Description

Madison Bank of Maryland is a classic vanilla community bank in the business of residential mortgage lending. They operate in Baltimore and Harford counties in Maryland with two full-service branch offices located in Aberdeen and Perry Hall. After converting from mutual status back in 2015, they engaged in a 10% buyback program to appease shareholders, but still trades right around book value of $30.5mm and remains highly overcapitalized with a 20% TCE ratio. With significant pressure from activists who have run this playbook time and time again (and a total of ~40% of shares owned by top bank investors), I believe that a takeout at a ~20-25% premium to the current share price is imminent.

Business Snapshot

While uninspiring, MBB's financial profile looks nearly identical to recently acquired community banks (as will be discussed further on).  78% of the portfolio is 1-4 family residential mortgages At December 31, 2017, they had $13.2 million of non-residential real estate loans in our portfolio. The non-residential real estate securing these loans generally consists of churches, small office buildings and marinas (largest $3mm. At December 31, 2017, they had $3.2 million of construction and land loans, which represented 3.4% of the total loan portfolio; these are for residential home construction which convert to mortgage loan after construction. $3.5mm HELOC only offers consumers lines of credit secured by deposits. Once again, your run-of-the-mill community bank.

The core deposit story here is decent (62% CDs, 38% NOW+MM+Savings), but there are ZERO brokered deposits. Regardless, I see the value to an acquirer here more in the residential mortgage banking relationships.

Things have started looking up on the Income Statement this year. For 1H18, Net Interest Income increased from $1.68mm to $2mm on an expanding loan book. Net Income was $345k, the highest since the crisis. There was a $200k reversal, but still this number should continue to expand with improvements to the efficiency ratio (it certainly would greatly in an acquisition of MBB). NPLs of 1.6%, which is a bit high, but down from 2.43%. Some more key stats below; take note of the efficiency ratio. ~70%-75% is generally considered okay for a community bank, meaning MBB's is pretty terrible. However, this means there is significant upside in taking out costs from an acquirer's perspective.

Catalysts In-Place for Sale

A major part of this thesis lies in the ownership - an overcapitalized nano-cap in a hot market is great, but what you need are large shareholders who can affect change. As you can see the holdings list reads as a who’s who of financials investing (from April 2018 proxy):

Stilwell: https://www.sec.gov/Archives/edgar/data/1113303/000114420418010053/tv486647_sc13da.htm

For those who are unfamiliar, I’d encourage you to look at Stilwell’s filings which indicate his past activist positions. He, along with Maltese, are highly successful bank investors known for selecting these small banks and agitating for a sale/return to shareholders. In fact, Stilwell’s fund successfully helped sell another <$50mm market cap Baltimore bank in 2016.

Their intentions with MBB are clear “We filed our original Schedule 13D reporting our position on January 9, 2015. We urged management and the board to repurchase shares and on March 30, 2016, MBCQ announced and subsequently completed its plan to repurchase an initial 10% of its shares outstanding. We urged management and the board to complete the existing 5% share repurchase plan and put MBCQ up for sale when permitted in January 2018.” Now that the 3 year post-conversion is up, MBB is free to be sold. Since that 2017 filing, there have been new developments. In February, Corissa Biglia was appointed board member as representative of Stilwell in exchange for a “standstill agreement” under which Stilwell agrees essentially to not wage a proxy fight until the 2019 annual meeting. Jeff Thorp, MD at Sonoma Capital Management (I’m unfamiliar with the group), also agreed to a standstill agreement in exchange for a board seat. In June the 5% repurchase plan was extended through end of 2018.

One other thing to note is the management change that took place 2016 (presumably instigated by the shareholders). CEO Philip Phillips was appointed in September 2016. Prior to that he was CEO at Patapsco Bancorp, another Baltimore area bank, from 2013-2015 when it was acquired for $10mm. Having a CEO who has been through the process before, rather than some long-time family related management team as is often the case, instills even greater confidence that a deal will be done.

While I can’t necessarily say Philip is pushing for a sale, it certainly wouldn’t hurt him; from the recent proxy we know that “If a Change in Control of the Bank or the Company occurs during the term of the employment agreements and either party of their successors involuntarily terminates the executive’s employment other than for Cause, or if the executive voluntarily terminates his or her employment for Good Reason as defined in the agreements, the executive will receive a severance payment equal to three (3) times the executive’s then current base salary in the case of Mr. Phillips and Mr. Wright, and two (2) times the executive’s then current base salary in the case of Ms. McGuire-Dick.” This agreement runs through September 2019...he also earns about 40% of his $300k salary in stock.

M&A Activity

It’s no secret that the community bank industry (<$500mm assets) has been in consolidation mode over the last ~30 years and shows no signs of stopping. Other posts with “community bank” tag on VIC have discussed this, if interested. Historically, small mutual institutions have been happy to be independent, member-owned, community banks with limited access to the capital markets, relying primarily on retained earnings for capital and growth. However, given the higher operating costs and growing regulatory compliance burden on community banks, scale increasingly matters and so does access to capital for growth (SNL Financial).

Maryland in particular is ripe for merger activity: “Maryland’s community banks tend to focus on specific areas, rather than try to serve customers on a state-wide basis. The more dynamic markets are based in Montgomery County (near Washington, D.C.) and along the Washington-Baltimore corridor.”

http://www.ambfg.com/wp-content/uploads/2018/03/Community-Bank-MA_A-Look-At-DC-DE-MD-and-Northern-VA.pdf

According to LendingTree, Baltimore is one of the top 10 most competitive MSAs for lending mortgages. If you want to expand your mortgage book, it’ll likely need to come through acquisition. Maryland area banks have certainly been acquiring; according to FFIEC the number of insured savings banks in Maryland has fallen from 33 in 2012 to 14 today. This type of action typically leaves the remaining banks even more coveted due to scarcity in the local region.

Full List of M&A in area since 2016: http://www.ambfg.com/wp-content/uploads/2017/12/Flying-Under-the-Radar-DC_MD-NOVA.pdf

Valuation

As there has been significant activity, including by banks previously owned by Stilwell, I believe the best way to find a target takeout price is by analyzing previous transactions and their P/TBV premia. There are quite a few of these low/no earnings banks with high TCE ratios that have been acquired in the area over the last few years and make for quite good comps. Data can be found through FFIEC call reports and corporate sites. When comparing to past transactions, I think some relevant items here are (1) Interest Income makeup, (2) TCE Ratio (tangible equity/assets), (3) NPL ratio, (4) deposit makeup, and (5) Net Interest Margin. Current ROE and ROA are crucial but don’t tell us as much with an underperforming (high cost structure) and overcapitalized situation such as Madison Bank. Deals not in chronological order.

Fraternity Community Bancorp - Baltimore (May 2016)

I consider this transaction as a lowball “floor” takeout value for MBB. The $162mm asset bank was acquired for $27mm by Hamilton Bancorp (who I see as a top candidate to acquire MBB). 84% of loan interest income comes from 1-4 family housing. NII of $4mm on $5.8mm Interest Income. Looks strikingly similar to MBB EBT of-815k, 15% TCE ratio, 1.2% NPL/loans, and similar deposit makeup. Was offered at 118% P/TBV in late 2015. Based off of this transaction I think at least a 25% premium on book is reasonable. Stilwell owned 9% of Fraternity and Corissa Biglia had been on the BOD.

Fairmount Bank - Baltimore (April 2015)

Another Hamilton Bancorp acquisition, this one for $15.4mm cash on $12.1mm equity for a 27% premium. 76% of interest income from 1-4 family residential. Net Income of $450k on $3.4mm interest income. Deposits are 66% CDs with 34% savings accounts, and cost is decent at .9% (recall this is 2015). Fairmount also had TCE ratio of 15.7%. I see this as very close comp to MBB.

DCB Bankshares (February 2017)

DCB Bankshares is not a great comp due to different lending areas but I thought I’d mention due to similar size and proximity. 20% residential, 30% commercial RE, 50% consumer and other. Bought for $40.7mm  160% premium to TBV. $1mm net income for 4% ROE. DCB had an 8% TCE.

Colombo Bank (March 2018)

Colombo bank based in Rockville, MD (DC metro area) has 5 branches, $154mm loans, and $145mm deposits and is being acquired for $33.3mm by the $1.1bn asset FVCBancorp. The purchase price represents 158% of TBV as of 12/31/17 of $21mm. The bank is in a slightly better financial situation, more geared towards commercial, and received a higher premium than what MBB would get, but I think with certain improvements MBB could narrow the gap.

--1-4 family RE makes up 51% of II, with the balance coming from commercial RE loans.

--TCE ratio of 11%

--NPL/Total Loans of 2.3%

--NIM of 3.3%.

--Deposits: 63% CDs, 31% savings/money market. Fairly low cost at .8%

--$1mm net income for ROE ~3.3%; had $1mm of one- time provision reversals

Given the M&A environment and dwindling number of insured Maryland savings banks (once again, the number has fallen from 33 in 2012 to 14 today), I don’t see any reason that an acquirer wouldn’t be willing to pay at least what Hamilton did 3 years ago. Now there are even less options as M&A market has heated up in Baltimore area and banks are being acquired/merging at high rate, MBB has higher TCE than comps, and has already turned profitability corner. Also recall MBB's worst-in-class efficiency ratio and potential for significant cost cuts. MBB should sell for 25%-30% over book.

Conclusion

In this situation, we have (1) a bank that is momentarily underperfoming both in capital deployment and expense efficiency (2) 4 outside shareholders - 3 of which are renowned value investors, especially in banks - owning 37% of the stock who are pushing for a sale (3) an M&A market with both cyclical and secular trends behind it, and (4) clear precedents that set a valuation floor. If it’s not bought out this is a tougher scenario to value, but given these factors I find that outcome highly unlikely.

Risks:

--Doesn’t get bought out. However, I find it unlikely that this drifts too far below book value given the long-term secular trend in community bank consolidation and highly competitive nature of the Baltimore market.

--Spike in NPAs in slowdown, leading to less attractive loan book for acquirer

Catalyst

Sale of the bank