Description

Ocean Shore Holding Corp - $14.25

Ocean Shore Holding Corp is the holding company for Ocean City Home Bank, a $1bn asset community bank located along the Jersey Shore. It trades at 0.89x TBV, and there are numerous catalysts in place that make it a likely candidate to be sold in the next six months to one year. In a sale, I believe it could fetch upwards of 1.3x TBV, a 45% premium to the current trading price.

(HT to jet and rii who wrote this up in the past – hopefully third time’s a charm!)

Community Banking

As anyone who invests in the space will tell you, the United States is overbanked. There are well over 6,000 banks in this country, a legacy of an era when branch banking was severely restricted. As anyone who invests in this space will also tell you, most small banks are run by bankers who are reluctant to sell. Most bank mergers involving small banks create significant cost synergies, however most bankers are reluctant to be synergized out of a job, particularly when they have limited equity in their employer (as is often the case).

Demutualized banks have historically been more immune to this agency problem. As part of the conversion process, management usually grabs a massive helping of  equity for themselves on the cheap. Given the incentives involved, management is usually chomping at the bit to sell (though for the sake of propriety they sometimes have to pretend otherwise). There is a three year window following conversion where selling out is prohibited, but once that clock is up, it’s usually off to the races. These days, management is usually egged on by the activist shareholders they pick up along the way, but to use a Buffettism, it’s like telling teenagers to have a normal sex life – they hardly need the encouragement.

In March 2011, mrsox did a writeup of WBKC which cited a (then) recent Sterne Agee report which stated that 60% of all mutual conversions done since 1982 eventually resulted in the bank getting sold. A commenter on that thread thought that report was “backward-looking and far too optimistic”. Well, now that four years have passed, we can judge if times truly are any different. I looked up every bank that converted in 2009 and 2010 (meaning they have been able to sell since sometime between late 2012 or late 2013). I excluded the few tiny banks below $30mm of market cap (not really investable) and the couple of large banks above $300mm of market cap (at that size they’re already at an efficient scale). Here is the complete list I came up with:

So of the 16 banks on the list, 9 have already sold, despite the selling window having been open for only 1-2 years! Yes, incentives still matter.

(To anticipate some questions, most of these went for a premium to tangible book, returns to shareholders ranged from modest to obscene, and 3 of the 13 relevant banks that went out in 2011 have already been sold.)

This writeup focuses on only 1 of the 7 that haven’t been sold, because I think it is the most actionable and the most attractive, but anyone interested in this sort of idea might take a look at the other 6 on this list, as well as the 2011 list (who have been able to sell since 2014).

Company Overview

Ocean City Home Bank has 11 branches in southeastern New Jersey, mostly in the little resort towns along the shore, like (surprise!) Ocean City. These are mostly summertime places – Ocean City itself for example has 15,000 year around residents but that jumps to over 100,000 in the summer. The area is more family oriented than Seaside Heights of MTV fame – people come in from Philadelphia, which is only an hour or so way, or sometimes NY which is two hours+ away.

OSHC is unusual in that 41% of their loans are secured by second homes, and another 15% are secured by rental properties, which is sensible given their location. They have historically had very low default rates and have been able to charge a premium for these loans. They emphasize that loans backed by second homes have to be backed by borrower income. As long as the NYC/Philadelphia area continues to prosper economically, and the beach doesn’t go away, they should be fine. This isn’t a high growth area but it’s hardly dying.

Geographically, they are not too far from Atlantic City, which I believe has been an overhang on the stock, but I think the concern there is minimal. In the latest 10-K, they disclose that only 2.3% of their loans are to borrowers who were employed by the gaming industry at the time of origination, and less than a third of those loans were to borrowers who were employed by one of the affected casinos. Overall, nonperforming loans were at a low 0.81% as of year-end 2014, similar to rates seen in prior years.

ROA last year was 0.61%, and ROE was 5.89%, both fairly uninspiring numbers but average for a community bank these days given where interest rates are and the low scale. At any rate, the juice is in the cost savings to an acquirer. TCE/TA is 9.8%, so they’re not carrying a ton of extra capital at this point, unlike some of their peers. NPLs have been under 1% every year for the last five years, so credit quality has been very high. They’re buying back stock steadily and in early March approved another 2% buyback on a 10b5-1 plan.

On the asset side, most of their book is in their loan portfolio. 75% of their loans are 1-4 family residential, chiefly second homes and rentals as mentioned before. Commercial real estate and home equity loans make up most of the remainder. They also have a small securities portfolio pledged against the municipal deposits they take in. Loan growth has been fairly anemic over the past few years.

On the liability side, most of their deposits are savings accounts and MMDAs, with some small time deposits. Importantly, they have no brokered deposits and only a tiny amount of jumbo deposits. Core deposits have been steady over time. They also have some FHLB advances which offsets some of the interest rate risk involved with their big fixed rate loan book.

Valuation

On to the fun part. Let’s go by methodology:

Tangible Book Value – I estimate that TBV at the end of this quarter will be $15.93, which takes into account buybacks that happened in the last two months. The stock trades at $14.25, which is 0.89x tangible book.

There are a lot of factors that go into pinning down a fair TBV multiple – size, geography, profitability, overcapitalization, credit quality and so on. Jet posted a Sandler O’Neill list of M&A comps in his writeup last year which put the multiple in this kind of deal at 1.3x – 1.5x.

Rather than rehash his list or a list lifted from a proxy statement, I would add that ALLB’s sale earlier this month to WSFS went out at 1.3x TBV, and I would say that ALLB is as good a comp to OSHC as we’ll find – sure the geography (suburban Philly) is a bit better but on the other hand ALLB is smaller and more overcapitalized. So let’s stick with the 1.3x – 1.5x range, which would be $21 - $24 a share.

Core Deposit Premium – Core deposit premium is a better metric than TBV, in my opinion, since it controls for factors like overcapitalization – important because a lot of recently converted banks are highly overcapitalized. Similar recent deals seem to be going out in the 5%-8% range. The comp list for the PEOP deal found a median premium of 6.6%, while PEOP itself went out at 7.4%. The ALLB deal was priced at about 6%. Also relevant is a deal last year where Sturdy Savings bought several bank branches from Sun just down the road in Cape May, paying an 8.8% core deposit premium, though it should be noted that they commented the price reflected an especially good fit.

OSHC had core deposits of $779mm as of year end 2014. A CDP range of 5% - 8% backs into a price of $22 - $26 per share.

Economic Value of Equity – The 2014 10-K estimated an EVE of $153mm, which is about $24 a share. Like any DCF, EVE models are fairly sensitive to assumptions, particularly discount rates, so take it with a grain of salt, but I think they’re useful insofar as they’re a window into how management thinks about the value of their own company.

Earnings – I think this is the least valuable analysis, since annual earnings are highly sensitive to the interest rate environment, but less dilution makes it easier for a deal to get done. OSHC had an EPS of $1 per share last year, and if an acquirer cut non-interest expenses by a third (usually a reasonable estimate), they could get to $1.70, by my estimate. Strip out some excess capital, and an acquirer should be able to pay well over $20 per share without much dilution.

Event Analysis

Major shareholders include Rangeley (8.9%) and M3 (6.2%), two of the usual community bank activists. Rangeley sent a letter to management in November 2013 urging management to consider a sale. In response, management said (in part):

We have never ruled out a merger or acquisition as an option for generating value for our shareholders; in fact, we have stated many times since the completion of our second-step that no strategy is “off the table.” We have reviewed M&A alternatives at each of our annual reviews and expect to continue to do so. We have observed the current M&A market to be challenging and pricing to be uneven. We consider a sale of the company to be one alternative out of many, which we compare to the other alternatives we have available to us at the time, including our prospects for continuing to increase our value as an independent company.

Which I read as saying, “we want to sell as much as you do, just bear with us as we try to maximize the price”.

Jet discussed the M&A environment in NJ in his writeup last year, which I will just update here. The most obvious acquirers are ISBC and BNCL, both of which are in the same area, both of which recently completed second step offerings, and both of which have been vocal about their desire to expand via acquisition.

ISBC has been the most vocal, and the most acquisitive in the past, but they have been held out of the market for a year now because they are doing a systems upgrade and can’t integrate an acquisition. However, they have said that once that is completed in August, they are ready to go shopping. BNCL had been sidelined from the market for a year or so by a DOJ investigation, but they got that out of the way and completed their second step in January, so they should be open to doing deals now. I think with these two players in the mix now, OSHC will be more aggressive about finding a buyer.

There are several other possible buyers in the market – KRNY which has a second step scheduled in April, and a number of other midsized community banks in the area as well. It all depends on who feels like extending their tentacles into the area.  New Jersey should be an active M&A market for the next couple of years.

Incentives

Executive officers and directors own 6.6% of the company outright, and own significant options as well. Upon change in control, their contracts entitle them to receive 3 years of base salary (up to the 280G limit), assuming termination. The CFO just had his contract altered in February so that he gets 3 years rather than 2 years.

As an added incentive, 269,511 options expire on August 10, 2015, with a strike of $13.19. If they can strike a deal by that date, those options would be worth a couple of million dollars more than they would have otherwise. Needless to say, I think incentives are aligned, and they should be looking to get a deal done sooner rather than later.

Risks

I would highlight interest rate risk here – their loan book is largely fixed rate since it is mostly residential. Their deposit base is largely savings accounts, so funding costs won’t go up too much if interest rates rise, but they will tick up a bit. Management estimates that a 200bp rise in rates would lower EVE by 15%. Since there is a big gap between price and value, and a major possible near-term catalyst, I think the risk is acceptable but it bears watching.

Of course, general economic risks are important – the loan book is concentrated in a small area so that bears watching as well.

Finally, there’s the risk that management can’t come to an acceptable deal to sell the company.

Catalyst

Sale of the company