Description

Codorus Valley Bancorp (“CVLY” or the “Company”) is a small cap bank based in York, PA.  Its shares are down over 45% this year, as it took some rather large one-time loan loss provisions primarily associated with two borrowers, the larger of which is a result of alleged borrower fraud.  Further, it reduced its dividend from $0.16 per share per quarter to $0.10 in July, adding additional pressure to the share price.  Management and the board have been buying shares during this decline. 

CVLY now trades at 0.6x book value compared to its post financial crisis average of 1.1x and five-year average of 1.3x book.  Over that time period CVLY has earned an ~9% ROE, and I believe they will be able to do so again soon, as currently elevated loan loss provisions roll off the LTM figures in 2021.   

Codorus Valley Bancorp, Inc. primarily operates through its financial services subsidiary, PeoplesBank.  PeoplesBank operates throughout South Central Pennsylvania and Central Maryland. CVLY has the second largest deposit share in York County Pennsylvania.  The Company’s loan book is primarily C&I related with approximately half of C&I being real estate related.

Historically, the Company appears to have done a good job on credit quality and reserving.  Non-accruals have averaged 1.0% of gross loans since 2012.  Non-accruals ticked up to 1.44% last quarter due to in large part an allegedly fraudulent borrower, but have come back down to 1.31% as of 6/30.  Over the past five and ten years, provisions for loan losses have exceed charge offs by 2.7x and 2.0x, respectively.  Loan loss reserves are relatively elevated today at 1.3% of gross loans- roughly in line with non-accruals.     

The Company has been led by Larry J Miller since 2004.  Mr. Miller seems to be well aligned with shareholders as he owns $1.6mm of CVLY stock compared to a base salary of $375k.

Due to heavy and unusual loan loss reserves, the Company has generated an ROE of 5.1% in the LTM period.  I believe the Company can earn an 8% - 9% ROE on a normalized basis, even considering the lower interest rate environment. 

• If you annualize Q2 quarterly interest to interest earning securities and loans and then adjust for the 20 bps LIBOR has fallen to today compared to the overall Q2 average, I expect the Company to generate a 3.6% return on yielding assets.

• Applying the same math to interest bearing liabilities, results in a 0.6% cost of funds and $59mm of NII.

• If you then use the average provision for loan losses over the past five years relative to average gross loans over the past five years, you deduct $3.8mm to arrive at NII less provisions of $55.6mm.

• Note that of the $12.2mm of LTM provision for loan losses, $7.5mm relates to a single, allegedly fraudulent borrower.  Further, PLL is elevated due to COVID.

• LTM non-interest income is $14mm (run-rate Q2 slightly higher).

• LTM non-interest expense is $52mm.  Deducing $3mm for COVID related expenses and one-time integration expenses, results in $49mm of non-interest expense (note Q2 run-rate is lower), resulting in $20.5mm of pre-tax income and $16.2mm of after-tax income or an 8.4% normalized ROE.

   

I then looked at valuation a couple of different ways:

1. An M&A based valuation that applies a premium to core deposits.  I used a 2.5% premium, which was in-line with the 2.0% - 3.0% average for bank transactions during ZIRP.

2. An ROE based valuation and a downside analysis, assuming ROE stays at current levels despite the one-time expenses associated with COVID, merger integration, and extraordinary loan loss reserves.

As show above, I think there is a material case for 60% - 80% upside, while downside appears to be limited.  I think this is an attractive risk / reward, and the shares should rebound as the extraordinary provision for loan losses, COVID expenses, and integration costs roll-off in 2021. 

Catalyst

Roll-off of elevated provision for loan losses in 2021