Description

Disclaimer: Not investment advice. I own PDLB shares but may buy/sell them without notice. Information herein is according to my best knowledge and could contain factual errors.

Ticker: PDLB

Price: $10.00

Market cap: $224M

Readers of VIC are familiar with: 

• ECIP banks 

• Attractive thrift conversions as take-out candidates

• The distortion of high interest rates on short-term earnings for a bank with 5-year asset duration and very short liability duration

PDLB is a triple whammy on those three themes. 

ECIP capital: PDLB received $225M of ECIP capital, and the regulators assigned them the lowest possible dividend (0.5%) on this capital for the first year of payments (announced in June). If we assume PDLB continues to pay 0.5% on this preferred and they have a cost of preferred equity of 10%, then we can calculate the value of this $225M liability as just $11M, with the rest a write-up to equity. 

This adjustment brings P/TBV from 82% to 46%.

Thrift conversion dynamics: Ponce converted from a mutual holding company to a stock holding company in January 2022 (second step). PDLB is an unprofitable and under-levered bank. However, there are reasons to think management may be preparing to sell the bank:

• They did a second step conversion in January 2022. Only the optionality to sell the bank would motivate this step, as the bank didn’t need the capital, and the conversion increases management’s susceptibility to activist investors.

• Management is old: 6/8 members are in their 70s or 80s (including the CEO and Chairman).

• Together, the Directors and Officers own >2M shares of stock, worth ~$20M. The CEO owns 580,000 shares, worth ~$6M. His total compensation is ~$1.3M (and he'll need to retire soon anyway). Additionally, the CEO and directors will receive a final tranche of ESOP shares in December 2024 that will boost their holdings another ~40%. 

Distortion of high rates on PDLB’s short-term earnings: PDLB NIM is at trough levels for multiple reasons: 

• 5-year ARM loans were issued during very low rates in 2019 - 2021. 5-year treasury yields were between 0.2% and 1.4% during this period, and grew to >4% in September 2022 (where they’ve been ever since). Loans issued in 2019 - 2022 will reset to higher levels in 2024 - 2027

• Yield curve is inverted. Ponce lends based on the long end of the curve (five-year rates at 4.1%) and funds on the short-end of the curve (brokered deposits come in at ~5.3%). The yield curve will flatten as rates are cut, driving down the cost of brokered deposits and driving up Ponce NIM

In addition to the yield curve dynamics, Ponce is at an inflection in leverage on its management infrastructure. It built out management capabilities for a much larger bank, and is currently seeing decreasing Q/Q non-interest cost, while assets and interest income are growing nicely. 

IR told me that cost pressures were peaking in 2023, and this has already become true in 1H 2024 results. 

Description of the bank:

Ponce serves minority and low-to-mid income borrowers through its branch network in the New York metro area. 

Low-income and minority social groups make up the banks customers and managment:

• 75% of all loans are to low-to-moderate income communities (above the threshold of 60% to be a CDFI); retail deposits also serve low-income communities

• The board of directors is composed of immigrants or children of immigrants

• Ponce has been in this game for decades and has developed grant-writing teams to take advantage of special funds available based on their mission (e.g. $4.7M grant earned in 2023)

Ponce sourced $225M in 2022 in preferred equity capital from the government (ECIP program) on extremely favorable terms (low cost, perpetual duration, treated as Tier 1 equity capital by regulators). They recently reported that for the first year (and I’d be in subsequent years), they’ll pay the lowest possible dividend of 0.5% (the range is up to 2% for the program).

Ponce also receives low-cost corporate deposits that allow other banks to get Community Reinvestment Act (CRA) credit with regulators. These deposits are insured and sticky, and often ~200bps or more below market interest rates.

Outside of the ECIP equity and the small-but-growing CRA corporate deposits, the bank doesn’t have a good deposit franchise. The blended total cost of interest-bearing liabilities in 2023 is 4.0%. 

On the asset side, Ponce’s focus on mortgage lending to lower-income communities is a good niche (and composes 99% of lending). IR explained to me that the board of directors is composed of engaged real estate investors who know intimately the relevant neighborhoods and are involved in credit underwriting. Ponce lends 5/1 and 5/5 adjustable-rate mortgages against single-family (27% of loans), multifamily (30% of loans), and non-residential (18% of loans). Construction (23% of loans) properties are 36-month fixed-rate loans. LTVs on all these segments are ~55% and debt service coverage ratio >1.25x. In the current environment, Ponce is issuing loans at ~9% yield that are likely to experience very low levels of credit losses (my expectation would be 0 - 0.1% per year in annual credit cost). Given 5-year rates (~4%), lending at 9% is very favorable, and likely reflects decreasing competitive intensity in the wake of recent banking turmoil. 

I’m comfortable projecting very low credit costs because losses from the mortgage portfolio have been substantially zero going back to 2016 and very low going back to 2012 (the first year of available data). Charge-offs seemed to peak in 2013 at 0.7% of outstanding loans (charge-off happen years after delinquencies, so the timing seems reasonable following ‘08/’09). Given the peak of 0.7% and the more common experience of 0.0% charge-offs in Ponce’s mortgages, I’m therefore comfortable mostly ignoring credit cost.

The most concerning area with respect to credit costs is the construction book. Although they scaled the construction business in 2023, it's not a new business for PDLB (they've been doing construction loans on the order of ~100M per year since 2017, and on a smaller scale before that). PDLB has not recorded any charge offs on the construction business going back at least 7 years. PDLB had no new delinquencies on this book in 2023 (I.e. from loans made in 2020). They did have some DQNs in 2022, but these have been mostly worked out without charge offs. 

Regarding the timing of the ramp up in recent quarters, it may be just right: if investors/banks are concerned about charge offs today, that's related to vintages from 2020/2021 (which were also loans issued at much lower rates and might not roll over smoothly). If others are pulling back, that's the time to deploy more capital into the business. 

The bank is currently very under-leveraged: Tier-1 equity / RWA is 21% (vs. minimum 8% regulatory requirement)

Between the low leverage and the very low level of charge-offs and delinquencies, I view Ponce as an extremely safe bank to invest in. 

Investment thesis:

• Earnings will accelerate due to interest rate normalization and leverage on fixed costs

• As with many thrift conversions, PDLB is a take-out candidate upon 3-year anniversary (January)

Earnings will accelerate due to interest rate normalization and leverage on fixed costs:

Although the 2023 / 2024 rate environment has pressured NIMs, there are already signs that interest-rate spread / NIM have bottomed, even as no interest rate cuts have happened. Interest rate spreads have leveled out in the past three quarters at ~1.7%. Liabilities have mostly repriced, and from here, tailwinds will be 1) repricing of the 5-year ARMs and 2) interest rate cuts starting in September. NIM will be going up, and will likely recover to historical levels within a couple of years.

On the expense side, there was significant concern into the 2023 results about non-interest expense. Compensation and benefits grew by 13% CAGR from 2019 - 2023. Growth was 10% in 2023, showing deceleration but still to a high level. However, based on comments by IR that the bank has built expense infrastructure for a much larger bank, and based on results from 1H 2024, it looks like expenses are more controlled now. Non interest cost was in the 17.0M - 17.9M range for the last four quarters (prior to recently announced Q2). Q2, on the other hand, showed non-interest expense at 16.1M. Meanwhile, interest earning assets continued to grow at ~12% Y/Y. The combination of flat / decreasing costs and double-digit asset growth is very favorable for expense leverage.

Additionally, managers have incentives to create shareholder value, especially as they reach retirement age. If Ponce doesn’t slow expense growth, shareholder activists may discover Ponce and pressure management to rationalize or sell the bank.

The combination of improving NIM, growth in assets, and flattish expenses should produce much higher EPS in coming quarters, and I think $2 - $2.50 in EPS by 2026 is likely (if the bank isn’t sold).

As with many thrift conversions, PDLB is a take-out candidate:

The three-year anniversary of the thrift conversion is in January. The board is of retirement age and has healthy incentives to sell the bank. A buyout is likely a home-run from today’s stock price of $10.00: 

If a buyer preserves Ponce as a subsidiary and CDFI, they should keep the ECIP capital (and there is precedent from merger announcements in recent months). 

Risks and mitigating factors

• Ponce is susceptible to credit risk, especially in a severe real estate downturn in New York. However, from what we can see of the wake of 2008/2009 financial crash, realized losses on the portfolio were quite low. Additionally, current credit metrics are pristine. 90-day delinquencies are just 0.5% of loans. Construction loans were the worst performers at 1.6%, followed by (counter-intuitively) owner-occupied at 1.4%. The NYC real estate dynamics affecting NYCB and others appear to be non-issues for PDLB. However it’s worth keeping a close eye on credit metrics. 

• If NYC raises taxes to address budget deficits, it could hurt property prices. However, the low LTVs and conservative credit standards discussed above should mitigate this risk.

• In recent years, the bank went into non-core areas and made significant losses, which calls to question management judgment. The biggest example was the Grain partnership, for which they ended 2022 with an $18M write-off. I believe the colossal failure of this episode, combined with management’s shareholdings, will cause management to be more careful. However investors ought to be vigilant for PDLB going outside its land again.

• If U.S. inflation flares up again and the Fed needs to further raise rates, Ponce’s NIM will remain compressed. 

• Contractual terms are already set for ECIP capital, and a Republican President/Congress couldn’t reverse it. However, this bank is likely to continue getting other benefits and goodies going forward under Democrat political control, and may not do so under Republican control.

Catalyst

Earnings acceleration (just barely started in 1H 2024)

3-year anniversary of thrift conversion in January