.9 mm (0.4%) and 5) loans past due 90 days or more - $3.9 mm.  Not a suprise that construction is performing the worst and also not a surprise that construction has been declining as a share of total loans over the last several years - declining from $308 mm in 2007 to the current $248 mm while total loans have increased from $1,287 mm to $1,749 over the same period.  Non-performers were 1.42% of total loans and have been in that range for the last several quarters.  NPAs were 0.79% as of 1Q2012 and, similar to NPLs, have stayed in that range for the last several quarters.  Net charge-offs were $16 mm in 2011 and provisions have exceeded net charge-offs on a consistent basis.  Credit is not great but slowly improving.  The worst appears to be behind TBBK and the provision should continue to trend down.  I forecast a gradual decline in provisions given the improving credit environment and the conservative provisioning over the last several quarters.

 

NIM on a reported basis can be misleading given the seasonality of deposits causing the fluctuations in fed funds balances.  As an example reported NIM over the last five quarters was 2.67%, 3.06%, 3.08%, 2.84% and 2.14%.  NIM after adjusting for the excess balances of fed funds over the last five quarters was 3.86%, 3.71%, 3.79%, 3.75%, 3.72%.  Asset yields have been declining but the impact has been softened by decreasing liability costs - shift in deposit mix and elimination of higher cost borrowings.  I don't expect deposit costs to decline from current levels so NIM should be under pressure as lower yielding securities make up a larger proportion of earning assets.  Weak loan demand and growing deposits exacerbate this challenge.  This is a drag on the story.

 

Adjusted non-interest income (excluding gain on sale and impairment) increased from $12.6 mm in 2009 to $29.8 mm in 2011.  NII is made up of deposit fees, merchant processing, leasing income, stored value card income, etc.  The largest component (~62% of NII) is fees generated through the stored value card business.    The rationale behind the SVS acquisition was cheap deposits - while that remains trues, stored value has also become a huge driver of non-interest income.  Stored-value fee income is a function of gross dollar volume transacted on the cards.  TBBK finally started reporting GDV so you can more easily see what is happening.  GDV ($mm) over the last few years:

 

2009          $3,950

2010          $6,050

2011        $14,400

1Q2012      $8,800

 

Fee income was $8.0 mm in 2009 and $9.0 mm in 1Q2012, declining from 20 bps of GDV to 10 bps of GDV.  Over the last few years TBBK has decided to accept a lower fee share given the potentially larger accounts thus driving down the average rate.  The rate declined significantly from 2010 to 2011 from 18 bps to 13 bps.  It appears that we have reached the steady state level at 10 bps but there is a risk that it declines further.  Management does not provide much detail on this issue, which is understandable given the competitive environment but frustrating from an analysis perspective.  Although public comments from management suggests the rate should stay around current levels.  TBBK further breaks down the GDV by year of card activation so you can see the layering effect each period.  A few takeaways:

 

1.  Pre-2008 card GDV has been growing in the 25% - 30% range for the last three years.  This was SVS plus one full year of program development.  Consistent with industry growth.

2.  In 2011, the GDV of cards activated 2008 and prior roughly equaled the GDV of cards activated in 2009, 2010 and 2011, with little impact from 2011.  TBBK has increased investment in this business over the past 2-3 years and is starting to see the impact.

3.  TBBK experiences very little, if any, GDV in the year a program is developed but incurs a significant portion of the costs.  Typically takes two years before a program reaches a level of maturity.

4.  Programs started in the last two years are experiencing 150% - 200%+ growth.  One example: programs started in 2010 had ~$4.2 bn in GDV in 2011 and ~$4.2 bn in GDV in 1Q2012.  The programs experienced the same GDV in the first quarter of 2012 as they did all of last year.

 

TBBK has stated that they anticipate GDV of $20 bn - $30 bn for 2012.  I anticipate a number closer to $35 bn given recent growth and new program ramp up periods.  Time will tell.

 

The efficiency ratio has been trending down slightly but is still in the mid 60s.  The largest driver of non-interest expense has been salaries and benefits accounting for 80% of the dollar increase in non-interest expense in 2011 compared to 2010.  Management has suggested that the big investments in people and infrastructure supporting the growth in the stored value business are largely behind them.  The efficiency ratio has declined (albeit modestly) each of the last three quarters and I expect this trend to continue (and most likely accelerate) providing the operating leverage.  Why?  The GDV ramps quickly and as it continues to grow the business will more easily generate economies of scale.

 

Let's start with tangible book value:

 

Shareholders' equity        $278,233

Intangibles                           $7,754

Tangible book                   $270,479

 

Shares                                 33,107

 

TBV/share                              $8.17

 

I grow average interest earning assets from $2,632 in 2011 to $3,050 mm, $3,417 mm and $3,759 mm in 2012, 2013 and 2014, respectively.  NIM declines in 2012 to 2.77% compared to 2.90% in 2011 due to lower rates and the increased proportion of investment securities.  I assume NIM remains relatively flat over the next few years.  Provision declines from $17.5 mm in 2012 to $10.0 mm in 2014.  So, net interest income after provision is $67.0 mm, $81.5 mm and $95.2 mm.  Non-interest income - I project GDV of $35 bn in 2012, $45 bn in 2013 and $55 bn in 2013.  Keeping fee income as 10 bps of GDV generates $35 mm, $45 mm and $55 mm.  Other components of non-interest income should grow as well, although at a smaller pace.  NII as a percent of total income increases from 36% in 2012 to 40% in 2014.  I slow the growth in non-interest expense as the business scales, producing a 55% efficiency ratio by 2014.  Assuming a 35% tax rate and slightly increasing share count generates EPS of $0.60, $1.00, and $1.35 over the next three years.  There are clearly a number of factors at play well outside anyone's capacity to predict.  However, the forecasting exercise helps to put what is possible in context.

 

 

Top 5 holders:

Wellington             9.66%

Yacktman               7.29%

Second Curve        6.19%

Blackrock               5.57%

Wells                     5.55%

 

Betsy Cohen          4.78%

 

Executive officers and directors own 11.76%.

 

Betsy's salary has been ~$500,000 for the last few years.  Most other senior management is making ~$250,000 - ~$400,000.  I would always like more inside ownership and lower salaries but I've seen much worse.

 

1.  Netspend entered into a distribution agreement with Family Dollar.  Family Dollar has ~7,200 locations and targets an attractive demographic for pre-paid stored value cards.  TBBK is the issuing bank.

2.  TBBK announced a new relationship with PayPal to provide P2P payment services.  This is likely the first of several solutions that will be offered through the PayPal relationship.   

 

Pre-paid stored value cards and, more generally, alternative banking should continue to experience significant growth over the next few years.  TBBK is poised to benefit.  The drag created by recent elevated levels of upfront investment should abate, allowing earnings growth.  The road will undoubtedly be bumpy but the earnings power is there.  TBV/share should provide valuation support although during the seasonal market swoons we have had over the last two years TBBK has bottomed around 0.9x tangible book.  Therefore, $7.40 - $7.50 should be the downside in a shaky market unless fundamentals deteriorate substantially.