Exchange Bank (EXSR) is a small, under the radar CA community bank, trading at 64% of TangBV, a runrate P/E of 7.75x, 2.4x pre-provision earnings, less than 5x conservative normalized earnings, and about 1/3rd of its conservative private market value to the many banks that would buy them today if they could. The bank has an excellent deposit franchise, with about 1/3rd non-interest bearing deposits and deposit share in Santa Rosa of 12.6% (behind only BofA & Wells Fargo).  Exchange earned $4.91/share in 2010 despite still elevated LL provisions and TARP dividends.   I believe the opportunity exists to buy this bank at a substantial discount to intrinsic value due to a confluence of short-term factors that will work themselves out sometime within the next 2 years. Catalysts include: resumption of the company’s historically substantial dividend, repayment of TARP (within the next 2 years), further reductions in NPAs over time, and eventual return of investors to small, illiquid, cheap stocks like EXSR.  In the meantime, at current earnings levels, the stock should continue to compound BV at 8-12% per year and trade to 2-4x current levels (1-2x BV / 8-15x earnings) within the next 3 years once the company pays off TARP and re-instates its dividend. Management seems to agree, and has recently been buying stock. The bank makes enough pre-provision earnings that they can provision for 3% of loans each year and still break-even, so downside would appear to be limited from these levels, given where book value is today and the magnitude of incremental credit issues that would need to occur for the bank to see book value impaired.  Unfortunately, liquidity is pretty awful, making this appropriate only for PAs or small funds. 

Why the opportunity exists:
EXSR is one of the few stocks that has gone nowhere since the stock market bust despite drastically improving its capital position, credit metrics, and earnings.  In 2009, the stock traded for between $40-50 a share, after taking TARP and posting a -$10.70 EPS in 2008 due to aggressive provisioning for loan losses in its C&D portfolio.  Two years and five consecutive quarters of profitability later, including $4.91 of earnings in 2010, the bank still trades for $43/share and at a cheaper P/Tang BV than it did in 2009 (since TangBV has grown).  The key reason for this dynamic, in my view, lies with the unusual shareholder base.  Slightly over 50% of the shares outstanding are held in a perpetual trust (the Doyle Trust) that funds scholarships at the local community college.  The bank has historically paid ~70% of earnings out in dividends, the proceeds of which the trust used to fund the scholarships.  Outside the trust, the bulk of shareholders are employees and depositors in the community, who mostly bought the stock for its consistent dividends.  In mid 2008, the dividends stopped.  In 2010, the trust announced it had run out of money to pay for scholarships and suspended its scholarship program (subsequently, community members have donated funds that has allowed the trust to continue scholarships, albeit at a lower than historical rate).  To the degree that the retail shareholder base largely valued the bank based on dividend payments, some community members have sold the stock into an illiquid market.  Some community members have also been forced to sell out of financial necessity, due to unemployment or other personal financial issues.  At the same time, the stock’s low liquidity and lack of SEC filings (financials only available on its website and through call reports) make it tough to spot for institutional or other savvy investors.  The bank also took TARP, has a highish NPA level (5.3%), high classified loan level, and has a still meaningful C&D portfolio (9.7% of loans), all of which might scare off investors not willing to buy anything other than clean-credit banks. Also, because the trust controls the vote and has (to date) had no interest in seeing the bank sold, the most likely way value will be realized is through the slow process of continued earnings, which will over time facilitate the re-payment of TARP, reinstatement of substantial dividend payments, and growth in book value.

Credit Quality:
In 2005-2007, the bank made some lending mistakes by following its customers outside its core Santa Rosa market and into Sacremento.  Like many CA banks, they got too heavy into C&D loans, which resulted in substantial losses and write-downs. The former CEO, who was responsible for these decisions, was replaced by more conservative management. Exchange aggressively charged down and wrote off bad loans in 2008: they’ve worked their C&D portfolio down to 9.7% from 26% of loans in 2007.  They have charged off 112M since 2007, or about 10% of their 2007 loan balance, which mostly has come from their C&D portfolio.  Although NPAs remain at 5.3%, credit metrics have been improving and the company is reasonably reserved against current NPAs (~60% ALL/NPA).  Santa Rosa is still depressed economically, and real estate prices remain under pressure.  Most their remaining exposure is to commercial real estate in Santa Rosa, which has seen prices decline about 20-30% since the peak.  NPAs ticked up slightly last quarter, and the bank probably still has some further provisions it will need to take (the CFO estimates the 3M/quarter number is good for now).  Despite elevated LL provisions, the bank remains very profitable due to its strong core deposit franchise, and can continue to absorb these losses (and even higher loss levels) without losing money.

Financials / Valuation:
Financials below were compiled from call reports going back to 2005, since the company only makes publicly available 2009 & 2010 results on their website.  The company has historically achieved mid-teens ROEs.  To be conservative, I use a ~11.5% normalized ROE, in line with what the company would be earning today with a lower level of LL provisions, without TARP dividends, and with higher go-forward capital requirements. This creates the company today at less than 5x normalized earnings and at a dividend yield of 15%.  Unlike many other banks trading below book, the company is already substantially profitable today even with it’s elevated LL provisions, and looks attractive at 7.75x earnings even if LT earnings power is impaired for some reason. 

Regulatory:
Until a few weeks ago, the company was confident that it would be able to replace TARP with the small business-lending program, which would allow them flexibility to re-instate a dividend sometime later this year.  Unfortunately, last minute changes have now made this unlikely, meaning the bank will probably continue to have to retain earnings until it earns enough to comfortably pay off TARP.  Capital ratios including TARP are strong, with Tier 1 leverage ratio of 9.55%, Tier 1 risk based capital ratio of 11.8%, and TCE of 7.9%. The bank currently has an informal agreement with regulators to keep its tier 1 leverage ratio above 9%.  This is well above the 5% historically used to classify a bank as “well capitalized”, and above the new 8% “informal” requirement.  As the bank continues to reduce NPAs and generate earnings, its capital ratios will improve and the informal agreement will likely end. The company currently has a leverage ratio, ex-tarp, of 6.7%.  A combination of continued retained earnings, declining average assets, release of the current 18M disallowed deferred tax asset to Tier 1 Capital should allow the company to achieve an ~8% Leverage ratio ext TARP by Q1 2012, and a ~9% leverage ratio by Q1 2013.  This should allow the bank to repay TARP within the next 2 years.  Management has stated that this is their intention, rather than raising capital at these valuations.

Key Risks:
**Any abrupt spout of substantial credit losses (e.g. writing off 6% of the loan book in a year) could overwhelm pre-provision earnings, and force the bank to raise capital in an unfriendly environment.  Although the company can whether continue steady provisions at current levels or higher, any substantial double dip or hidden credit problems that have yet to surface (e.g. in the CRE portfolio) would likely wipe out earnings for a period, but could even impair TangBV and hit capital ratios if the losses are bad enough.
**The trust has two primary mandates: 1) to support the Doyle Scholarship program, and 2) to keep the bank independent.  The bank could likely sell themselves for 2-3x what its trading for today if they wanted to, but this likely won’t happen as long as the trust continues to view one of it’s primary responsibilities as making sure the bank stays independent.  Although this is unfortunate for shareholders, the positive offshoot from this is that the trust’s interests result in the bank paying out a large portion of it’s earnings as dividends, which is generally a shareholder friendly action.

**More aggressive regulatory requirements which delays the time it takes for the company to repay TARP, or in a worst case scenario requires the bank to raise capital.  I’d view the  bank raising capital as a potentially good thing, as it would increase liquidity and allow interested holders to build a larger position at what still should be an attractive price.

**Eventual repayment of TARP

**Reinstatement of dividend

**Continued improvement in NPAs and reduction in LL provisions, eventually leading to ROEs, earnings and dividends (and eventually valuations) more in line with historical levels.

**Decrease in liquidity discount, return of investors to small community bank stocks