Description

Investment Thesis

StoneCastle Financial (ticker: BANX, $14.75 p.s., $96m MC, $150m EV) is a regulated investment company (“RIC”) that invests in the debt and preferred equity of U.S. community banks.  The Company trades at a 33% discount to book value with a well-covered 9.5% dividend yield ($1.40 p.s.), a stable, transparent portfolio and an external manager with a successful track record investing in community banks. The stock is misvalued as a BDC and the company is poised to increase distributable cash flow to $1.89 in 2016. The stock could revalue above $20 while investors collect a high, growing 9%-11% dividend.

At $14.75, the stock is 40% off its late 2013 IPO price. The company came out of the gate with a partially covered $2.00 dividend and was slow to complete a yield-enhancing CLO transaction so the stock underperformed. In May 2015, the company cut the dividend to $1.32, a level fully covered by net income, and the largely retail shareholder base purged shares. Recently, BDCs have sold-off strongly. The sympathy sell-off in BANX is overdone given that the company completed a CLO transaction in October that increased run-rate distributable cash flow to $1.57 p.s. and validated management’s long-term strategy.

Absent additional CLO transactions BANX is undervalued at a 10.6% pro-forma yield given the stability of its portfolio relative to the portfolios of BDCs, to which it is incorrectly compared. The community banking sector has low default rates (below 2%, Moody’s Baa rating) and BANX’s banks are geographically diverse, with low energy exposure and strong financial health (apparent in public FDIC filings). In contrast, most discounted BDCs with similar yields have low portfolio visibility, declining dividends, higher leverage, higher fees, oil-related and cash-burning tech investments, and less competent managers. The combination of a catalyst well underway, a healthy 9.5% dividend and increased attention from institutional investors has the potential to drive a substantial re-rating for a 40%-75% one year total return with a 13% future yield on the current price.

Other Investment Highlights

• Externally managed by StoneCastle Partners, the leading investor in the community banking sector, with a unique competitive advantage.

• Community banks have low historical default rates and are healthier than larger, noncommunity banks.

• Lower leverage, lower fees and more transparency than BDCs.

• The underlying banks have low oil-state exposure (11% of the book).

• Duration risk is limited ($0.017 dilutive per 25 bps increase in rates).

• The risk/reward is highly compelling at current prices. Assuming a very conservative downside scenario of (1) an additional 25 bps rate increase, (2) no more CLOs and (3) 100% of BANX’s energy-exposed assets written-off, the company would still have net income of $1.20 p.s. (an 8.1% yield on current prices). There is a much greater probability that BANX will complete an additional CLO and increase the dividend.

• A note on yields cited throughout this write-up: the current dividend is $1.40 (9.5% yield), with the October CLO the pro-forma dividend is $1.57 (10.6% yield) and closing an additional CLO would raise the dividend to $1.89 (12.8% yield).

Valuation Summary

Before delving into the portfolio and the merits of investing in the community banking sector, I will discuss the primary catalyst: the October CLO transaction and the impact of an additional CLO.

Impact of the Community Funding CLO and Potential for Future Yield Uplift

On October 15, 2015, Citigroup and StoneCastle closed a $250.5m CLO structured in two tranches: (Tranche 1) $205m of senior secured Class A notes yielding 5.75% (A3 Moody’s rating) and (Tranche 2) $45.5m of preferred shares. The collateral in the CLO yields 6.98% and consists of predominantly subordinated debt in 35 community and regional banks from 24 states.

The CEO of BANX, Josh Siegel, worked on the first TruPS CLO at Salomon Smith Barney in 1999 and played a key role coordinating the closing of the majority of the loans for the Community Funding CLO contemporaneously (no easy task). Closing the transaction validated a long-term strategic goal and opens the door for additional CLOs this year. Unlike the poor credit quality of subprime mortgage and auto loans (10% equity supported by junk bonds), StoneCastle structured Community Funding with an 18% equity cushion, supported by a pool of 97% investment grade loans. Also, the external manager, StoneCastle Investment Management, will rebate a 10 bps annual service fee back to BANX.

BANX acquired the entire $45.5m preferred tranche by contributing existing investments from its portfolio to the pool of CLO collateral. The net impact of the transaction resulted in a $2.1m increase in net income (they traded debt yielding 7.6% for preferred CLO shares yielding 11.7%). The transaction increases the risk of BANX’s portfolio—distributions to the preferred are first to be cut if payments from the collateral decline—but the collateral is sub/senior debt, not preferreds, so payments are relatively secure. The banks would have to incur significant stress to miss interest payments. The puts and takes are as follows:

Community Funding CLO Accretion

1. StoneCastle Investment Management rebates the servicing fee to BANX.

2. Values as of 9/30/15. Management will provide greater detail on the transaction in Q1 2016.

Adding the additional $2.1m of interest income and adjusting for the expiry of a fee waiver that had been in place until completion of the CLO raises net income from $1.37 p.s. to $1.57. Note that fees and interest expense do not change because the company is not increasing assets or adding leverage. The company demonstrated that go-forward net income had increased by raising the dividend from $1.32 to $1.40 in Q4 2015. We expect additional dividend increases will follow in Q1 2016 as the company realizes a full quarter with higher investment income. If the company closes another similar CLO in 2016, net income will increase by $2.1m for $1.89 p.s. of pro-forma net income. We believe management is well on its way to completing additional CLO transactions.

CLO Impact on Dividend Capacity

CLO Press release: http://ir.stonecastle-financial.com/releasedetail.cfm?ReleaseID=936939 (see the Q3’15 earnings call as well).

Note: the exact collateral in the CLO won’t be disclosed until March because of NDAs with a few of the banks involved.

Business Overview and Investing in Community Banks

External manager has a distinct advantage investing in community banks: BANX is externally managed by the $5 Bn StoneCastle Partners fund run by Josh Siegel. The fund has focused exclusively on investing in the community banking sector since 2004. Josh has long-term relationships in the sector that he has developed over fifteen years and his team includes former bank regulators, bank employees and ratings agency and investment analysts. The team, track-record and relationships make StoneCastle a well-known source of financing for the clubby community bank space that is otherwise difficult to penetrate because of the local nature of the business and the large proportion of private banks (90% of community banks). Loans are regularly below $20m, but require extensive due diligence so few private equity and large institutional investors compete in the space (Charlesbank, founded by the former PE team from the Harvard endowment, was an early investor in StoneCastle and owns a minority interest).

Higher than investment grade yields with investment grade risk: community banks have unique characteristics that distinguish them from larger noncommunity banks, namely smaller asset books, a focus on traditional banking (making and holding loans), higher capital ratios, higher core deposits and specialized knowledge of their local communities. Historically, default rates and nonperforming loan rates have been much lower at community banks than at larger rivals. The superior credit performance is generally attributed to (1) private ownership better aligning interests of management and shareholders and (2) local knowledge of the lending environment. Despite these positive credit characteristics, sources of capital are limited so borrowing rates are generally higher than is commensurate for the risk: an attractive dynamic for a specialist in the space.

The default rate of community banks is equivalent to a Baa investment grade rating. The highest annual default rate of 3.4% (534 of 15,796 banks) occurred during the Savings & Loans crisis in 1989. Over the length of the crisis, from 1982-1992, 2,808 banks failed (and nearly 2,400 new banks were chartered). During the Great Recession, from 2008-2011, about 300 of 7,000+ community banks failed and 707 banks (community and noncommunity) received TARP funds. High-yield default rates were much higher during these crises and BANX is invested in top tier banks that exhibit strong credit metrics (see the portfolio overview below).

Community Banks have a larger proportion of loans backed by real estate than do noncommunity banks

Note: the reason community banks have higher mortgage lending is because of thrift rules that require 65% of assets be invested in real estate mortgages.

Source: https://www.fdic.gov/bank/analytical/quarterly/

Lower leverage, lower fees, and lower turnover: BANX is a RIC so it does not pay corporate tax, but it differs from BDCs in a few important ways:

• First, RICs have lower leverage limits of 3x assets/debt versus 2x assets/debt for BDCs (0.5x debt/equity for RICs and 1.0x debt/equity for BDCs).

• Second, RICs and closed-end funds generally do not charge incentive fees whereas BDCs generally charge 20% of returns above a 7%-8% return threshold (aggregate BDC fees are often greater than 3% of assets). BANX only pays an annual management fee of 1.75% of total assets to StoneCastle Asset Management.

• Finally, BDCs typically experience more frequent portfolio turnover of 1-2 years whereas BANX intends to make long-term, 5-10 year investments. Lower turnover generally results in lower fees and an investment philosophy that seeks investments with less downside risk over an economic cycle.

• At the prevailing 2.5%-3.5% cost of debt and assuming a 6%-10% return on assets, a RIC like BANX will generate a 1%-2% higher ROE than a comparable BDC with higher leverage and fees.

Ultimately the comparison to BDCs is moot because BANX most closely resembles a closed-end fixed income fund: similar fees, similar default risk (Baa or better) and similar leverage. Investment grade closed-end funds trade at 6%-7% yields while higher risk funds (EM debt, common/preferred stocks, high yield debt) trade at 8%-9% yields. With BANX at a pro-forma $1.57 dividend, on assets with a Baa default rate, it should trade, conservatively, at an 8% yield, implying a $19.63 price.

Portfolio Overview

Ultimately, the merit of this investment is the company’s portfolio quality. Banking is highly regulated so even small community banks have to file publically available financial reports. As a result, we have an unusual degree of quarterly transparency into the performance of BANX’s underlying holdings (see below for a table outlining the portfolio and bank credit statistics).

Note: Dec-15PF is pro-forma for closing of the CLO investment in October 2015 and redemption of Preferred Equity during the quarter. I have assumed the proceeds from redeemed preferreds are reinvested in debt securities, similar to the pattern in previous quarters.

Energy exposure: the percentage of the portfolio exposed to oil & gas states is about 11% (includes TX, OK, LA, MO, and KS) and the rest of the portfolio should have low direct energy exposure. Community banks tend to have more mortgage assets and small business loans that aren’t directly tied to E&P activities (restaurants, farmers, seasonal inventory working capital lines) so their exposure will be from knock-on effects (i.e., fewer drillers eating at a restaurant). There is no denying there will be strain at Texas banks, but at this point the banks in the portfolio are healthy, well capitalized and improving. At a >30% discount to book, energy stress seems more than priced in (see below for more on this topic).

Slowly rising rates are not a major risk for BANX and widening spreads would be good for the health of its underlying banks: with the December rate hike, duration risk is an important consideration. The portfolio has $170m of fixed debt, $13m of floating debt and the remainder in cash and small equity positions. The approximate mark-to-market impact of every 25 bps increase in rates is -$4.5m ($0.70 p.s.) so if NAV was $22.10 p.s. on 9/30, it might be closer to $21.40 today. Interest expense is L+2.85% on $58m of debt that will cost $150K more in 2016, but is partially offset by $32K of additional interest income from floating assets (net $0.017 dilutive per 25 bps increase in rates). The table below outlines the impact of rising rates on net income and book value.

Reinvestment risk and changes in Q4: a lot has changed since Q3, so it is important to note a few differences between the Q3 actual and Q4 pro-forma portfolio below. First, BANX contributed a few holdings to the Community Funding CLO upon closing. Second, a few preferred stock investments were redeemed during the quarter. In the Q2-Q3 period, BANX reinvested proceeds from redeemed 9% preferreds in assets yielding 7.8% so the net loss in interest income is small (-$0.03 assuming BANX reinvests at 7.8%). The remaining preferreds yield 8% so future reinvestment risk is low. Cycling out of preferreds into sub-debt is key to BANX’s strategy of accumulating assets to contribute to future CLOs.

BANX Portfolio Overview

Note: the Texas Ratio = (Non-performing loans + owned real estate) / (Tangible common equity + loan loss reserves). The ratio compares bad assets to available capital and indicates whether a bank’s capital cushion is sufficient to absorb potential losses from bad assets (banks tend to fail when the ratio reaches 1:1 or 100%). Source of bank Filings: https://cdr.ffiec.gov/public/

Valuation & Financials

• Historical net income looks high due to a number of one-time asset sales and unrealized gains; about $3.3m of one-time revenue in the LTM period. Backing-out those gains, LTM earnings were about $1.16 p.s., which is indicative of the LTM net investment margin.

• Net income increased in Q2-Q3 2015 as the company fully invested capital so run-rate earnings are $1.37 p.s.

• With the CLO, BANX will generate about $17-18m of investment income annually and expenses consist of a $3.6m management fee, $2-2.5m of other OpEx and $2m of interest expense. Go-forward earnings should be in the $10m+ area or $1.57 p.s. (as a RIC, the company doesn’t pay taxes).

Financial Summary

Whether we value BANX as a BDC or a closed-end fund, the stock is cheap based on current earnings and very cheap assuming the company closes another CLO. On the conservative side, at a 10% yield, generally applied to BDCs, the stock is worth $15.67 without any additional CLOs and $18.91 with one more CLO. Given the lower risk, lower leverage, lower fees and greater transparency of BANX relative to BDCs, applying an 8% yield (in-line with investment grade closed-end funds) implies a value of $19.63-$23.64. While we wait for the CLO transactions to close we collect a well-covered 9%-10% dividend for total return potential of 40%-70% (bear in mind that the company may complete two CLOs in 2016, which would increase earnings even more).

The stock trades at a 33% discount to book value. Even if 11% of oil-state assets were written to zero, the company would still have $17.78 of book value and $1.31 of net income (8.9% yield). Additionally, at such a large discount to book it would be highly accretive to repurchase shares: for every $1m repurchased with excess cash, book value per share increases 0.4% and the dividend increases 1.3% (includes a reduction in the management fee for the reduction in assets).

Valuation Summary

Energy Exposure and Valuation Sensitivity

Exposure Parameters: High exposure: TX, OK, LA, MO and KS. Moderate exposure: primarily the CLO, which has 20% of its portfolio in states with oil and gas exposure. CA (oil producing areas), TN, and MO. Low exposure: CA (non-producing regions), IL, NY, GA, MA, PA (Philadelphia area), CT, OH, WI, DE, FL, NC, SC, MI, IN, VA.

Risks

• Oil-related stress in the banking sector, reinvestment risk as TruPS are redeemed and interest rate risk (less impactful than completing an additional CLO).

• Adverse Selection: one concern is that the banks that need to issue trust preferreds at 9% or have not redeemed TARP-related TruPS are less healthy than banks that can raise capital at lower rates or redeemed TARP TruPS. This doesn’t seem to be the case for BANX’s portfolio because the underlying banks are healthy, most of the TARP preferreds in BANX’s portfolio have been redeemed and the StoneCastle team is directing investments in attractive assets.

• Flattening Yield Curve: the pressure on bank net interest margins from a flattening yield curve (compression of the 10-yr vs. 2-yr treasury spread) is as indisputable as gravity. However, the risk of the banks in this portfolio not servicing debt is unlikely given that they have survived with low NIMs for over five years. Banks with prudent underwriting and strong capital ratios should not be at risk of defaulting. The Fed raising short-term rates in December should eventually improve bank NIMs. BANX is much more sensitive to RTY-beta than the 10-2yr spread.

• What is BANX doing with a $2m investment in Medallion Financial (ticker: TAXI)?: the amount of time the company spends discussing this position significantly outindexes its 1% weight in the portfolio. It is a distraction and the company is selling out of it.

• Follow-on equity offering: the company has an outstanding $150m mixed use shelf so it could do a follow-on equity offering, but we do not think it is management’s intent to issue equity at such a steep discount to book. An offering might be necessary to complete the third CLO, but there should be enough redeemable preferred to fund the second CLO without additional capital.

Resources

• Closed-end fund quarterly reports are called Form NQs and annuals are Form N-CSRs. BANX 3Q’15 NQ: http://www.sec.gov/Archives/edgar/data/1578987/000093041315004288/c82985_nq.htm

• FDIC Filings for StoneCastle’s banks: https://cdr.ffiec.gov/public/

• The Fed has published ample research on the community banking industry, including a detailed 2012 study found here: https://www.fdic.gov/regulations/resources/cbi/study.html

• The latest FDIC report on the health of the banking sector: FDIC, Q3 2015 “Quarterly Banking Profile”, https://www.fdic.gov/bank/analytical/quarterly/.  Note that revenue and income growth at community banks outpaced the banking industry as a whole; net income increased 7.5% y/y, average NIM is 50 bps higher than the industry average, net charge-offs were at the lowest level since Q3 2006 and the number of problem banks is the lowest since Q3 2008.

• “Smaller Banks Have a Historically Lower Default Rate Than Larger Banks”: http://tinyurl.com/zez2ptb

Catalyst

• Completion of a second community bank CLO increases net income
• Management raises the dividend after a full quarter with higher investment income from the October 2015 CLO