Thesis: Meridian Interstate Bancorp, Inc. (NASDAQ: EBSB) is an attractively priced, fast growing, and geographically appealing mutual bank with value trapped inside its legal / regulatory structure. Through EBSB's structure, management can actively generate shareholder value through loan growth, share repurchases, acquisitions, and a second step full demutualization.

Company: Founded in 1848, EBSB is a mutual bank based in the Boston Metro Area (Essex, Middlesex, and Suffolk counties).  The Company currently has 22 branches, including 8 full service locations in its Mt. Washington Bank division.  EBSB is ranked #15 in deposit market share (0.93%) in the Boston-Cambridge-Quincy MSA.  Richard J. Gavegnano is Chairman and CEO.

Major Shareholders: MHC (59.2%), Wellington / Bay Pond (15.1%), M3 Funds (1.9%), Richard Gavegnano (1.0%), All other directors and executives as a group (1.3%)

VALUE TRAPPED FROM FIRST STEP DEMUTUALIZATION / MINORITY PRICE TO TANGIBLE BOOK VALUATION

EBSB was originally structured as a pure mutual bank.  Unlike commercial banks, mutual banks have no stockholders; instead, the depositors own the bank through a mutual holding company (MHC).  The MHC is effectively a trust with a board of directors that looks after the interests of the depositors.  In January 2008, EBSB completed a "first step conversion" process through an IPO.  In this transaction, management essentially sold the bank away for free because EBSB did not have any non-mutual owners.  IPO participants invested ~$100mm and received a bank with ~$200mm in book value.  In the words of the great Seth Klarman, "The conversion proceeds are added to the preexisting capital of the institution, which is indirectly handed to the new shareholders without cost to them.  In a real sense, investors in a thrift conversion are buying their own money and getting the preexisting capital in the thrift for free."

Today, the MHC owns 13.2mm shares (59.2% ownership) and minority shareholders hold 9.1mm shares (40.8% ownership).  For GAAP / EPS purposes, the total share count is 22.2mm.  However, the correct approach is to apply 9.1 million shares only because the shares held by the MHC are essentially treasury shares from an economic standpoint and should be excluded in determining EBSB's fair value for two reasons:

1) The MHC has waived its dividend rights so profit distributions go to public shareholders (EBSB does not pay dividends to shareholders)

2) If the MHC shares are sold, it would be considered a primary offering because the net proceeds would not go to the depositors but used to capitalize the business.

As a result, the MHC structure is often misunderstood and many computer models (see Yahoo Finance, Capital IQ, etc.) calculate EBSB as being inappropriately valued at 1.4x price to tangible book at a ~$278 million market cap (based on 22.2 million total shares outstanding). 

Price: $12.50

Minority shareholders (incl. ESOP): 9.1mm shares, 40.8% ownership, $113mm valuation

MHC: 13.2mm shares, 59.2% ownership, $165mm valuation

Total: 22.2mm shares, $278mm market cap

TCE: $206mm

P/TBV (incl. MHC shares): 1.35x

P/TBV (excl. MHC shares): 0.55x

Once the MHC shares are excluded, we see that EBSB, a clean and geographically attractive franchise, is undervalued at 0.55x minority P/TBV.  I believe EBSB is currently undervalued because of (1) investor misunderstanding of the Company's shareholding structure, (2) many bank MHCs having recently demutualized in response to Dodd-Frank legislation (e.g. OTS merges into OCC, MHC dividend waiver in jeopardy, etc.), and (3) small cap financials having been in a bear market for the last few years.

FULLY CONVERTED PRICE TO TANGIBLE BOOK VALUATION

Since becoming public in January 2008, EBSB has successfully deployed its first round of capital through significant loan growth, share repurchases, branch build out, and the acquisition of Mt. Washington Co-Operative Bank in July 2009.  The acquisition increased assets by ~40% to $1.7bn and reduced TCE/TA from 16.5% to 11.7%. 

Given EBSB's growth trajectory, the Company will likely complete a second step demutualization over the next 2-3 years, and should be valued using the fully converted tangible book value approach instead.  Under this methodology, EBSB is currently trading at 80% of FCTBV (see Appendix B), which is a decent price for a fast growing and geographically attractive bank mutual that can earn 6-8% ROE and has a potential catalyst ahead in the future.

EBSB is currently capitalized at a 10.8% TCE ratio, but several catalysts exist to utilize capital (bring TCE levels down) in order to necessitate a full conversion in the future:

1) Significant loan growth.  Since going public, loans have compounded at a ~24% CAGR, growing from $572mm at the end of 2007 to $1.2bn as of Q2-11 (excluding the Mt. Washington transaction, loans have grown at a ~13% CAGR).  Over the last 2-3 years, EBSB has grown its loan book significantly as a result of a pull back in commercial and construction lending by the large banks in the Boston Metro Area. 

In addition, management has recently indicated that the Company's loan pipeline (~$120mm) is gaining strength, and recently established a C&I lending division after hiring a team of 6 veteran bankers from Danversbank, a competing institution.  At 30% cash and securities to assets and 79% loans to deposits, EBSB's balance sheet has ample liquidity and capacity to absorb more loan growth.

2) Share repurchases.  Since 12/08, EBSB repurchased a total of 1.4mm shares, or ~14% of the original ~10mm shares of stock sold in the offering.  EBSB announced on 8/9/11 that it completed its third share repurchase program, which consisted of 472k shares at an average price of $12.53 per share, as well as the adoption of a fourth stock buyback program of up to 10% of its outstanding common stock, or 904k shares, which translates to approximately $11mm based on the current $12.50 share price.  As of 3/31/11, there was ~$20mm in cash and securities at the parent holding company, Meridian Interstate Bancorp, Inc.  It is also interesting to note that the recently announced fourth share repurchase program is approximately twice as large relative to the first three share repurchase programs at 414k, 518k, and 472k shares, respectively.

3) Potential acquisitions, de novo branching.  Management has indicated that they are on the lookout for transactions similar to the Mt. Washington Co-Op deal.  In Massachusetts today, there are ~158 institutions with less than $5bn in assets, of which 39 are stock corporations, and 119 are mutual type institutions.  EBSB's acquisition of Mt. Washington was the first time in Massachusetts that a MHC structure acquired a mutual bank.

In addition, EBSB recently announced that it will be opening two new branches in Cambridge, MA and Danvers, MA by year end.  With the addition of these two branches, EBSB will operate 24 full service locations.

LONGER TERM FRANCHISE VALUATION / RETURNS ANALYSIS

Assuming EBSB can achieve 7-8% loan growth, repurchase a moderate level of stock, and complete a second step conversion at 90-95% of TBV by mid 2014, then fully converted 6/30/14 TBVPS, in current terms, would equal ~$20.68-21.86 per share.  At this appraisal, exchange ratios would equal 1.86-2.08x, implying a future share price of $18.61-20.77, or a 15-19% IRR over the next 3 years.  This analysis is conservative because it excludes the impact of a "pop" post conversion, future acquisitions, and the possibility of an earlier second step offering (a demutualization event one year earlier in mid 2013 at 90-95% FCTBV increases the returns to 19-26%). 

On 6/27/11, EBSB issued an 8-K in response to Mergermarket's report, which indicated that an employee of EBSB asserted that the Company had a high probability of engaging in a second step transaction within the next 12 months.  In response to the report, EBSB stated that it has not adopted a plan of second step conversion yet and currently has no plans to do so.  As such, for conservatism, we have assumed that EBSB would demutualize later in ~3 years when TCE capital levels are more likely than not to reach single digits.

While EBSB is more likely to be an acquirer in the near future, we should highlight that the Company's longer term valuation multiples are likely to be higher than 90-95% due to the scarcity of attractive Boston metro banking franchises.  According to Sterne Agee, as of December 2000, this same market had 12 institutions with assets between $1-5bn, and all but three of the original institutions sold at an average valuation of ~2.65x TBV.  As a side note, People's United Financial has taken over three Boston Area franchises (Danvers, LSB Corp, and Butler) since 2010.

While a return to historical deal pricing metrics seems unlikely, it is interesting to highlight that recent Massachusetts strategic bank and thrift acquisitions since 2009 have priced around 1.4-1.5x TBV.  As such, a 90-95% TBVPS exit seems conservative, and there could be further value creation (upside to the returns) post demutualization as EBSB continues to leverage its capital base, execute upon its business plan, and look more like a "regular" banking franchise several years out.

INVESTMENT CONCERNS / ADDITIONAL AREAS OF DILIGENCE

Uncertain regulatory climate.  The regulatory landscape is still developing in the "Bank MHC" world.  As a result of recent Dodd-Frank legislation, the OTS will be merged into the OCC, and the Federal Reserve will act as the new holding company regulator.  Second step conversion regulations do not exist yet under the Fed and may result in future unfavorable treatment for bank MHCs.  Moreover, the OCC and Fed are seen as more stringent regulators, and may require stricter standards.  With that being said, Meridian Interstate Bancorp and Meridian Financial Services are regulated as bank holding companies by the Federal Reserve Board and the Massachusetts Commissioner of Banks.

Securities portfolio.  EBSB maintains a $181mm portfolio of high quality corporate bonds, which comprises about half of the Company's securities portfolio.  While this level of concentration is higher than industry averages, management has indicated that (1) virtually all of these securities are rated investment grade by Moody's and S&P, and (2) there are no issues above $5mm.  Within the corporate bond securities portfolio, 27% mature within the next year, and 68% mature within the next 1-5 years.

Asset quality of loan portfolio.  The Company's loan portfolio consists primarily of SFR (32%), multi-family (15%), and commercial real estate (38%).  Construction loans comprise 7% of the portfolio.  CRE and multi-family loans are primarily secured by apartment buildings and commercial properties.  Generally, these loans do not exceed 75-80% of appraisal value, have debt service coverage ratios of at least 1.20x, and have concentration limits of up to $20mm per borrower.  Management intends to continue growing these loan segments. 

Historically, loss rates for EBSB have been low: net charge-offs to average loans peaked at 38 bps in FY08, and was 19 bps in FY-10.  Today, the Company has a 4.2% NPL and 2.9% NPA ratio.  EBSB has a 26% Texas ratio, but a second step offering would lower this figure. 

Operational efficiency.  Given EBSB's strategic focus on growth (e.g. branch expansion, new lenders and products, etc.), the Company will likely have an elevated expense base over the next 2-3 years.  EBSB's efficiency ratio in Q2-11 was 75.2%.  While a high efficiency level is not a positive attribute for bank mutual investments, nevertheless, with continued balance sheet growth, EBSB's efficiency levels should improve over time.  Essentially, EBSB needs to grow into its expense base.

Liability sensitive balance sheet.  According to the latest 10-Q, if rates were to increase by 300 bps, net interest income would decline by 7.4%.  In consideration for this point, the Federal Reserve has recently said that it will keep interest rates at record lows for the next two years.

40% stake in Hampshire First Bank (OTC: HFBN).  In addition to providing investors with a demutualization play, EBSB also owns a 40% stake in HFBN, a 2006 New Hampshire chartered de novo commercial bank.  This franchise has 5 branches, and reached earnings breakeven in June 2009, a critical factor for de novo franchises.  HQ: Manchester, NH.  $272mm assets, ~$28mm of book value.  Annualized Q2-11 earnings = 1.7mm x 20 P/E = $34mm market cap x 40% = $14mm value of stake (carried on books at $12-13mm).  The investment in HFBN is accounted for under the equity method of accounting, under which EBSB's share of net income of HFBN is recognized in the Company's consolidated financial statements.

APPENDIX A: SUMMARY FINANCIAL PROJECTIONS / ASSUMPTIONS

Loan Growth: 7-8% annually.  This assumption is conservative as management has historically compounded the loan book at a ~13% CAGR.  The addition of the new C&I team will also bolster EBSB's loan growth.

Net Interest Margin: The NIM is expected to increase from 3.20% as of Q2-11 to 3.50% by mid 2014.  EBSB has a liability sensitive balance sheet, and we are in a historically low interest rate environment.  Strong deposit growth has led to excess liquidity in the franchise.  The addition of the C&I team is expected to bring in some low cost deposit relationships, which is a positive.  Nevertheless, EBSB is likely going to be challenged in growing its NIM in the future compared to other commercial banks whom I believe should be near a high three to mid four NIM a few years out.

Provisions: EBSB has had a stellar track record when it comes to credit losses, and net charge offs to average loans have been modest over the last 2-3 years.  I believe EBSB's credit performance has to do with management's prudent underwriting and the attractive geography of Boston, which has been less susceptible to the downturn of the US economy leading to higher recoveries in the non performing portfolio.  Nevertheless, as EBSB's loan book continues to season over time, loan losses should begin to approach that of other normal, healthy, banking franchises.  Hence, I have assumed that net charge offs to average loans would reach 30 bps by mid 2014, and the reserve ratio would increase from 89 bps at Q2-11 to 1.25% over the next 3 years.

Fee Income / Revenue: EBSB's fee income represented ~15% of revenue in Q2-11.  The Company does not have a robust fee generation business.  Customer service fees (64%) and loan service fees (10%) represent the bulk of fee income excluding gain on sale type revenue.  The rest of fee income comes from BOLI and affiliate earnings.  Given EBSB's strategic focus on growing its lending base, the Company's core fee income as a percentage of revenue will likely decline while affiliate earnings continue to grow quickly.  As such I have modeled a slight decline in overall fee income to revenue from ~15% to ~12.5%.

Operating Expenses: Given EBSB's strategic focus on growth (e.g. branch expansion, new lenders and products, etc.), the Company will likely have an elevated expense base over the next 2-3 years.  The Company's efficiency ratio was 75.2% for Q2-11 as compared to 67.1% for Q2-10.  The increases were due to employee, occupancy and equipment expenses associated with two new branches opened in Q1-11, another new branch opened in May 2011, and costs associated with the expansion of residential and commercial lending capacity.  EBSB reported a 65% efficiency ratio in FY10, and I expect the Company to eventually return to this level in the future.

Core ROAA / ROACE: Putting all of this together, under this set of conservative assumptions, projected core ROAA and ROACE is 63 bps and ~6.3% by mid 2014.  These performance metrics should be achievable, and I would not be surprised if management beats our numbers.  While hard to compare last year's environment to 3 years out, as a point of reference, EBSB reported a 77 bps ROAA, 6.4% ROACE, 3.80% NIM, and 65% efficiency in FY10.

APPENDIX B: DEMUTUALIZATION MATH

Assumptions:

1) Issue Price: $10.00 per share

2) Expenses: 4.0% of gross proceeds

3) ESOP Stock Purchase: 6.0% of gross proceeds

4) Stock Based Incentive Plan: 4.0% of gross proceeds

If Convert Today:

- At today's price ($12.50): Price / FCTBV: 80.1%, Exchange Ratio: 1.250x

- At 90% FCTBV: Exchange Ratio: 1.537x, PF Market Cap: $342mm, Value to Minority Shareholder: $15.37

- At 95% FCTBV: Exchange Ratio: 1.702x, PF Market Cap: $379mm, Value to Minority Shareholder: $17.02

If Convert in 6/30/14:

- At 90% FCTBV: Exchange Ratio: 1.861x, PF Market Cap: $385mm, Value to Minority Shareholder: $18.61

- At 95% FCTBV: Exchange Ratio: 2.077x, PF Market Cap: $430mm, Value to Minority Shareholder: $20.77

1) Second Step Conversion

2) Share Repurchases

3) Acquisitions / De Novo Branches

4) Loan Growth