Description
Long Idea: Beverly Hills Bancorp Inc. (BHBC - $10.60)
$225M market cap bank based in southern California
Consensus EPS
2005 2006
IBES EPS* $.70 $.90 * (only 1 analyst – Hoefer and Arnett)
P/E 14.6X 11.1X
P/B 1.26X
Dvd Yield 4.75%
Executive Summary:
BHBC is a small, inexpensive bank stock with several positive catalysts in the next few months I expect the stock to trade to $13 by the end of the year, which combined with the dividend results in a 25% return over that time.
The likely catalysts are as follows:
1) The company currently is overcapitalized with a Tier I ratio of close to 15%. Management wants to return capital to shareholders and was unable to do so as it waited for the approval to switch its charter from savings bank to a state commercial bank. The change has just been approved and will lead to a new lead regulator (FDIC instead of OTS) and allow BHBC to announce a major buyback or tender in the next few months that will bring Tier I down to the 10-12% range. After this takes place, the company could raise $25M or more in Trust Preferred Stock that can be counted as Tier I capital and buy back another 10% of outstanding common shares. EPS and ROE will be significantly improved.
2) Capital Research owns 14% of the stock and has been selling down its holding over time. The tender/buyback can clean up this seller and remove the overhang.
3) The charter change will allow the bank to hold less than the current requited 60% of assets in residential loans and MBS and to deploy the capital into higher yielding commercial loans.
4) The company has one large non-performing loan of $1M on a home appraised at $4M in Woodside, CA where the owner tried to file for bankruptcy. BHBC has reserved about 25% of the loan amount. The personal bankruptcy got thrown out of court and BHBC management says that the ‘for sale’ sign recently got put out in from of the home. A payoff of this NPA would significantly improve asset quality ratios at BHBC.
5) Management has indicated that significant non-interest expense costs can be eliminated in the next few months that would lead to an improved C/I ratio at BHBC and higher EPS.
By 1/1/06 I believe BHBC could trade at $13 per share with a valuation of 12.4 ’06 P/E (expected ’06 EPS of $1.05), a P/B of 1.9X and an expected ROE of 12%. This valuation would still be inexpensive for a commercial bank in Southern California and would be based on 1) a 20% share buyback with its impacts on EPS and BVPS, and 2) some measure of cost saves. Adding in the expected $.25 of dividends yields a 25% return over the next four months.
Background
BHBC has had a difficult past. The old CEO ran the company into bankruptcy with asset quality problems and ended up in jail. Capital Research was a large bondholder and ended up with stock when the company once again emerged in 1999. The three large shareholding Board members also got their stock in the recapitalization at around $2 per share and have been doing a very good job of turning the bank around and cleaning it up.
BHBC has sold off its mortgage banking and mortgage servicing arms and has retained its commercial bank that focuses on multi-family and commercial real estate loans funding itself with wholesale borrowings from the FHLB and the capital markets. Now that the charter change has gone through, as a commercial bank, BHBC does not have to hold any residential housing credits or MBS. Thus, the MBS portfolio can be allowed to run off and/or be sold and the proceeds used to support commercial loan growth. In general, commercial banks trade for higher valuations than savings banks and S&Ls.
The challenge is to grow loans in the current market. To spur growth, BHBC recently purchased a pool of loans from ABN and is trying to buy more credits from other banks in the Midwest where spreads are currently better than in southern California. Even though spreads on multi-family loans are low right now, the mix shift out of MBS and into Prime-based loans will help to support the net interest margin at BHBC in a flattening yield curve environment. Also the current CEO of the bank operating unit has intimated that the Board brought him in to help clean up the institution, get its commercial loan growth moving and then sell out for a couple of times book value.
The CEO of BHBC is also interested in cutting some costs out of the small branch system. The branches are primarily bringing in large CD’s at rates not much below wholesale borrowings and there is room to cut some costs. By charter, the bank only needs to keep one branch open (it has three) and while branches may not be closed, we may see costs taken out over the next few months.
Another area where costs will come down is in the legal front. The old CEO (currently still in prison) has been suing BHBC for $2M. The company believes they owe him nothing and in fact they have significant claims against him for legal costs incurred by the bank before he got sent away. It has been a long process (remember the bank emerged from bankruptcy in 1999), but we are likely finally near a resolution. The case has now been pushed to arbitration which is scheduled for 1Q06, but BHBC management believes a settlement may occur prior to year end. In any event, a settlement should remove an overhang from the stock and will certainly lead to litigation costs falling significantly in ’06 vs. ’05.
I have spoken to the analyst who covers the stock and his $.90 estimate for 2006 assumes zero share repurchase, no cost cutting in the branch network and a NIM a bit lower than it was in 2H05 due to a flatter yield curve. Thus, a 20% share repurchase/tender and some cost cutting could easily move ’06 EPS to the $1.00 level.
BHBC could end up buying back significantly more than 20% of its stock. It currently has a Tier I ratio of 15%. Commercial banks only need to keep 8% to be considered ‘well capitalized’. However, due to the company’s past, and the new lead regulator, it is likely that the FDIC will want BHBC to keep at least 10% Tier I for the time being. Buying back stock to the 12% level (20% repurchased) should be easily accepted in the near term, and of course as much as 45% of shares outstanding could be bought back over time. In addition, almost every bank in the US now makes use of raising Trust Preferred stock which is counted as Tier I capital up to a certain percent of the total. BHBC has not yet done so and has the capacity to raise at least $25M of Trust Preferred which would be counted as Tier I. Due to current low interest rates on Trust Preferred, and the low P/E on the stock, raising this debt capital and buying back an additional 10% of the company’s stock would be quite accretive and could be executed in the near future.
Finally, in terms of potential positives, BHBC’s CEO believes that one or two new sell-side analysts will pick up coverage in the next several months. This is due to the streamlining of the company’s operations (sale of its mortgage servicing unit to MER took place in 1Q05), the outlook for more aggressive management of capital, the shift in the charter that allows for more commercial lending asset growth and an outlook for improved efficiency ratios. Making money in the stock is not predicated on additional sell-side coverage, but it wouldn’t hurt
Let’s be clear – BHBC is not one of the greatest banks in the world. It does not have a strong retail deposit base, its loans are concentrated in California and a quarter of its assets are MBS which are yielding an increasingly narrow spread as the yield curve flattens. In fact, an inverted yield curve could seriously hurt EPS in the near term. However, the stock is very cheap vs. other smaller commercial banks that trade on up to 300% of BHBC’s valuation. Management has some easy levers to pull to increase the share price and the Board is heavily invested in the stock.
Thus, if management buys back 20% of the stock, reduces Capital Research’s position and is able to improve the operating metrics of the company slightly, I believe we could see the stock at or above $13 by year end.
On a longer term view (end of ’06) we could see BHBC having bought back close to 50% of outstanding shares (raising Trust Preferred and reducing the Tier I ratio to 9%). Assuming the yield curve is just a little bit steeper by then than it is today could produce forward ’07 earnings of $1.40 ($.90 current ’06 estimate with 45% fewer shares, $.05 from better yield curve spread and $.05 from cost cutting and asset mix shift from MBS to Prime-based loans). Small commercial banks are selling for around 20X LTM EPS and 3-4X book values these days and if BHBC is able to execute, we certainly could see the stock go for $20 or more.
The major risks I see in the next few months with BHBC are as follows:
1) Management does not follow through on their promises to reduce the share count
2) A flat/inverted yield curve leads to much faster prepayment speeds on MBS which would reduce BHBC’s assets and earnings
3) Loan losses on the new book of commercial and multi-family loans rise quickly. I believe these risks are unlikely, but the 4.7% yield, excess capital and low P/B and P/E multiples gives one a significant marg
Catalyst
1) Large share repurchase/tender soon to be announced.
2) Overhanging selling shareholder (Capital Research) likely to be eliminated.
3) Just approved charter change will allow for mix shift to higher yielding commerical lending.
4) Clean up of one large non performing loan to improve asset quality ratios.
5) Cost saving program likely to be announced in the near future.
6) Additional Sell side coverage to be launched