Description

Southern National Bank of Virginia (NASDAQ: SONA)

Supplemental Financial Metrics

Tang Book:                 $6.92    

P/TBV                         91%

Tang Common Ratio    15%

Tier 1 Ratio                 21%

NPA Ratio                    1.4%

Loan/Deposit Ratio       100%

Investment Thesis

SONA is an asset sensitive, overcapitalized bank with no credit problems.  It is currently under-earning due to the low interest rate environment and the weak economy.

SONA is poised to more than double the size of its asset base as it takes advantage of the credit crunch to increase loan originations.  Furthermore, due to its extremely high capital ratios, the company also has the financial flexibility to acquire deposits from failing institutions - either in asset divestitures or FDIC assisted transactions.

Like many small community banks, SONA's stock is currently trading below tangible book value.  The primary reason in my opinion is that the low interest rate environment has depressed the net interest margin, which is depressing the ROE (2% on a LTM basis).  It also has taken some write downs on a portfolio of Trust Preferred that it owns and has been building provisions due to the credit cycle.  These headwinds have also contributed to the low earnings the past few quarters.

If SONA is able to deploy its excess capital at attractive rates of return (which is a reasonable assumption, given where we are in the economic cycle), there is tremendous earnings growth ahead.  The $78M of tangible capital the bank has should support an asset base of $1B (8% TCE).  Furthermore, as the bank grows, it will generate operating leverage.  This will help lift the ROA to a higher normalized rate.  Finally, there are cyclical drivers of ROA which should turn positive soon: namely, higher interest rates and lower credit expenses.

My 3 year price target for SONA is $11/share, which is a 20% compounded return from the current price.  This assumes that the assets grow to $1B and the ROA increases from 40bps to 120bps.  This should be enough to deliver $1.10 in EPS, which would translate into a 15% ROE.  That would be enough to get the P/B multiple up to 150%, which would result in a stock price somewhere around $11.  The valuation could conceivably go higher if either the company were perceived at that point as a high quality "growth" bank, or an acquisition candidate.  In that scenario, 2x tangible book (which could actually be higher than the current $7/share) could push the stock price into the $15-20 range.

The risk to this investment is that the company has not yet felt the full impact of the credit cycle.  55% of the loan portfolio is listed as "Commercial Real Estate" of some sort or another.  There are a few mitigating factors here which I think protect the company against significant future write downs:

- SONA's CRE exposure is really an asset based lending exposure.  They lend to small businesses and often require them to post include their facilities as collateral for what is essentially a cash flow loan.  Thus they obtain an extra layer of protection against default.  This is not anything like the CRE books at regional banks which are currently engaging in "extend and pretend" with sophisticated professional real estate investors.

- We are now two years into the recession and SONA has NPA's of a meager 1.4%.  This suggests they are good underwriters of credit.

- With its under-levered balance sheet, SONA should be able to grow through the crisis, thus mitigating the earnings headwind from the provisioning cycle.

The company also has a $24M par value portfolio of trust preferreds.  The market value of the portfolio is $10M, but the company is carrying it at $12.5M based on its assessment of the underlying securities.  Given how small this differential is relative to the common equity base of the company (roughly 2% after tax) I don't think it's a meaningful issue.  But it's worth pointing out that if there is further deterioration in the financial sector, they could have some modest exposure.

The final negative is that the stock is fairly illiquid.  There are 11m shares outstanding and they trade by appointment.  It can be difficult to build a meaningful position.

To that point, the company right now has no institutional coverage.    A few weeks ago, the company raised $27M of equity through FIG Partners, which resulted in a little broader exposure to the buy side.  Also, Grant's IRO made favorable comments about the company a few months ago.  However, management is experienced and well regarded by the buy side (they founded Southern Financial Bancorp in 1986 and sold to Provident Bankshares in 2004 at a hefty premium).  I therefore suspect that the liquidity issues improve over the next few quarters as the company expands.

Catalyst

- If/when short-term interest rates begin to rise, the company will see an immediate earnings lift as its net interest margin expands

- An FDIC assisted transaction of size could lead to an immediate re-rating of the stock as the market discounts higher earnings

- The assumption of sell side coverage by FIG, SOP, KBW or FPK would provide greater visibility among the buy side

- Rapid asset growth would generate interest among the growth investors who typically drive small cap bank stocks mid-cycle

- The management team is in its early 60's and have been sellers before.  It's possible they could sell the bank within 3-4 yrs when the period of rapid expansion is over.