Description

Northeast Bank (“NBN”) is a ~$3bn bank headquartered in Portland, Maine. Tangible book value is $312mm. Market cap is ~$430mm, and liquidity is ~$1mm/day. NBN has a differentiated business model and a management team with a multi-decade track record of compounding capital at an attractive risk adjusted rate of return. At $55/share, NBN trades at ~7x P/E and 1.4x P/B. At this valuation, NBN is set to deliver a 15 to 20+% IRR over the next several years. 

History:

The NBN team has a strong history of creating value for shareholders. In 1988, NBN CEO, Richard Wayne (“Rick”), and a partner founded Capital Crossing Bank with $7.5mm of equity. Capital Crossing’s strategy was to use brokered deposits to purchase commercial real estate loans, initially from the FDIC and expanding from there. Over the next 18 years, Rick and his team built Capital Crossing to $1.2bn of assets.  In 2006, Capital Crossing was purchased by Lehman Brothers for $210mm (>2x book value and ~12x earnings | 100% cash consideration). From a minority shareholder’s perspective, Capital Crossing went public in 1996 at <$4/share and sold to Lehman for $30/share 10 years later (>20% CAGR). 

In 2010, Rick put together an investment group to buy 60% of Northeast Bank, a small community bank in Maine earning anemic returns on capital. Rick sold off the sub scale insurance and investment divisions and refocused the company around the loan acquisition strategy that he ran at Capital Crossing. Seven members of the Capital Crossing management team, including Sr. VP Patrick Dignan, joined Rick at NBN to help build the business. 

Origination Strategy:

As part of acquiring control of NBN, Rick committed to the Federal Reserve to limit purchased loans to 40% of total loans, to fund 100% of their loans with core deposits (i.e. no brokered deposits), and to maintain 15% total risk-based capital ratio as well as a couple other constraints. These constraints forced Rick and his team to build out the National Lending Division’s origination business in order to be able to continue to grow the loan purchasing side of the business. 

Although the Fed constraints are no longer relevant today (NBN was able to drop them in 2022), the origination strategy has become an extremely attractive business in its own right. From a standing start in 2011, the NBN team has originated $2.76bn of loans with zero charge offs to date. The economic landscape for bank loans in the lower 48 since 2011 has been relatively benign, but still! Zero charge offs on almost $3bn in loans over 10+ years is a worthy record. As of 9/30/2023, the origination business has ~$950mm of loans outstanding.

The origination business focuses on short term (~2 years), low LTV, variable rate loans. About half of the origination business is Lender Finance loans where NBN provides financing to non-bank lenders who make small loans to small borrowers (does not sound like they still lend to the purchased loan competition). These loans are classified as Commercial and Industrial loans and are fully collateralized by hard asset value. Weighted average LTV in the Lender Finance business is 45%. The other half of the origination business consists of direct commercial real estate loans with a weighted average LTV of 54%. The origination book is well diversified across collateral type with minimal exposure to Land / Construction (see Appendix A). 

 Purchased Loan Strategy:

The successful growth of the Origination loan book allowed NBN to execute its Purchased Loan strategy. Starting from 0, Rick and his team have constructed a ~$1.5bn Purchased Loan book of small, performing, low LTV commercial real estate loans diversified across collateral types and location. They have done this while incurring annual net charge offs of between 0% and 0.2% on their loan book as a whole for 10 years running. Since originated loans have had 0 net charges offs per management, the annual net charge off rate for the Purchased book would likely be more accurately described as between 0% and 0.4%, which is still strong to very strong. 

The Purchased Loan book growth did not happen overnight, and it did not happen in a straight line. The capacity constraints imposed by the Fed make it clear that NBN’s team was patient and opportunistic in executing their Purchased Loan strategy. Since taking control of NBN, Rick and his team have maintained significant spare capacity to increase their purchased loan book versus their constraints. From FY 2020 to FY 2022, they could have increased their Purchased loan book by an additional 50% every year versus what they actually purchased. A lesser management team might have done just that in order to juice short term earnings and ROE. Rick and his team maintained balance sheet capacity and waited for their moment. In December 2022 they were rewarded for their patience. 

On December 1, 2022, US Bancorp completed its acquisition of Union Bank. As part of that acquisition, they were forced to sell a portion of their combined loan book. At that time, many banks were retrenching due to mark to market losses on security portfolios and deposit cost creep shrinking net interest margins, issues that came to light in a big way a few months later. NBN did not suffer from either of these issues. NBN did not burden their balance sheet with long term, fixed rate securities and their loan book consisted almost entirely of floating rate loans which protected their net interest margin. In addition, NBN’s total capital ratio was ~20% heading into CY Q422. All of these factors allowed NBN to purchase a ~$1bn commercial real estate loan portfolio from USB at a ~9% yield and a 33.5% LTV, expanding their balance sheet by ~65% quarter over quarter. 

The USB purchase was funded with brokered deposits and FHLB loans at ~5% WACC. In addition, because their balance sheet was stretched to the limit by the purchase (11% total capital ratio vs 10% “well capitalized” minimum threshold), NBN issued ~$8mm of equity under an ATM program. Overnight, this opportunistic acquisition roughly doubled NBN’s run rate earnings and ROE. Due to the extremely low LTV of this portfolio, I believe that this huge increase in earnings power was accomplished with minimal incremental risk. 

The Beal Bank Analogy:

Andy Beal has become a billionaire by using brokered deposits to buy loans opportunistically. He expands and contracts his balance sheet based on the opportunity set. He has been incredibly aggressive at times and has gone years at a time without doing much of anything. NBN is running a variant of this playbook. Although they have found “things to do” and grown their loan book for 10+ years running, they have demonstrated the rare ability to wait for the fat pitch to take a big swing. This is one way to generate excess returns. On a call with Rick and his team, Rick brought up Andy Beal as probably the only market participant that operates on a larger scale than they do in the purchased loan market, although Andy is executing different and more varied strategies than NBN. 

Returns: 

Since taking control of the company, Rick has steadily increased NBN’s ROE. In 2021, their ROE jumped due to PPP loan related fees as mgmt. quickly and aggressively helped customers nationwide with that program. Those fees started to roll off in FY 2022 and have essentially completely rolled off as of year end of FY 2023. The decrease in revenue and earnings has been offset by the much more durable net interest margin generated by the USB loan purchase. Notably, the USB loans have several years of weighted average duration and unless the origination business unexpectedly falls off a cliff, NBN is set to earn mid to high teen ROEs for years to come. 

Total Capital Ratio:

NBN has historically operated with meaningful excess capital. After the USB loan purchase, their Total Capital Ratio troughed at ~11% but has already inched back up to 13.5%, mostly through retained earnings. Looking forward, NBN has sufficient capital to continue to grow their loan book, take advantage of opportunistic loan purchases, and/or return meaningful excess capital to shareholders in the coming years. 

Credit Quality:

Given the returns and valuation, the critical piece of the NBN puzzle is credit quality. Historically, it has been pristine. Since 2014, NBN’s charge-offs have fluctuated between 0 and 25bps. It is worth pointing out that the 25 bp charge off rate peak that occurred in the most recent quarter ending 9/30/23 was due in large part to CECL adoption not credit deterioration. 

Past due loans (30+ days) have historically ranged between 50 bps and 100 bps. 

Although these are strong indicators of NBN’s conservative lending culture, they are backward looking statistics. Fortunately, NBN provides incredible detail and transparency into their current loan book. The table below lays out the weighted average LTV statistics by lending strategy (Direct Origination, Lender Finance, and Purchased) as well as by collateral type. These are very conservative LTVs, with the overall average sitting at 47%. 

Helpfully, NBN also provides the table below stratifying their loan book further into LTV buckets. SVP Patrick Dignan told me that NBN is “constantly refreshing appraisal values” to monitor their loan book so these are not based on stale values. According to this table, only 3% of NBN’s loan book has a LTV >80% and only 12% has a LTV >70%. 

NBN provides a lot more detail in the quarterly deck. I have pasted some relevant slides in Appendix B. A few things I want to highlight. 

First, NBN makes small loans. Only 14% of their loans are >$15mm and over half are <$6mm. Their single largest loan is $26mm (~1% of the loan book; 8% of equity). They have strict internal credit concentration limits. 

Second, one potential risk is the 14% exposure to Office, a sector that is facing strong headwinds (WFH). I am not the only investor to have expressed this concern to NBN’s team. In response, NBN provided loan by loan detail for their office book in their presentation for the quarter ending 6/30/23. From the CC, “the vast majority of our office portfolio is comprised of low-rise buildings with local tenants, that is tenants serving a local neighborhood or a community as opposed to more traditional office space that is in central business districts or office parks”. Looking at the data in the slides below bears this out. Not every loan on the list looks perfect, but NBN is clearly not facing the same type of challenges in their office book that some other banks and mortgage REITs are facing.

NBN’s team plans to provide additional loan by loan transparency for their other collateral types in future quarters. I am not aware of any other banks that provide this type of granular disclosure. 

Allowance for Credit Losses:

NBN’s allowance for credit loss reserve is $25mm (1% of loans). Based on the past 10 years' charge offs, this is overkill. Looking forward, NBN’s management believes that their loan book is adequately reserved for a recession. Their expectation in a recessionary environment is for delinquencies to increase but charge offs to remain low due to the low LTV ratios in their book. They are very confident in the “V” in their low LTVs. For what it is worth, I asked management how the Capital Crossing loan book performed during the GFC and was told “fine – better than expected”.  

For NBN to work out as expected, future loan losses are critical. What will we see next time the tide goes out? NBN’s track record and detailed disclosures provide confidence that they are adequately reserved. 

It is worth noting that the large increase in NBN’s ACL in the most recent quarter (to 1% of loans) was due to their adoption of CECL accounting standard. The vast majority of that increase was effected via a transfer from the purchased loan non-accretable discount balance to the reserve balance with minimal impact to book equity. 

Interest Rate Risk:

The conventional wisdom regarding banks is that a strong deposit franchise is critical. For many banks that is be true. NBN is different. They do not have a strong deposit base. They fund 60% of their loan book with brokered deposits and FHLB loans. However, the majority of their loans are variable rate, and they did not burden their balance sheet with long term, fixed rate securities. Because of this, NBN has managed to maintain an extraordinarily strong and consistent net interest margin (~5%) through multiple interest rate regimes. On their October 2023 CC, management indicated that their deposit repricing is almost done and the quarter ending 12/31/23 will be the high water mark (barring additional Fed hikes) as a tranche of brokered deposits repriced during the quarter. If there are additional Fed hikes, NBN’s assets will reprice with their cost of funds. 

Corporate Capital Allocation:

Over the years, NBN has been an active repurchaser of shares at accretive prices. They have also been intelligent and extremely selective in share issuance. In short, they behave like shareholders because they are shareholders. 

Management / Board Ownership:

Rick owns ~9% of NBN (~$38mm) due to his participation in the original control buyout, the 2012 capital raise*, open market purchases, as well as stock compensation. In addition, Sr. VP Patrick Dignan owns ~2% of the company (~$9mm), and Chairman of the Board Matthew Botein owns 1% of the company (~$4mm). In total, directors and officers own ~15% of the company. They have skin in the game. 

*In 2012, NBN raised $50mm at $8.00/share to support the growth of the loan book. There was broad participation by management and board members in this offering. At today’s price of $55/share, investors have earned a ~18% CAGR since this offering.

Outlook / Model:

Since making the large USB loan purchase, NBN has paused net loan growth. They have done this for 2 reasons. First, they needed to delever the balance sheet, and second, the commercial real estate industry is still adjusting to the changing interest rate environment. 

While they have been able to build some additional breathing room into their capital ratios over the past few quarters, the real estate macro picure remains cloudy. That said, management continues to sound extremely optimistic regarding the near and medium term purchased loan market. Some quotes from the October 2023 CC: “On the purchased side, bright skies in front of us” and “we see lots of opportunities” and “we are optimistic about our opportunities to purchase loans in this environment”. Management provided multiple reasons for this optimism, but I believe a key reason is that banks are trying to reduce their commercial real estate exposure to appease nervous investors (“window dressing”). This type of behavior can create opportunities for rational, well capitalized players like NBN. 

In my forecast, I am modeling ~4.9% net interest margin through 6/28/23. I believe that this is an achievable, conservative margin assumption for NBN in most interest rate regimes. Provision for loan losses is set to 1% of loan growth to maintain a reserve of 1% of total loans. Non interest expenses increase at 4% / year. I hold NBN’s balance sheet flat until 6/30/24. From there, I sensitize annual loan growth from 0% to 15% annually through 6/30/28. A reasonable base case is probably somewhere between 5% to 10% loan growth per year, but it will not be linear. NBN’s trailing 5 yr Total Loan CAGR is 24%, but a chunk of that growth was achieved with the USB loan acquisition, and their bigger balance sheet today will be harder to grow going forward. 

At a 1.25x to 1.50x P/B exit multiple and 5% to 10% annual loan growth, NBN will achieve a mid to high teen CAGR through 6/30/28. In a takeout scenario at 2x book, you are looking at closer to 30% CAGR. 2x book is about where Capital Crossing sold to Lehman Brothers. Opportunistic repurchases could increase these figures as even in the 15% loan growth case, NBN’s balance sheet continues to delever. 

 Risks:

1. The key risk for NBN is commercial real estate Armageddon. Their conservative LTV’s notwithstanding, a dramatic rerating of commercial real estate values would hit them. NBN has $300mm of loans north of 70% LTV. If we assume the average is 80% LTV and property values fell by 30%, you would be looking at close to a $40mm hit to book equity (~13% of 9/30/23 value). 

2. NBN’s CFO announced he was leaving the company in December. A young CFO leaving a bank can be a red flag, but in this case I do not think so. NBN announced his replacement today. I had a call with the NBN management team last week and both JP (old CFO) and Richard (new CFO) participated. Everything is amicable. JP got a big job offer at another bank. Richard seems good. 

Appendix A:

Appendix B:

Appendix C:

Catalyst

Continued compounding of book value and EPS