We believe Eastern Virginia Bankshares, Inc (EVBS) presents a compelling investment opportunity. We believe the stock could be worth ~$7.25 per share in the next 6-12 months, or ~40% upside from current levels.

Situation Overview

EVBS is a ~$1bn asset bank holding company headquartered in Tappahannock, VA (~35 miles northeast of Richmond). Like many banks, EVBS over-indulged on high-risk real estate loans during the housing bubble. As a result of credit issues arising from these loans, EVBS was forced to enter into a Written Agreement with its regulators in 2011, subjecting EVBS to several limitations and regulatory restrictions. Additionally, in 2009, EVBS received a preferred equity investment from the US government under the TARP, which they have yet to repay. In March of this year, to address their regulatory issues, EVBS announced a capital raise and strategic initiatives. On June 12, EVBS closed on a large private placement, which we believe has successfully recapitalized the bank and should pave the way for several positive catalysts.

Investment Thesis

EVBS’ capital raise was a transformative event. It increased their equity base by nearly 80%, bolstering their capital to a level where they can aggressively reduce the level of problem assets and restructure their balance sheet to increase profitability. This should put them in a position to be able to repay the US government and accelerate the removal of the Written Agreement with their regulators. We believe these events could transpire in the next 6 to 12 months. This will allow EVBS to be able to pay a dividend to common shareholders, which should be a further catalyst for the stock. Currently, EVBS trades at ~0.95x tangible book value (TBV), whereas comparable banks trade at an average of ~1.3x. We believe this is principally due to the issues mentioned above (regulatory overhang, depressed profitability, no dividend). As EVBS executes their strategic plan, these overhangs should be removed, and the valuation gap with peers should narrow. In terms of valuation, we estimate that year end TBV will be ~$5.80 per share.  At 1.25x TBV, EVBS would be worth ~$7.25 per share at year end 2013. This would represent ~40% upside from current levels.

Business Overview

EVBS operates twenty-two bank branches in Eastern Virginia.  At a high level, as a bank, EVBS business model is very straightforward. They take in deposits and use that cash to either originate loans or purchase securities. We believe that in banking, the real value of a franchise lies primarily in the strength of the deposit base. What is interesting about EVBS is that it appears that they have a very strong deposit franchise. While EVBS is a small player in the state of Virginia (21^st largest bank with 0.5% deposit market share), they hold very strong positions in the markets in which they operate. In the five counties in which they operate, they hold the #1 market position in four, and the #2 market position in the fifth. On average, EVBS holds ~$4 out of every $10 of deposits in the banking system in the markets in which they operate, an extremely robust market position.

Regulatory Issues

While we believe that the real value of a bank exists in its deposits, we also acknowledge that value can easily be added or destroyed by a bank by the way they choose to invest those deposits. In the case of EVBS, during the housing boom, they chose to invest their customers’ deposits predominately in real estate loans. As the housing market swooned, so did EVBS’ real estate lending portfolio. Total non-performing assets at EVBS increased from 0.4% of loans and owned real estate in 2007 to a peak of nearly ~5.0% in 2010. Unfortunately for EVBS, the large spike in non-performing assets caught the attention of the regulators, and in 2011, EVBS was forced to enter into a Written Agreement. The Agreement requires EVBS to address significant aspects of their business operations, and requires EVBS to submit capital plans to maintain sufficient capital, and refrain from declaring or paying dividends without prior regulatory approval. For those interested, a copy of the Written Agreement can be found in the link below. While non-performing assets have declined from ~5.0% down to ~2.1% at 3/31/13, the Written Agreement still is in force. In addition to the Written Agreement, EVBS also still owes ~$27mm to the US government to repay a preferred stock investment received from the TARP in 2009 ($24mm in original investment and ~$2.7mm in accrued and unpaid dividends).

Link to Written Agreement: http://www.sec.gov/Archives/edgar/data/1047170/000115752311001039/a6621352ex10_12.htm

Capital Raise and Strategic Initiatives

On March 26^th, EVBS management announced a capital raise and strategic initiatives, in order to strengthen the balance sheet and, in their words, “better position the Bank and the Company to expeditiously exit the Written Agreement, which currently restricts us from paying dividends to our shareholders, and TARP”.

EVBS raised $45mm in private placement to two sponsors, Castle Creek and GCP (see links below for info). Additionally, EVBS issued a $5mm rights offering to existing shareholders, which recently expired oversubscribed. In total, we estimate EVBS raised net proceeds of ~$47mm, and increased their TBV from ~$59mm before the offering to ~$106mm post the offering. Importantly, this offering increases EVBS’ capital base by nearly 80%, and by our calculations moves their tangible common equity to tangible equity ratio (TCE/TA), a key regulatory ratio, up from ~5.6% to ~9.4%. Pro forma for the offerings, Castle Creek and GCP hold a cumulative economic interest of ~58% of EVBS, while existing holders own ~42%.

With the proceeds from the offering, EVBS will be able to accelerate the disposition of problem assets, and prepay expensive FHLB borrowings to improve their ongoing earnings profile. Specifically, we believe that these two actions will result in an approximate ~$10mm hit to TBV. However, once these actions are completed (next 6-12 months), EVBS will be in a much stronger position with their regulators, as their problem assets will be reduced dramatically (we estimate an ~40% reduction) and their profitability will be markedly improved.

Memo: Links to PE Sponsors Websites:   Castle Creek: http://www.castlecreek.com/     GCP: http://www.gcpcapital.com/us-home

Valuation

In terms of valuation, it is best to look at EVBS on a multiple of book value. Pro forma for the capital raise and strategic actions, we estimate that pro forma book value will be ~$96mm, or ~$5.60. It is important to note that this assumes that the entire hit from the strategic initiatives is incurred up front (ie taking the losses today on the bad loans, and incurring the prepayment expenses on the FHLB borrowings), whereas in reality these should occur over the next 6-12 months. Through the end of the year, we estimate that EVBS will grow TBV through retained earnings by ~$0.20. Therefore, we use ~$5.80 in Year End 2013 TBV as the basis of our valuation.

TBV Rollforward:

TBV 3/31/13:                                                        58.9mm

Est Private Placement Proceeds:                             42.3mm

Est Rights Offering Proceeds:                                   5.0mm

Est Loss From Strategic Initiatives:                      (10.5)mm

PF TBV                                                                95.7mm

PF Shares                                                             17.1mm

PF TBV / Shr                                                          $5.61

Est Retained Earnings (through 2013)                        $0.21

Est PF TBV / Shr (YE 2013E)                                 $5.81

EVBS’ peers trade at an average of ~1.32x TBV. We believe that the discount of EVBS to its peer group is due to the regulatory overhangs, depressed profitability from inefficient balance sheet, and the lack of a dividend on the common stock. We believe that once these issues are addressed and the overhangs are removed, the valuation gap between EVBS and its peers should narrow significantly. At 1.25x our estimate of Year End 2013 TBV, EVBS would be worth $7.25, or nearly ~40% upside from current levels.

In terms of earnings, EVBS peer group earns a median return of ~10% on equity and trades at a ~14.3x earnings multiple. By our analysis, once EVBS restructures its balance sheet, removes the additional costs of carrying a larger than average nonperforming asset load, and regulatory costs from dealing with the Written Agreement, ROE should be in the neighborhood of ~9%. This would equate to ~$0.55 in EPS. Our $7.25 price target would equate to ~13.5x on this pro forma earnings number, or a ~1.0x multiple turn discount to the peer group, due to the slightly lower ROE.

Link to the peer analysis (SNL via EVBS IR site): http://www.evb.org/peer.aspx?iid=1974273

Potential Dividend: We believe it is not unreasonable to think that over time, EVBS could pay out ~40% of their earnings in the form of a dividend. This would equate to ~$0.22 in annualized dividend, or a 4.2% yield on the current price.

Additional Longer Term Upside

Higher Interest Rates: We mentioned earlier that we believe that the real franchise value with EVBS lies with its core deposit franchise. Unfortunately, the benefits of a strong deposit franchise are minimized when interest rates are near zero. As interest rates rise, the banks with stronger deposit franchises should be able to defer increasing rates to their customers, and therefore should benefit more than the average bank when rates rise (to be sure, most regional banks will do well in a rising rate/steepening yield curve environment such as the once we are beginning to see). To put numbers around this, a 100bps increase in EVBS securities and loan portfolio, offset by a 50bps increase in deposit costs would by our estimates increase EVBS EPS by ~$0.20… obviously on an EPS base of $0.55, this represents a significant increase to profitability. To be clear, this would not happen immediately, as all existing securities and loans would need to run off and be replaced by higher yielding assets. However, higher rates should provide a nice tailwind to EPS over time.

Potential Takeover: Over time, Castle Creek and GCP will seek to monetize their investment in EVBS. Given the strength of the core deposit franchise at EVBS, the digestible size of an acquisition by a strategic acquiror, and the illiquidity in the public equity, it seems logical to us that a sale should be the best exit. Obviously, this is a longer-term option, but any premium garnered in a takeout would be additional upside.

Catalysts

Removal of Written Agreement

Repayment of TARP

Reinstatement of common dividend

Risks

Failure to exit TARP or remove the Written Agreement with regulators (however, we view this as low probability given strength of capital levels post the equity raise)

Weakness in housing market which would reduce asset values for problem loans (however, our bias is for continued strength in the housing market)