Description

Colonial Bankshares (COBK) is a $318 million asset thrift in Southern NJ. It operates in two counties - the southern county is Cumberland County which is a little slow and agricultural, and has an average household income of $53,338, and the northern county is Gloucester County which is more suburban with people who work in the Philadelphia area, with an average household income of $71,664. The main office in the southern county of Cumberland, in Bridgeton, NJ, is 35 miles south of Philadelphia. They did a first step mutual holding company (MHC) sale on 6/30/05 and sold 46% of their shares to the public at the usual $10 a share. For additional details on the MHC thrift structure, please read the write-ups on NWSB, ONFC and BRKL.

In 2000, Edward J. Geletka was promoted to CEO after being with the bank for 13 years, and he has done a great job of growing the bank and of growing deposits. In 2000, they had 7 offices and deposits of $139.5 million. In 2004 they had 6 offices and deposits of $259.9 million. As of 6/30/05, 46% of deposits were CDs (versus 90% at WAUW and 73% at ISBC, both recent MHC thrift conversions). That is deposit growth of 16.8% a year from 2000 to 2004 without turning the place into a CD shop. That is phenomenal growth. NJ banks are being bought out at a deposit premium of 10% (conservative number) and higher, so you can see the importance of deposit growth to the value of the franchise in 5 to 6 years.

The lending book is typical for a thrift. Residential mortgages are 45% of loans, almost all of them fixed-rate. They recently were approved as a qualified servicer with Fannie Mae, which allow them to sell their fixed-rate mortgages. HELOCs are 22% and commercial real estate loans are 20%.Total net loans receivable were $138.6 million as of 6/30/05, non-accrual loans accounted were just $183,000 - a very respectable 0.13% of all loans. Credit quality is very good, as non-performing assets (NPA) since 2000 have been at 0.05% or less.

COBK had to demutualize to raise capital to continue its growth, and they will have to second step sooner rather than later if this growth continues. The Equity/Assets ratio pre-deal was only 5.85%. Post-deal, the E/A ratio is 11.3%. They are planning on opening a new branch in 2006 and building a new administrative headquarters/full service office in Vineland, NJ in 2006.

Insiders have a vested interest, as they bought 7.5% of the initial offering that had an individual order limit of 25,000 shares and 40,000 for group. The 86 year-old Board Chair bought 25,000 shares in the offering and bought 5,000 more in the open market on 8/22/05 at $10.70 a share. The 71 year-old vice chair bought 25,000 shares in the offering. The 43 year-old CEO bought 17,500 shares and as time goes on will own more and more shares and have a vested interest in cashing out.

Let us look at some numbers:

Year___ROE___ROAA___Efficiency
2002__ 8.13%___0.47%___74.3%
2003__11.75%___0.71%___67.1%
2004__11.96%___0.67%___67.7%

While the ROE is good, especially for a recently converted thrift, the ROAA and efficiency ratio leave something to be desired. However, that is something that they should be able to improve as they deploy their new capital and adjust to being a public company. The key discussion here, though, is the capital structure. As of 6/30/05, the key stats on Colonial are:

Total shares 4,521,696
Public shares 2,079,980
MHC shares 2,441,716
Equity now $36.148 million
Deposits $277.9 million

If you assume a second step in 4 years, they should be able to add $8.0 million to equity via retained earnings based on earning $2 million each year, bringing equity to $44.148 million. Let us assume that COBK is appraised at $69 million. There is nothing magical about that number but I did set up a spreadsheet where I could plug in numbers to see the end result, namely, the pro forma tangible book value.

Next, I divide $69 million by the 4,521,696 shares outstanding to arrive at the exchange ratio, which is 1.5260. This is what shares are multiplied by in order to arrive at a 2nd step share value of $10.00. If you have to ask about the $10 price, it is a thrift thing.

Then, multiply the exchange ratio by 10 times the number of MHC shares to arrive at the 2nd step offering size:

1.5260 X $10 X 2,441,716 = $37,260,000

Every offering has friction, so reduce the gross offering proceeds by 4% for underwriting fees and 8% for various stock plans. The net proceeds are then $32,788,800. Add that to $44.148 million of equity and the pro forma equity is $76,936,800. Dividing the $69 million appraisal by the pro forma equity gives us a pro forma price to tangible book value of 90%. This means the adjusted book is $17.02/share and if you buy at $9.95 now, you are paying 65% of future adjusted book at 90%. That comes to a 11.3% annual return, which is okay, but there is more. Recent 2nd step conversions have been over 100% of book. A 2nd step at 100% TBV would result in a pro forma book value of $18.58 and would produce a 16.9% CAGR.

After Colonial does the 2nd step conversion, they should be able to earn a 4% ROE in the next three years. In 7 years from now, book value should grow to $86.2 million or $19.06 per current share (before the 2nd step). Considering that 70% of converted thrifts eventually sell out, what is the takeout value of Colonial?

The basic thrift takeout formula is tangible book value plus a deposit premium. Assuming 5% annual deposit growth over the next 7 years, deposits should grow from $278 million to $391 million. Adding a 10% deposit premium of $39.1 million to $86.2 million of tangible BV comes to $125.3 million or $27.70 per current share and a 15.8% CAGR.

The 10% deposit premium is conservative, as the HU and ICBC deals are at 21% deposit premiums. A 15% deposit premium would result in a takeout at $32.0362 for a 18.2% CAGR. Assume a little good fortune with a 100% TBV 2nd step and a 15% deposit premium, and takeout is $33.79 and a 19.1% CAGR.

This is not a sexy investment and will require patience, but the downside is limited.

Risks:
- They do not do a 2nd step
- They remain independent
- Deposit growth slows
- Illiquid, micro-cap

Catalyst

Cheap valuation that would be unlocked by a 2nd step conversion and buyout.