Description

Northeast Bancorp "NBN" appears to be a standard, in-efficient, low-return community bank; however, it's led by an excellent owner/operator and capital allocator with a niche strategy, running his old play-book where he compounded investor capital at a 23% CAGR over 10 years (9x MOIC). 

Most importantly, NBN is at a major inflection in earnings (last quarter earnings were up 82% YoY) and I believe the company will earn around $2.60 in 2018 (a 15+ish% ROE) and continue to compound earnings between 15-20% in the medium-term. At a conservative 12x 2018 earnings discounted back to today I believe fair-value is $28.5 - over 100% higher. In addition, trading at 1.1x tangible book and .9x economic tangible book there is a strong margin of safety. 

For investors willing to take a longer view I do not think it is a stretch to see the stock being a multi-bagger.

At 15x 2019 earnings, at the low end of peers with substanially lower ROEs and growth prospects, the stock would be $45. 

Management, History, and Board

NBN is run by Richard Wayne. Richard started Capital Crossing Bank and in 1996 focused on a strategy of buying discounted, performing small-balance commercial loans. At their peak they were able to have on balance sheet over $700 million of these assets, and when they felt the opportunity was maxed out, they turned around, and from 2000 to 2007 repurchased 50% of the outstanding shares before selling the bank at 3x tangible book*.

Act II

In December 2010, an entity managed by Wayne, FHB Formation LLC, got approval to acquire NBN. 

In connection with the merger, the company made the following commitments - to maintain a tier 1 leverage ratio of at least 10%; to maintain a total capital ratio of at least 15%; and to limit purchased loans to 40% of total loans. The purchased loan limitation is important and will be discussed further below.

I think it is also worth noting that the board here is not your typical community bank board - the Chairman is Robert Glauber a former Under Secretary of the Treasury for Finance and former CEO of NASD. Another Board Member is Mathew Botein, former Head of Alternative Investments at BlackRock.

What they do

NBN's bread and butter is purchasing at a discount performing, small-balance loans that are primarily secured by commercial real estate. They have set up a national infrastructure to source, due-diligence, and close these assets.

This market exists because banks regularly dispose of unwanted or non-strategic relationship assets. Furthermore, and likely a source of additional future growth, consolidations often force banks to sell assets that would give them above desired exposure to any segment, geography, or collateral. Competition is fairly limited as PE buyers are focused on larger balance loans, have a higher cost of funding, and few if any banks desire to own out-of-market loans. 

Their Loan Acquisition and Servicing Group ("LASG") underwrites each loan, which entails an internal analyst reviewing the file, working with local counsel to determine the quality of the documentation and its enforceability, collateral evaluations, an environmental assessment, and a property inspection.

They typically bid on multiples of what they actually win - in fiscal '16 they reviewed 105 transactions with unpaid principal balance ("UPB") of $800 million, placed bids on 61 transactions worth $256 million of UPB, and closed 35 transactions with $109 million of UPB. 

While they are happy to own this paper, as a non-relationship lender, they usually try to work with the borrower to refinance or pay-off prior to maturity. There are a variety of reasons why the borrower may decide to pay-down the balance of their loan early, such as the borrower has additional financing needs and will seek to work with a relationship lender or there is an opportunity to refinance at a lower all-in rate. To facilitate these transactions NBN may give them a slight haircut to their UPB or waive any pre-payment penalty.  

Today, the company talks about this is as being an 11% ROE business through the cycle. As a reference, a performing commercial loan with a 5% coupon purchased at 90% of face that is paid-down 2 years later will drive a 11% ROE.

As Capital Crossing was public we can see that business performed very nicely from 1996-2006 in a variety of macroeconomic environments. 

As it stands today their portfolio has a net investment basis of 88% of UPB - with 65% greater than 90%, 24% between 80-90%, and 8% in the range of 70-80% of UPB.

The average loan is $694k with diverse collateral: 13% multi-family, 16% retail, 13% industrial, 11% office, 13% hospitality, 10% other CRE, and 15% non-CRE.

And diversified by state with 18% in NY, 17% in CA, 7% in NJ, 6% in IL, and 25% in all other states.

While I will not go into depth here (happy to do so in the comments) the accounting for purchased loans will also make their loan loss reserves appear artificially low.

In addition to their purchased loans, another unique element of NBN's business, which also leverages their national infrastructure, is their focus on SBA 7(a) loan origination and sales. A large portion of SBA 7(a) loans are guaranteed by the government, and originators are usually able to sell the guaranteed portion into the market at a significant premium. 

The SBA 7(a) market is $20 billion in annual originations with Wells Fargo as the largest lender. Live Oaks (ticker: LOB) is the second largest with a sole focus on the market (not sure if the market 'thinks' this is some sort of SBA technology company) but the bank trades 3.4x tangible book 20+x forward earnings.

NBN should be able to ramp this to over $150+ million of annual originations generating over $10 million in high-margin fee revenue.

LASG also works nationally to originate commercial real estate loans and their community bank is focused on residential mortgages where the majority of annual production is sold.

Why this is particularly interesting

Due to the need to build out their LASG staff and the purchase limitations, for the last few years has looked like a typical under-earning, in-efficient, sub-scale community bank.

In 2012, the bank had expenses of $32 million and loans of $355 million. By the end of fiscal '16 the bank's expenses were only $34 million but they had grown loans to over $700 million.

Furthermore, in order to maintain purchased loans at less than 40% of total loans, the company originated over $60 million of loans to broker dealers - these loans had a 100% risk weighting but yielded sub 1%. They are currently at $48 million of these loans and they will run-down in the near-term.

SBA 7(a) is also now ramping with originations of $25 million in the last quarter.

Putting it all together, the business is on the precipice of massive operating leverage as NIM scales with additional loans, fee revenue grows from additional SBA 7(a) loans and expenses stay relatively flat.

The model is fairly simple -- in calendar 2018 should have on average $950 million in loans, at 33% purchased loans and with $135 million of originations of SBA 7(a) loans the business should earn around $2.60.

Interest Income:                $69,900

Allowance for loan losses:      (2,000)

Fee Income                         $12,000

Interest Expense                   (10,000)

Operating Expenses               (36,000)

Pre-tax income                   $33,900

Net income                         $22,035

EPS                                      $2.60

If tax rate were to come down from 35% to 25% for 2018 EPS would be $2.99 

From the table below it is easy to see how the business has scaled over the last few years:

For SBA please note these are originations, not the amount held on balance sheet. In the earnings breakdown above, I assume they have retained $75 million of SBA loans, and $10 of the $12 million in fee income is from gain on sale on $135 million of SBA originations.

Runway

The runway is extremely long. They will have just over $300 million in purchased loans with an opportunity to double this book of business over the next few years.

With 6+% NIMs and the capacity to annually grow the loan portfolio by over $100 million NBN will compound earnings at 15-20% the next few years. 

Comps

There are no direct competitors, however:

Marlin Business Services which focused on small commercial leasing market (copier leases) written up by CFAvenger trades 1.9x tangible book with 11% ROE 

Live Oaks a pure-play SBA lender trades at 3.4x tangible book.

Scanning a list of banks with 3 year average ROE above 10%: they all seem to trade 2+x tangible book and 15-20x earnings.

Risks

Like all banks, the individual loans are a black-box

Need to replenish purchased loans as they get paid-off

Risk Mitigation:

Long history of performance as Capital Crossing Bank

Counter-cyclical elements to the business - in times of stress there is an ability to buy loans at larger discounts

There are 500+ publicly traded banks, many of which can be used to hedge against changes in sentiment or general risks of the industry

*To Lehman

Catalyst

Operating leverage