Description

Executive Summary

Broadway Financial Corporation (herein “BYFC” or the “Bank”).  BYFC represents a unique opportunity to buy into a local bank at a very reasonable price.  BYFC is currently trading at book value and at a 10.6 P/E.  BYFC is a sixty-year-old community-focused bank with four branch locations which primarily on serve the African-American and Hispanic communities of Mid-City and South Los Angeles.

The Bank has $284 million in assets and an equity value of $19.1 million.  I think there are a number of exciting opportunities to profit from an investment in BYFC.  Certainly, the Bank’s focus on the Hispanic community is a solid area for growth going forward.  Historically, the Bank has served primarily an African-American customer base, and now has a large opportunity to pursue the growing Hispanic population.

Here are the key metrics for BYFC:

At current prices, given the overall asset quality and equity value there is nearly zero downside risk. 

Business

BYFC is a community-focused bank which primarily serves the African-American and Hispanic communities of Mid-City and South Los Angeles.  The Bank seeks to attract deposits through its retail branch locations and invest these deposits into multi-family residential loans and commercial loans.  The loans are generally all on properties located in the Bank’s surrounding area.  As of December 31, 2005, 76% of the Bank’s loans consisted of residential real estate.  The following table provides a breakdown of the loan portfolio at December 31, 2005 ($ in thousands):

There are several notable items with respect to the loan portfolio:

1. The Bank typically sells all conforming fixed rate loans that it originates.  Accordingly, the loan portfolio was comprised at December 31, 2005 of 94% adjustable rate loans.  This is a central strategy of the Bank to maintain a loan portfolio which reprices frequently, such that mismatches between asset repricing and liability repricing do not occur.  Still, given that liabilities tend to reprice more quickly than assets, short term compression or expansion of the interest rate spread can occur.

2. The loans in the portfolio have long durations and contain prepayment penalties.  The following is a chart denoting the duration tiers as they existed at December 31, 2005:

3. The asset quality of the portfolio appears to be very good.  As of December 31, 2005, there was only one loan totaling $35k categorized as non-performing and there have been no charge-offs since 2000.  Certainly, the bull market in real estate has helped this statistic as well as declining interest rates which have allowed borrowers on even poor quality assets to refinance and, in many cases, dramatically improve property cash flows.

4. Underwriting standards are pretty tight.  Loans are limited to the lower of 75% of the selling price or appraised value of a property.  Further debt service ratios must exceed 120%.  The Bank utilizes a group of independent appraisers to appraise properties.  Such appraisers are periodically approved by the board.  Typically, the Bank is seeking to lend to multi-family operators with prior property management experience.  Loans up to $500k can be approved by management.  Loans over $500k require various additional approvals, including board approval, at varying levels depending on the size of the loan.  The largest loan in the BYFC portfolio at December 31, 2005 was a 26-unit building in Van Nuys with an outstanding balance of $1.8 million.

5. Within the non-residential loan category, are a number of loans to church groups secured by their buildings.  BYFC was one of the first banks to begin making church loans many years ago and has had a positive experience in this asset type.  Additionally, the loans on churches further help BYFC stay connected to the community while promoting awareness of the Bank.

On the deposit side, BYFC is focused on attracting low cost deposits to fund its loans.  In a recent study of bank profitability, a consulting firm looking at BB&T, a $23 billion S&L, found that 75% of that institutions’ profitability came from attracting the right deposits at the right price.  The most attractive and lowest cost form of deposits are called “core deposits.”  These are savings accounts, demand deposits, and money market accounts.  Unlike certificates of deposit, core deposits are attracted and maintained by an institution for other reasons than the offering of a competitive rate.  Rather, customer service, branch location, etc. are generally most important to attracting and growing core deposits.  Since core deposits are not highly interest rate sensitive, these liabilities tend to reprice more slowly than other forms of funding an institution might seek.

The following table outlines the deposits held by BYFC at December 31, 2005 ($ in thousands):

Core deposits amounted to 49% of all deposits at December 31, 2005.

In addition to core deposits, BYFC can borrow funds from the Federal Home Loan Bank.  BYFC is currently approved by the FHLB to borrow up to 40% of assets or a maximum of roughly $106 million as of December 31, 2005.  Such advances are more expensive that core deposits and outstanding advances totaled $56.5 million at December 31, 2005.  The interest rate on FHLB advances was 3.27% at year end and averaged 3.08% during 2005.  BYFC also has $6.0 million in junior subordinated debentures outstanding with a floating rate coupon of 3-month LIBOR plus 2.54%.

Another positive about investing in a bank is that the regulators, as well as auditors, perform annual monitoring.  BYFC is subject to an annual examination by the Office of Thrift Supervision.  Such audits are focused on operational and credit quality issues.  Further, the capital ratios of a bank are periodically measured to determine the adequacy of an institution’s capital base.  As of December 31, 2005, BYFC earned the highest designation, well capitalized.  The following were the capital ratios at December 31, 2005 for BYFC:

BYFC operates from four locations as follows:

1.  4800 Wilshire Blvd., Los Angeles, California

2.  4835 West Venice Blvd., Los Angeles, California (own bldg./lease land)

3.  170 N. Market Street, Inglewood, California

4.  4001 South Figueroa Street, Los Angeles, California

I did a visit to all the locations.  All are well located.  Three of the four locations are on corners and all have good signage.  The scariest location from a personal safety location is 4001 South Figueroa Street.  At the Figueroa branch there were two security guards in the parking lot watching activity very closely.  Both the 4800 Wilshire and 170 N. Market locations are very nice and the neighborhoods are seeing good development activity.  Each of the four locations have been owned for almost 10 years and are carried on the books at $5 million.  Current market values are certainly much higher than net book.

Opportunities

When I first came across BYFC a couple years ago, I had a sense that there might be big opportunities.  I really think those opportunities are more real today than they have ever been.  As I researched the Bank in more detail, I had a chance to speak with the new President and COO F. Glenn Harvey.  Mr. Harvey has been on the payroll for several months and is full of energy.  He is very focused on expanding the bank’s presence within the Hispanic community and promoting business by focusing large corporate prospects on the bank’s status as a minority owned business.  Currently, roughly 30% of the front line branch personnel are Hispanic, but the customer base to date is more African American than Hispanic.  This is partially to blame on branch location, but probably more to blame on a lack of a targeted marketing effort.  BYFC has recently contracted a new public relations firm to help improve the Bank’s image.

Mr. Harvey also intends to reconnect and build better relationships with the Bank’s existing customer base.  No new products are targeted as of yet, but the focus is on building low cost core deposits.  Obviously, in a rising rate environment, adding cheap core deposits can substantially enhance profitability.  To further assist in the regard, Mr. Harvey recently created a new wealth management department from existing employees to chase larger customer prospects for core deposits.

One does not have to look farther than the recent announcement of a new bank in Los Angeles focused on Hispanics to know that the current Hispanics are underserved by the existing institutions.  While not a current focus of BYFC, several of these newer institutions are focused on helping Hispanic entrepreneurs with business loans.  Further, many Hispanics are very focused on buying single family homes.  Clearly, the bank that steps up to make the first home loan or finance a fledgling business opportunity will likely earn a tremendous amount of goodwill from its customer base which, over time, should turn into core deposits and even more income opportunities for the institution.

In addition to services aimed at Hispanics, other lending products such as reverse mortgages could easily be offered on a targeted basis to the Bank’s existing customer base.  Reverse mortgages are starting to generate a fair bit of publicity.  Since the refinance boom has slowed, many mortgage brokers have begun to focus on alternative products, and talk of reverse mortgages has begun popping up everywhere.  Typically, reverse mortgages are offered to people over the age of 62 who have limited current income but a strong desire to tap into the equity of their primary residence.  These loans allow retirees who are short of cash to not only stay in their homes, but also to enjoy a better standard of living while doing so.  Products like a reverse mortgage could easily be targeted at BYFC’s customer base and resultant mortgages could be sold off leaving BYFC with only fee income.

Another area of potential for BYFC is potential acquisition.  Banking mergers have been heating up in recent weeks and many firms are focused on bolstering their retail presence in California.  While it is true that BYFC is probably too small to garner much attention, the institution could be quite attractive because of its commitment to its community.  All banking institutions must comply with the Community Reinvestment Act (“CRA”).  The Community Reinvestment Act is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound banking operations. It was enacted by the Congress in 1977.  The CRA requires that each insured depository institution's record in helping meet the credit needs of its entire community be evaluated periodically.  That record is taken into account in considering an institution's application for deposit facilities, including mergers and acquisitions.  CRA examinations are conducted by the federal agencies that are responsible for supervising depository institutions: the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision.

In the case of BYFC, the Office of Thrift Supervision periodically reviews BYFC’s compliance with the CRA.  BYFC has earned an “Outstanding” rating as its focus is completely in-line with the CRA legislation.  Many institutions have difficulty receiving an “Outstanding” rating because, in many cases, they seek to avoid or, at least, not target the very customers that BYFC is serving.  These institutions can solve their regulatory issues by focusing on these underserved customers, buying a bank who is serving this market or investing in a bank that serves this market.  Cathay General Bancorp in 2004 sought to make an investment in the common stock of BYFC for exactly this purpose.  The transaction was put on hold pending regulatory approval, but closed in April 2006.  Following this transaction, Cathay General Bancorp will own more than 13% of the outstanding stock of BYFC and Cathay’s investment was made solely to help it comply with CRA.  Cathy has been very acquisitive historically, and they will likely ultimately be a buyer of BYFC.

Financials and Valuation

Rather than get too detailed on the valuation of BYFC, I have tried to keep everything as simple as possible.  The following is my current valuation:

As you can see, the bank is trading at book value.  The owned real estate held by the bank is certainly worth in excess of its carrying value as most of the properties were bought in the mid-1990’s or earlier.  While the Bank’s owned real estate might seem like a minor asset, it could be fairly material to the tangible book value of $19.1 million.

The loan portfolio appears to be of reasonable quality given the lack of any charge-off activity since 2000 and the absence of any problem loans.  Further, the portfolio is not concentrated from a size perspective or with respect to any individual borrower.  The mutli-family focus on Southern California is a positive from my perspective as I think there is a lack of affordable apartment housing in the area already which should bode well for current owners, in this case our borrowers, being able to ratchet up rents over time.

From an interest rate risk perspective, I think the worst pressure on interest rate margins may already be behind BYFC.  Interest rate spreads by my calculations looking at all assets and all liabilities got compressed during 2005 especially in the first, second and third quarters.  Since low point in third quarter, spreads are widening.  This makes sense given that the asset side of the BYFC balance sheet is repricing slower than the liability side.  While the loan portfolio is comprised of ARMs, some of the ARMs have fixed interest rate periods and others float, but reprice periodically based on a set schedule.

BYFC is classified as a savings and loan.  On a comparative basis, there are 220 savings and loans that are publicly traded.  If you rank the 220 institutions on a market cap basis, with #1 being the largest, BYFC ranks #201.  The average equity market cap is roughly $500 million.  On a price-to-book basis, where #1 has the highest price-to-book, BYFC ranks #203.  There are only 17 institutions that trade at or below book.  The group, on average, trades at 1.64x book value with the maximum price to book at 4.4x.  BYFC has a dividend yield of 1.86% and the group average is 2.42%.

Next, I ran the same comparisons on all savings and loans that had equity market caps of under $100 million.  There are 115 savings and loans with market caps equal to or under $100 million.  The average equity market cap is roughly $45 million.  There are only 14 institutions that trade at or below book.  The group, on average, trades at 1.45x book value with the maximum price to book at 2.9x.  The average dividend yield is 2.68%.

The one thing that BYFC has done from a balance sheet management standpoint that I don’t like is they loaded up in late 2004 and early 2005 on $43 million worth of mortgage backed securities.  These securities are classified as held to maturity and have maturities more than 10 years out.  The classification as held to maturity is advantageous because changes in value are not recorded in the income statement on a mark-to-market basis.  Given this favorable treatment, accounting rules state that if you sell held to maturity securities very often prior to their maturity you run the risk of tainting your entire held to maturity portfolio and can loose the ability to classify investments as held to maturity.  The held to maturity portfolio has lost value in the last year and would have reduced earnings by 35% if these securities were classified as available for sale.  Ultimately, I think this investment will work out fine, but I would have classified these securities as available for sale and taken the hit currently for declines in value.

Key Risks

There are obviously many risks that could impact a bank.  Some of the key ones are as follows:

1. Tightening of the interest rate spread between assets and liabilities could cause future profitability to decline.

2. BYFC is highly focused on the Southern California market.  A decline in economic performance for this region or a natural disaster, such as an earthquake, could have a material negative impact on BYFC.

3. BYFC operates in a heavily regulated industry and an inability to maintain its well-capitalized status and good exam ratings could materially impact its ability to operate.

DISCLAIMER:  This does not constitute a recommendation to buy or sell this stock.  We own shares of the BYFC and may buy shares and sell shares at any time.

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