Description
Service Bancorp is the intermediate holding company for Strata Bank which IPO'd in August of '98 at $10 a share. Currently, about 43% of Service Bancorp is held by the minority public shareholders with the remaining shares held by the mutual holding company (Service Bancorp, MHC). The only asset of note which Service Bancorp has is Strata Bank...so the write-up will focus on Strata.
The bank is a community-oriented Massachusetts-chartered stock savings bank that provides financial services in Norfolk County and surrounding markets in the Greater Boston metropolitan area. Historically, the bank put up some decent numbers before it's IPO, with a 3-year average exceeding the common thrift benchmarks of 1% ROA, and 12.5% ROE. The profitability ratios since going public, however, are nothing to write home about...coming in at less than half of historical averages. What happened?
The bank made the decision to go for growth at the expense of short-term profitability. MHC's can get away with this because short-term stockholder interest is just one of the considerations that are taken into account (and it's a minor one). Insiders and employees own over 30% of the outstanding public shares, so they are by no means disinterested parties with respect to a healthy stock price...but they can afford to take a slightly longer perspective. In the last 3 years, the bank has nearly doubled its branches to 8 full service and 2 limited service branches. And they paid the price in the short run with higher labor and operating expenses. (New branches usually don't start contributing positively to the bottom line for several years, in fact, they are quite a drag in the early years).
In the last 3 years, the bank has grown its assets from $131M to $241M, its deposits from $108M to $186M, and loans receivable from $72M to $113M. The infrastructure is now in place for incremental business to produce a larger impact on the bottom line. Strata's home city and County have experienced population growth during the 1990's at a rate that is almost twice the rate of growth for the Commonwealth of Massachusetts as a whole. In particular, the town of Franklin (3 branches) has experienced the greatest population growth of any town in Mass, according to the Massachusetts Institute for Social and Economic Research. The growth is being driven by the area's proximity to Boston as convenient transportation and more affordable housing have attracted many individuals who work in the City of Boston. In addition, Strata's market area has seen an expansion in commercial real estate development as a number of small businesses have migrated to the area. (OK, they're in a nice growth area but so are hundreds of other banks...what's the attraction to this bank at this time?)
First a few comments on the 'mutual holding company'(MHC) structure. GAAP 'understates' both the P/E and P/B ratios because they fully count the shares the MHC holds...but the shares have never been sold publicly. Others posters on VIC have commented that all the economic value of the enterprise should accrue to the public minority shares only...but I'm afraid that 'overstates' the true economic reality in most cases. (There is a very large exception where this does hold true, however...and, is in fact, one of the reasons why I recently bought SERC). It's not difficult 'adjusting' P/B and P/E for a publicly traded sub of an MHC at the IPO...but it is a little trickier after it's been trading for a few years. The easiest way is to assume a second-stage conversion at a reasonable P/B (second-stage conversions are primarily priced according to book). The Mass median P/B is 117% and the national average is 108%. Most recent second-stages have conservatively been priced to go off at a minimum of 75% P/B. Assuming SERC is priced at 75% in any second-stage, the current price is an adjusted 59% P/B (this asumes all the underwriting expenses and a realistic 8% ESOP and 4% MRP expense). SERC will not stay long at that 59% P/B mark with the average Mass thrift trading at twice those levels. But is there anything indicating that the bank would want to convert?
Management has stated, "they would consider a conversion transaction if attractive acquisition or expansion opportunities make raising additional capital necessary, or if financial conditions dictate such a transaction." They opened a new mortgage loan center last week and plan on becoming a more significant player in that market. At today's present 7.53 E/A, there isn't a whole lot of room for asset growth before a raising of equity will be necessary (although they could shift their balance sheet assets to buy time).
The MHC structure and Mass regulations generally restrict conversion of an MHC to stock form for a period of 3 years following a minority stock offering, creating substantial impediments to 'second-stage conversions' and any 'change of control' of the MHC during that time period. I've specifically targeted SERC for this write-up because of the 'timing' and 'growth' issues...but there are a dozen other thinly-traded OTC MHC's that are also good candidates because not only are they dirt-cheap and favorably positioned...but because a wonderful new exit strategy has very recently emerged (but it's particularly relevant in Mass). Massachusetts is the 'bedrock state of mutuality', with far more 'MHC's' and 'mutuals' than any other state in the union. MHC's, even after they convert, often act like mutuals. And last week, another thinly-traded Mass MHC that I own, RFED, announced they were going back to 'full mutuality' by allowing themselves to be purchased by mutual savings bank, Danvers Savings.
When a 'mutual' buys an MHC, it's a very interesting transaction...and while still rare, to date, it's always been extremely profitable (an MHC buying an MHC is more common but can be just as profitable). These win-win transactions, at even 2-3 times current depressed MHC market prices, can still be accretive to the acquirer. In RFED's case, Danver's is paying $22.75 for each publicly-traded minority share, for a security that almost exclusively traded at single digits for its entire 3-year stint as a public company. Danver's is still paying less than book value because the majority of RFED's shares are now being extinguished, with RFED's depositors (who in effect have the rights to those shares in a full conversion), now having those ' mutual rights' transferred to Danvers.
In SERC's case, a 'mutual' or an 'MHC' (there are dozens nearby who'd be ready and willing), could offer to pay $25 per minority share, and it would still be immediately accretive to both the acquirer's book and earnings. Not only would the acquirer's equity per share increase but they would also opportunistically leverage their balance sheet in one fell swoop. In addition, SERC's attractive deposit base could be much better utilized by a more productive balance sheet (SERC's deposits are under-utilized at an anaemic 61% deposits/loans).
In any change of control, SERC's management and employees, who are the bank's largest block of shareholders, would get 'all' unredeemed ESOP, MRP, and option shares released at 2.5 times the current market price. There is usually a very nice 'change of control' bonus also. The deal could be structured like Revere's deal, where management is keeping their jobs and can do it all over again 'if and when'` Danvers decides to convert...it's a sweet deal for everybody!
The one drawback is if SERC doesn't decide to do anything for years. The illiquidity and value of the stock at $9.75 a share would still give patient investors 'private equity-like returns' over the long haul...but it would be like watching grass grow over the short-term. Management's able to take the long view but they are also human, and 3 years of 'no stock price appreciation and only depreciation' has to weigh on everyone's morale (and paychecks)...especially if there's a very lucrative alternative. My guess, if the stock price doesn't move in a year...'a monetizing of true value transaction' is likely to occur!
Catalyst
(1) SERC's IPO 3-year anniversary is around the corner.
(2) There are dozens of over-capitalized 'mutuals' and 'MHC's' in the area, who would be more than 'ready and willing' to consummate this deal.
(3) Human nature being what it is...it's not a difficult sale for SERC's managenent. Cash out at a wonderful premium on even your unvested shares, and still maintain your job in some form of mutual establishment. Life is good!