Description

aaron16 wrote up Northeast Bancorp in March 2017. Since then, the stock has risen ~40%. At the time of the write-up, NBN had an LTM EPS of approximately $1.18.  Today, LTM EPS stands at approximately $2.05. The run-up in the price is warranted by the earnings growth and does not indicate over-valuation today.

Thesis

A recent reorganization at Northeast Bancorp presents investors with a compelling opportunity. As a result of the reorganization, regulatory limitations, including a critical one related to purchased loans, were relaxed or eliminated.  These changes reduce interest expenses related to legacy preferred stock and increase earnings power at the bank.

A key earnings driver for NBN is its purchased loan book.  Purchased loans are purchased at a discount to their Unpaid Principal Balance (UPB) and, if appropriately underwritten, maintain higher yields than originated loans.  The CEO is a skilled owner/operator, has an impressive track record purchasing loans in the secondary market, remains committed to conservative underwriting standards, and has recently been buying shares for his own account.  As mentioned above, prior to the recent reorganization, NBN was limited to holding purchased loans to less than 40% of total loans. Today, post-reorganization, that limit has been increased to 60%.

Background

CEO Richard “Rick” Wayne co-founded Atlantic Bank & Trust Company in 1988. In 1993 the bank began purchasing quality assets in the secondary market, primarily from regulators who had taken over failed competitors. The strategy proved very successful.  The bank went public in 1996, changed its name to Capital Crossing in 1999, and was ultimately acquired by Lehman in 2007 and surrendered its bank charter at that time. We all know what happened to Lehman. Today it appears Capital Crossing operates as a non-bank LLC.

In 2009 Wayne raised funds for FHB Formation, LLC with the intent of investing the capital in a financial institution. At the end of 2010, FHB Formation, LLC merged with Northeast Bancorp. NBN remained as the surviving entity.  At the time, NBN was a sleepy community bank with ~$600M in total assets and net interest income of roughly $16M. The bank specialized in lending in its local region primarily in Maine.

Note: NBN operates on a 6/30 fiscal year.

Operating Segments

Today NBN operates three business segments: Community Banking, the Loan Acquisition and Servicing Group (LASG), and Small Business Administration (SBA) lending.

Community Banking

The Community Banking segment generates deposits (the company also generates deposits online via ableBanking).  However, community lending is not the focus of the NBN business model. This is exemplified in the following CEO responses to a question regarding why Community Banking loan balances were down 20% over the trailing nine months (our emphasis):

“...community banking in Maine...is a very important part of our entire bank where they provide operational services, raise deposits in our branches…”

“...to get a satisfactory grade in CRA [Community Reinvestment Act], you need to do half of your lending in your footprint...as a national real estate lender, that would be impossible for us, so we have a CRA strategic plan where we have agreed with the FDIC in how we can get a satisfactory CRA grade”

“when we have a choice of lending money nationally at prime plus 2 or an alternative financing in market in Maine at 5% fixed for 5 or 10 years, we think it's a better allocation of our capital to be doing the national lending...it's not really an area where we're trying to grow our balance sheet [referring to Community Banking]..."

Source: Q3 2019 Earnings Call

Loan Acquisition and Servicing Group (LASG)

NBN launched its LASG division in Q4 2011. The division was started from scratch.  At the end of FY 2011, purchased loans made up just 1% of total loans. LASG purchases and originates commercial loans on a nationwide basis. This is NBN’s sweet spot and differentiator. NBN is able to purchase CRE loans nationally at prices which produce significantly higher yields than those generated on originated loans (see table below).

Source: SEC filings

NBN is able to execute on this strategy because its core competency is in underwriting national loans and servicing loans on a national level. Private equity funds against which NBN competes generally do not bother with small balance loans (the average LASG investment is $800k/loan as of 3/31/19) and NBN also has a lower cost of funding. Banks against which NBN competes generally tend to purchase loans within their local market area rather than develop a diversified nationwide portfolio as NBN does.  

With respect to the purchase loan market, the Company states that increasing credit quality and the low interest rate environment have decreased the supply of loans available for purchase, increased competition, and tightened spreads. Despite these trends, NBN maintains the competitive advantages above when competing in the market for loans.

Small Business Administration

NBN originates SBA loans nationally. The bank subsequently sells the guaranteed portion of the loan at a premium in the secondary market. In mid-2017, the bank moved to an inside sales model in the SBA business with the specific intent to focus on the hotel vertical.  Initially, that model appeared to be working as SBA loan originations began to grow. These have since tapered off a bit, as can be seen here:

Source: SEC filings

Source: SEC filings

Management suggests that although the market is very competitive, they will not compromise on credit quality.  Adherence to underwriting standards explains recent lower levels of originations. SBA originations and LASG originations are similar in nature and due diligence. Utilizing the infrastructure in place for LASG, SBA loans can be reviewed and originated very quickly which helps NBN compete favorably.

Merger-Related Regulatory Agreements

As a condition of the merger, NBN made certain regulatory commitments to the Federal Reserve in order to obtain approval of the merger. Those commitments were as follows (our emphasis):

(i)   maintain a Tier 1 leverage ratio of at least 10%

(ii)  maintain a total capital ratio of at least 15%

(iii) limit purchased loans to 40% of total loans

(iv) fund 100% of the Company’s loans with core deposits

(v) hold commercial real estate loans to within 300% of total capital (amended to exclude owner-occupied CRE loans)

Reorganization

Shareholders recently approved the merger of Northeast Bancorp, the bank holding company, and Northeast Bank, its wholly-owned subsidiary. The Bank will serve as the surviving entity. The merger is intended to increase efficiency by reducing redundancies in corporate infrastructure as well as associated supervision and oversight of the Board of Governors of the Federal Reserve System (FRB) applicable to registered bank holding companies.

The Bank will remain regulated by the FDIC and MBFI, but as there will no longer be a bank holding company, NBN will be relieved of its commitments to the FRB. The result of the reorganization is that purchased loans could constitute 60% of total loans as opposed to the current 40% level. The Company expects this to allow more growth in its loan portfolio. NBN’s ability to purchase loans will be less dependent on their ability to concurrently expand their originated loan portfolio.

Furthermore, post-reorganization, the limit on the ratio of loans to core deposits is increased to 125% from 100%, which will reduce NBN expenses as it will no longer need to “warehouse” excess cash to protect against an unexpected reduction in deposit levels.

The following chart shows that NBN does at times begin to draw down its available purchased loan capacity (see remaining capacity shrink to ~$76M last quarter) and, as will be demonstrated later, they stand to grow their purchased loan portfolio far past currently available capacity post-reorganization.

Source: Q3 2019 Investor Presentation

Here is a look at current purchased loan capacity and pro forma purchased loan capacity as a result of the reorganization:

Source: SEC filings and our estimates

Earnings Model and Valuation

Below we present an illustrative analysis of the potential effect the relaxing of the purchased loan restriction could have on expected earnings power. We believe it is reasonable for the Bank to add an additional ~$250M in purchased loans bringing its percent of capacity to 60%. We also assume that additional required capital will flow into deposits on a pro-rata basis across current deposit types. This analysis is followed by a sensitivity analysis.

Source: SEC filings and our estimates

At 60% of the new capacity, an additional ~$253K in loans may be purchased by LASG. We assume the funding sources to be various deposit types proportional to their 3/31/2019 mix. The below yield data and expense data were pulled from the 3/31/2019 10Q for Q3 2019.  We have left yields as is except for the originated LASG portfolio loans which today yield more than they did in the prior five years. With the possibility of a rate decline, we believe it is prudent to use the  5-year average yield from FY 2014 - 2018 of 6.61%, as opposed to the MRQ reported of 7.87%. Furthermore, while increasing capacity might require a few additional hires, the marginal operating expense should be small as in place infrastructure should be adequate to handle most of the increased volume allowing for positive operating leverage and efficiency.

Source: SEC filings and our estimates

Source: SEC filings and our estimates

Sensitivity Analysis @ Varying Levels of Capacity Utilization and P/E Multiples

Source: Our estimates

We do not believe it is aggressive to assume that the company will be able to grow purchased loan volumes to at least 60% of the new capacity over the next couple of years. In the Q2 2019 earnings call, CEO Wayne suggested that they would likely be able to add $100M - $110M a year to the purchased loan portfolio. This puts the equity value per share at around $32.91 assuming a conservative 10x multiple. It is also reasonable to assume that growth in the purchased loan balances would lead to multiple expansion, especially since NBN trades at the low end relative to community banking peers.

Peer Comparison: ROE, ROA, P/E, P/TB

In our view, NBN does not have any directly comparable peers. Peers listed in the proxy statement show banks “of similar asset and revenue size, revenue mix and business orientation.”

Source: NBN proxy and Sentieo

Source: NBN proxy and Sentieo

The peer group above contains community banks that operate in the Northeast.  Much of their business activity can be likened to NBN’s community banking division.  Some of them operate investment management or insurance lines of business as well, but none participate significantly in secondary market CRE loan purchasing. These banks all compete for deposits in the Northeast. Many of these banks, even those with lower levels of total assets than NBN, operate more branch locations than NBN does.  Since NBN is a community bank, these comparables are applicable to ballpark NBN’s relative valuation.

NBN boasts the highest LTM Return on Average Equity (ROAE) and the highest Return on Average Assets (ROAA). NBN generates both the highest unleveraged return on capital and the highest levered return. Meanwhile, NBN trades at the lowest LTM P/E multiple (P/E) and the 4th lowest MRQ P/Tangible Book Value multiple (P/TB).  In fact, placing the peer average multiple of 13.3x on NBN’s LTM EPS would yield a price of $27.25 (35% premium to its last close). Applying the median multiple of 12.5x to post-reorganization estimated EPS would yield a price of $41.23 (making NBN an eventual double).

NBN appears relatively undervalued as compared to the peer set identified in the proxy statement on both a P/E and a P/TB basis.  If we look at P/TB relative to ROAE, we find that NBN lies below the regression line giving further support to the hypothesis that NBN is relatively undervalued. See below:

P/TB Regressed on LTM ROAE (%)

Source: Sentieo

Further Comments

Disciplined Loan Purchasing

An obvious concern is whether or not NBN can increase purchased loan volumes to make use of the extra capacity without relaxing underwriting standards. The CEO’s track records at Capital Crossing and at NBN illustrate restraint and conservative practices. NBN remains very selective in its purchasing operations as can be seen here:

Source: Aggregated from filings

NBN reviews a large volume of loans each quarter, bids on a select few, and subsequently wins a small fraction of what was bid on.

Management has indicated that as a result of the increase in purchased loan capacity, it will be able to bid more aggressively for loans while maintaining a profitable yield spread.  Prior to the reorganization, the 40% capacity limitation led NBN to keep “dry powder” and thus they lost bids for otherwise profitable loan portfolios.

Asset Quality

As can be seen in the charts below, NPL, NPA, and CO rates are all below 3% which is generally considered a manageable level.  Furthermore, the trend in these metrics has been downward sloping in the last 5 quarters, which is good. Keep in mind that just because a loan has been labeled nonperforming does not mean it is worthless. Charge offs in the third table remain low and have also declined in recent quarters.  NBN currently maintains Allowances for Loan Losses of about ~50% of NPLs.

Source: Bankregdata.com (call reports)

Source: Bankregdata.com (call reports)

Source: Bankregdata.com (call reports)

Notable CEO Comments 2019 Earnings Calls

On post-reorganization purchased loan pricing (our emphasis):

...I would expect that we could price more competitively, and hopefully win more purchased loans if we can hold a bigger percentage of those on our balance sheet because even at a lower yield in purchased loans, it's higher than the yield on originated loans.”

Source: Q2 2019 Earnings Call

On the decline in SBA loans originated in Q3 2019 (our emphasis):

“I would say there's more competition in that space. We are unyielding in credit quality. When it comes [to making a loan], we were presented with a lot of opportunities, which we -- most of which we turned down for a variety of reasons: asking for too much debt, find a property for too much money, inexperienced operator, insufficient resources by the owner or borrower post financing.”

Source: Q3 2019 Earnings Call

Purchased Loan Trends

Source: Aggregated from filings

The discount to unpaid principal balance inherent in the overall purchased loan portfolio has come down over the last four years, however, it still remains around 10%.

Source: Aggregated from filings

The discount achieved in any given quarter varies significantly.

Source: Aggregated from filings

Yields on purchased loans have also trended downward, but still remain significantly above those on originated loans.

Insider Buying

Source: Aggregated from filings

The CEO has been buying shares and owns an estimated 5% of the company not including in-the-money options he has been granted over time.

Interest Rate Sensitivity

At the end of FY 2018 (June 30, 2018) NBN’s balance sheet was asset-sensitive with the following reported sensitivities:

Source: FY 2018 10K

Note the following from the MRQ conference call from Rick Wayne on interest rates sensitivity (our emphasis):

Analyst: ...can you talk about how [the] balance sheet is positioned in case the next rate move brings rates lower?

CEO Wayne:   Well, we're generally slightly asset sensitive, so if rates were adjusted lower, there would be some slight decrease in net interest income. Most of our originated loans, most of our loans are tied to prime. I would point out that most of our loans are structured with floors as well at the time that we originate them. So if we, for example, originate a loan today at prime plus 2, that rate would be 7.5. And if prime went down to -- by 0.25 point, the rate on that loan would stay the same, so I would say it will be fairly negligible.

Counter-cyclicality

Increased credit quality, low interest rates, and competition have tightened spreads in the purchased loan market.  In the event of a recession, so long as the bank has been steadfast in maintaining underwriting standards, the market for purchased loans will likely improve.  Given that Wayne and his team have demonstrated prudence in the past, it is our position that NBN will not only survive a downturn, but will also prove well positioned to benefit from such a turn in the economy.

Conclusion

NBN is a compounder of investor capital. The CEO has a proven track record of purchasing loans in the secondary market. The recent reorganization opens up the opportunity for the company to increase the proportion of higher-yielding purchased loans in its portfolio.  This has the potential to boost the bank’s earnings power leading to increased net interest income and net income. As the bank increases the level of purchased loans, without sacrificing on credit quality, we expect to see multiple expansion. NBN currently trades at a discount to peers without consideration of the benefits which may accrue from the reorganization. CEO Rick Wayne owns 5% of the company and recently purchased shares around the current price level for his personal account.  Over the long term, we see a strong margin of safety and an attractive opportunity as the company continues to compound both earnings and book value.

Risks

Decrease in underwriting standards in order to utilize excess purchased loan capacity

Interest rates decrease (asset sensitivity)

Catalyst

• Reorganization
• Increased purchase loan volume
• Increasing interest rates (asset sensitive)
• Recession (possible countercyclicality in purchased loan market)