Value Investors Club / FIRST NORTHWEST BANCRP (FNWB)

Description

First Northwest Bancorp (NASDAQ: FNWB)

Thesis

FNWB is a clean, well-capitalized and growing $1 billion community bank with a strong deposit footprint northwest of Seattle, Washington trading at a significant discount to tangible book value (TBV) -- 0.81x P/TBV at today’s market price). As a result of the bank’s recent standard demutualization transaction completed 1/29/15, FNWB is now a publicly traded banking organization with ~$97 million in excess capital (60% of current market cap) assuming a 10% leverage requirement (pro forma TCE/TA is 19%). A new management team plans to lever this excess capital through a mix of organic growth, share repurchases post the 12-month lockup period as well as dividends. We expect new management at FNWB to drive shareholder value by responsibly levering excess capital, growing assets and achieving competitive ROA/ROE. The combination of these efforts should position the bank as a compelling takeout candidate in 3-5 years (especially for mid sized regional acquirers like HFWA), especially in an improving economic/rate environment.

Background – Standard Demutualization

FNWB completed its standard demutualization on 1/29/15. The bank raised $121.7 million gross proceeds at $10 per share in an over-subscribed offering that was at the super-max of the offering range. The offering resulted in shares outstanding of 13.1 million, capital ratio (TCE/TA) of 19% and TBVPS of $15.33. Today’s market price of $12.32 represents 0.81x P/TBV.

Franchise & Strategy

FNWB is the holding company for First Federal Savings & Loan Association of Port Angeles, a 90-year old community savings bank that serves the North Olympic Peninsula region of Washington via nine full- service branches and one lending production office in Bellingham, which opened in July 2012.

Source: FNWB S-1

Given its thrift roots, the franchise has historically been a residential lender. Changes in market conditions have led to changes in business strategy – the bank is transitioning into a more robust commercial lending platform to better service its consumer and business clients.

FNWB is executing its organic growth plans via a de novo branching strategy. It plans to open four new branches in the Puget Sound market over the next three years post conversion. The bank

is also growing its lending exposure outside core markets via new originations and loan purchases and participations, given slower growth in the primary market. The bank has no immediate plans to grow via acquisitions.

The franchise is well situated with nine branches and one LPO in a deposit-rich and economically improving marketplace. The state of WA has 80 institutions and $122 billion in total deposits, signifying considerable organic growth potential for the franchise (increasing scarcity value) as well as future consolidation activity.

Moreover, large, stable employer bases in relatively non-cyclical industries characterize the markets in which the bank conducts business.

Regulatory

There are no restrictions or orders in place regarding capital management or M&A apart from standard capital adequacy rules. The company is subject to the standard post conversion 1 year restriction on

dividends and share repurchases and 3 year restriction on being acquired.

Loan Portfolio & Credit Quality

The loan portfolio is predominately 1-4 Family and CRE today (see portfolio complexion below as of 12/31/14, source: SNL Financial). The bank has been adding 30-year fixed rate mortgages to the portfolio

in an effort to enhance NIM. Going forward, the vision is to better diversify the mix into commercial lending (C&I and CRE).

The bank has improved credit quality over time. Credit performance has improved post crisis, as legacy management has completely turned over since 2011. Legacy credit metrics are shown below from 2008-2014. Nonperforming assets have declined over 22% from their peak in 2011 and are now under 2% of assets as of YE2014. This has been driven by the decline in real estate nonaccruals, the major category, which have dropped over 50% since their peak. Reserve coverage has steadily increased from ~30% of NPLs in 2009-2011 to over 50% at YE2014.

Source: SNL Financial.

Deposit Base

The bank has an excellent deposit franchise with > 90% core deposits and relatively shorter-duration CDs. The all-in average cost is 25 basis points. We expect this to only improve as the bank executes on its commercial banking strategy.

Source: SNL Financial.

Sensitivity to Market Risk

The B/S is liability sensitive. Management is actively trying to reposition the B/S into more commercial loans (from 20% in 2010 to 38% in 2014, +$100M). However, they have been adding 30-year fixed-rate mortgages since 2012 to the portfolio in an effort to boost Net Interest Income. Good deposit franchise with 90% core, all-in weighted average rate 25bps, most CDs are short term due 2015. Management is thus using B/S tools to manage market risk as it executes on its commercial banking strategy.

Markets

The Puget Sound economy is characterized by less boomand bust than other parts of the country, given the region’s large employer base in basic industries and less cyclical businesses. Key demographic data points are shown below by county:

The branch network is located in high household income areas of the market:

Source: SNL Financial.

Competitive Positioning

The top 30 competitors by deposit market share in the state of Washington are presented in the table below. This is a fragmented market with 80 total institutions and $122B in total deposits. FNWB ranks 23rd on this list. There are many regional acquirers looking for bolt on transactions including: Washington Federal (WAFD), Banner (BANR), Columbia (COLB), Heritage Financial (HFWA), Umpqua (UMPQ), and HomeStreet (HMST.)

Source: SNL Financial.

Precedent Bank & Thrift M&A Transactions since 2010 in Washington / Comparables

Source: SNL Financial.

The list above shows all transactions in the state of WA since 2010. Given FNWB’s asset size, a good comparable could be Washington Banking Company (WBCO) which sold to Heritage Financial in October

2013 for 1.5x P/TBV and 15.6x P/E.

Model & Returns

Our model was developed independently based on a reading of the bank’s S-1 and recent public filings. The central questions underlying the model are the capacity to which the bank can lever its excess capital through organic growth, share repurchases and dividends, as well as achieve sustainable earnings power via executing on its commercial banking plans, to become a compelling takeout candidate in several years time. Key model assumptions include:

1. Starting point for the model is 4Q 2014, adjusted pro forma for $121.7 million offering

2. Approximately 4% loan and deposit growth per year, driven by de novo efforts

3. NIM trends to 3%+ as bank grows commercial lending business and rate hikes expected in latter half of 2015 into 2016

4. Credit quality remains excellent with 1.5% ALLL

5. Modest increases in fee income and overhead expense

6. No dividends

7. 5% repurchase program at 0.81x P/TBV after 12-month moratorium period

8. Capital levered from 19% to 16%

This is a conservative case as growth and NIM could exceed expectations as the bank executes on its strategic plan and rate increases take place. Under this forecast, TBVPS grows to $17 per share by 2018. If the bank remains at 0.81x P/TBV, this equates to a $13.80 stock price. If the bank executes on its plan and levers excess capital more quickly and responsibly, thereby generating more competitive ROA/ROE, this would be attractive to a potential takeout by 2018. Assuming a takeout multiple of 1.5x P/TBV as was the case for WBCO, this would equate to $25 per share in 2018 (nominal), or $18 per share NPV.

Valuation

Merits

1. Attractive entry valuation

2. Attractive markets with strong economic drivers, large and stable employer base

3. Fragmented deposit marketplace with consolidation potential

4. Well capitalized

5. Clean credit

6. Superb deposit franchise

Risks

1. Abundant excess capital (19% TCE ratio) – overcapitalized, dragging returns (ROA, ROE)

2. Acquisition philosophy and willingness to do deals (banks and branches)

3. Strategic philosophy – standalone or sell in three years

4. Growth philosophy – including de novo branching and syndicated loans (participations)

5. Execution risk

6. Share repurchases

7. Dividends

8. Regulatory risk

9. Expense management

10. Interest rate risk positioning

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Company initiates a share repurchase program in January 2016 when it anniversaries its demutualization

Company can be acquired after January 2018 once the 3 year restriction on being acquired passes.

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			2015	2016
Price:	12.32	EPS	0	0
Shares Out. (in M):	13	P/E	0	0
Market Cap (in $M):	161	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0