Value Investors Club / NetBank (NTBK)

Description

Netbank Inc. is an online bank (with no sub-prime exposure) that is likely to be liquidated in a relatively short period of time. Over the past few months, Netbank replaced its empire building CEO, brought back its old CEO to clean things up and he has quickly proceeded to shutter or unload about five of its non-core business units.   Netbank is in the midst of a major restructuring that is probably going to continue until it is completely liquidated. I believe there is about 50% upside from here and if they do what I feel they will and should do, this gain won’t take long to realize. Time is not their shareholders’ friend and they know it, in my opinion.

Today, what is left of Netbank is now the original core of the bank; (a) its break-even deposit base of about $2.5 billion across over 250,000 customers, (b) its break-even “direct or retail” conforming mortgage business and, (c) a money-losing “third-party or wholesale” conforming mortgage business.

Beyond these three segments, there are four other significant non-core assets that factor into its liquidation value; (1) a book of auto loans that is for sale (2) a small equipment leasing business that generates around $12 million per year in profits, (3) an ATM and merchant processing business that is in the process of being sold, (4) a potential and probable $25 million insurance claim from an insured portfolio of bum leases the old management purchased a while back while unwisely reaching for yield and finally, and (5) a deferred tax asset that resulted from the closing of the sub-prime business last quarter.

Netbank shut its sub-prime mortgage business this past November and took a $30 million charge in the 4th quarter for forced sub-prime mortgage repurchases. They have reserved for another $10 million in losses from residual repurchase obligations and have said that this reserve will cover any 1st quarter obligations that are necessary. The tail of these obligations is short and done as of now. Basically, the sub-prime business is not an ongoing issue and they shut this unit down in just in time. I don’t expect any more negative surprises to book value.

A Tight Capital Position:

There are two big issues with Netbank today. One, they are experiencing a risk-based capital crunch. In early January they sold 6.5 million shares for $3.90, raising $23.7 million to shore things up. This capital raising pushed them up over the 10% risk-based capital ratio that makes them “well capitalized”. With the likely $15 million in 1st quarter losses they are projecting in their third-party or wholesale mortgage unit, they can ill afford to watch this division eat that capital away let alone watch its tangible book value erode further.

Maintaining adequate capital ratios as well as their goal of preserving tangible book value will push them to shut this business unit down. They’ve made this clear. They have already publicly stated that it needs to be fixed, shut down or sold. The conditions today are worse than when those statements were originally made. It is inevitable in my view that this unit is going to be shuttered and the bleeding will be stopped. The mortgage volume in the pipeline is half of what it used to be and this unit’s existence can no longer be justified to shareholders. Again, the third-party, conforming mortgage business loses about $15 million per quarter or $0.28 per share. When you look at their guidance for 1st quarter, that is what the whole of Netbank is projected to lose. All other units are just breaking even. Not a pretty picture.

It should be noted that a possible help to its risk-based capital issue is the sale of its book of auto loans. This business apparently ties up about $40 million of risk-based capital and they are looking to sell this block to free the capital up. However, its sale will likely result in a $5 million hit to tangible book value, but it gets the job done with regard to capital ratios.

Valuation Estimate:

As of December 31st, 2006, Netbank had a stated tangible book value of $185 million. This book value includes the insurance claim asset of $25 million held on the balance sheet. Looking forward a few months from this date, it is likely we’ll see the following hits or adjustments to tangible book value:

-$5 million for the auto loan sale (again, to help to shore up its capital ratio)
-$15 million in losses in the 1st quarter (all attributed to the wholesale mortgage business)
-$25 million of insurance claim on the books just to be conservative for now
+$18 million of intangible goodwill converted to hard tangible book value upon sale of ATM business.

These adjustments to book value leave about $158 million in tangible book value. To this, I’ve estimated that the shut down costs for the third-party mortgage business would be no more than $20 million. As a rough gauge for this assumption, the whole sub-prime business shutdown cost was about $8.5 million in the 4th quarter of last year. Without knowing for sure, it strikes me as a reasonable guess. They already took a $12 million charge to consolidate its operations last quarter, so it appears they’ve done some of the shut down cost work already. Once the wholesale business is shutdown and the losses are stopped, tangible book value could settle in as low as $138 million or $2.60 per share. Today’s stock price is at $2.31 per share. The downside looks protected based on the key assumption that action on the wholesale business is taken rather quickly.

The upside to the stock is as follows:

The disputed insurance claim that is now (very slowly moving) in the court system is worth something. This asset could ultimately be monetized for less than the $25 million owed.   This claim is likely worth about $0.35-$0.40 per share in a sale.

There is value in their $2.6 billion in customer deposits.   Some analysts out there are estimating $2 to $3 per share in value for this deposit base. I prefer to apply a big discount to this considering the declining deposit and customer base over the past few quarters and to the special nature of internet-only banking customers. They are probably not as sticky as traditional banking depositors. For the $200 million held in checking accounts that earn about 1% on their balances, I expect another financial institution could earn $5 million in incremental net profits if these customers are retained. For the $650 million in money market balances earning about 3.5%, I expect another company could earn $3 million in incremental profits. Finally, for the $1.5 billion in CDs under 100k that earn on average 4.8%, the spreads are really tight in this yield curve environment and I don’t expect much more than $4 million in profits today. I think these are pretty conservative profit contributions for a deposit acquirer. In total, an acquirer of the majority of the deposit base could make as much as $12 million in net profit with little to no ongoing incremental costs. Additionally, the acquirer might actually see value in this customer list for obvious cross-selling opportunities as well. To be conservative, I’d estimate the Netbank deposit value to be $60 million or $1 per share using a conservative 5x multiple to account for customer churn and to leave a healthy margin of safety for the acquirer.

Together, these two items supply about $1.35 to $1.50 per share upside to the current price. Adding the melt down tangible book value of $2.60 to these upside items brings the overall expected liquidation value of Netbank to about $3.75 to $4.00 per share. I’d think $3.50 upside is reasonable to expect.

The one major caveat to this idea is that management might try for too long to turn around the mortgage businesses. That would further exacerbate the book value erosion and could give the deposit base more time to churn away. Shareholders will need the deposit base sale to happen to realize a gain in this stock. If they don’t act within the next 90 to 120 days on these items, my thought is all bets are off and I’d just sell the stock at a loss. However, this “they don’t act quickly enough” scenario is probably not that bad from here due to the hard book value compared with today’s price.

Another possible negative, although I don’t see this as a big issue, is their failure to get a 10-K filed. This is due to them hiring a new auditor and they now hope to complete it 90 days late by June 30.   This may lead to a de-listing, but likely they will apply for an extension from the NASDAQ. Anyway, it is a negative situation for any financial company with a stock in near free fall. It looks bad, to say the least.

Catalyst

The shutdown of wholesale mortgage business, first and foremost, and then the eventual sale of deposit base. Complete liquidation of company to realize a tangible book value well north of current price.

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			2007	2008
Price:	2.31	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	122	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT