Trading at 33 times Q4/06 annualized EPS, Superior Bancorp is one of the most expensive regional banks in the country. There are several red flags—a promotional CEO, a large construction lending portfolio exposed to Florida real estate, several recent acquisitions that have execution risk, low quality earnings from bleeding loan loss reserves, aggressive branch expansion plans that will keep expenses high, poor credit quality culture, poor profitability, wavering bullish opinions on the sell-side—that lead me to believe the stock can easily get back to $8 (price in 2005 prior to new CEO’s arrival) and perhaps to its previous three-year low of $6.50, or down 25-40% from the current price.
Superior is a fairly typical regional bank based in Birmingham, AL, with operations (57 branches) throughout Alabama and Florida most recently (where it has made two acquisitions in the past year). The reason SUPR trades at its current valuation is the promotional CEO who openly talks about selling the bank in 2-3 years. The sell-side has bought into his pitch and have Buy ratings on the stock despite the sky-high valuation, multiple red flags, and numerous headwinds facing the banking industry— weakening housing and real estate, particularly in Florida; intense competition for both loans, deposits, and employees; inverted yield curve; deteriorating asset quality; hawkish minutes from the Fed.
Key Bull Points
1- CEO Stan Bailey is the former CFO of AmSouth, which recently completed its merger with Regions Financial (RF), a $25B market cap bank based in Birmingham, AL, with operations throughout the Southeast. He is also the former CFO of Hancock Holding (HBHC), based in Gulfport, MS. Clearly, Mr. Bailey is well-connected. He has succeeded in recruiting former colleagues and will no doubt continue to be opportunistic in picking off colleagues from both ASO and RF and most recently, Compass (CBSS), another large Birmingham bank that recently agreed to sell to the large Spanish bank, BBVA.
2- This is a turn-around story. Mr. Bailey was hired in early 2005 to clean things up after it had reported some serious credit quality issues. Mr. Bailey previously turned around a bank in Arkansas and sold it for a nice premium. (The bank in Arkansas was also called Superior. When Mr. Bailey joined his current company, it was called “The Banc Corporation.” He succeeded in changing the name to Superior in May 2006.)
3- Mr. Bailey has openly stated he wants to sell the bank in 2-3 years after getting some critical scale.
4- Florida and the Southeast in general has very favorable long-term demographic trends, making it an attractive place to bank. There has been a lot of M&A activity in the region.
5- Their headquarters is an old historic building that the CEO claims is worth $30M. There is talk that he will try to monetize it although it is unlikely anything will happen near-term—a perfect example of the CEO’s promotional habits. It underwent a serious renovation a few years ago. A Google search indicates that either $20M or 32M was invested by a variety of different parties including SUPR, the city of Birmingham, and other private investors. (For you real estate buffs, it is the John A. Hand Building.) A $10M gain for SUPR translates to roughly $0.30 per share pre-tax, or less than 3% of the market value.
1- The stock trades at an extremely rich multiple of 33 times Q4/06 annualized operating EPS of $0.08. This more than takes into account a lot of the bull points. Most southeastern banks trade at 14-17 times, with banks viewed as take-out targets trading at the high end of the range. CBH, written up earlier on VIC as a buy, trades at only 20 times Q4 EPS. Many other high priced bank stocks have gotten hammered in the last six months on results that typically have only modestly missed estimates. (Good examples include CACB of Bend, Oregon, PVTB of Chicago, MBHI of Chicago, OZRK of Arkansas)
2- 34% of SUPR’s loan portfolio is construction loans financing residential projects and land development. This has increased materially over the last couple of years—at the end of 2004 construction loans accounted for only 26.6% of loans. Several sell-side shops have recently put out reports highlighting the risk of banks with large concentrations of construction loans. There are two distinct risks. The first and most obvious, but less likely, is that some of the developers will go bankrupt as the housing market continues to worsen. The second, and more likely risk, is that loan volumes and balances will decline. Construction loans are often the single most profitable item on a bank’s balance sheet, often carrying rates of prime or higher (currently 8.25%+) along with lucrative origination fees that flow through non-interest revenue. There are only a small number of banks across the country with more than 30% of their loans in construction loans. UCBI, a Georgia-based regional bank with 38% of its loans in construction, just pre-announced lower earnings guidance for 2007 and has seen its stock sell off sharply.
3- SUPR is deal crazy. It has closed two acquisitions in the last eight months and will close on a third within a month or so. It will have roughly doubled the size of the bank in the past year from acquisitions, although management claims they are an “organic” growth story. Please. This is a roll-up and execution risk is material.
4- Earnings quality has been poor, as reflected by the deteriorating loan loss reserve ratio (LLRR), which has dropped from 1.25% to 1.15% over the past year. (For you non-bank analysts out there, below I have included a quick tutorial of how the accounting works.) This somewhat modest deterioration (many banks across the country have seen similar drops as asset quality has remained so good), however, has been masked by its recent acquisitions. From Q2/05 to Q2/06, a period with no deals, the LLRR declined precipitously from 1.36% to 1.14%. Without this decline, pre-tax earnings would have been $1.4M lower, quite substantial for a bank that only earned $6.9M in all of 2006.
5- Operating expenses are likely to remain high, as SUPR plans to open 13 more branches over the next 18 months to add to its current 57. (That is over 20% store growth, and they will be competing against the likes of far better operators such as CBH.) Given the inverted yield curve and the intense competition, we are skeptical that such expansion will offer any value and in fact will probably turn out to be a money pit. Tom Brown of www.bankstocks.com
has a good article citing the poor profitability of many recently built bank branches across the country. Washington Mutual and several other banks have had to slow their own expansion plans down as branch profitability has proven to be more elusive than initially forecasted.
6- Poor profitability—SUPR’s Q4/06 operating ROE was 7% while its ROA was only 0.50%. Many well-run peers have double or triple the profitability. With SUPR’s plans for aggressive branch expansion along with industry headwinds, improvements in profitability will be very slow in coming.
7- Non-performing loans (NPLs) are still relatively high at 0.63% and pose future risk. While Mr. Bailey has done a good job bringing them down from the high levels in 2003 (3%+), many banks have NPL ratios well below 0.50%. With a weak underwriting culture prior to Mr. Bailey’s arrival, there may be some lurking bad loans to surprise investors. Bad loans are made in good times.
8- The low hanging fruit from the turn-around play has likely already been picked. Mr. Bailey has been in charge for two years. If he hasn’t fixed the obvious things by now, then he likely never will. Additionally, almost half of the company has been acquired in the past eight months. These acquisition targets were actually fairly well run banks. While there will be normal cost savings from closing some over-lapping branches and consolidating back offices, any further gains from fundamental improvements in operations will likely be minimal.
9- While some people would call Stan Bailey confident, others would call it arrogance, a potentially dangerous quality to possess in this tough operating environment.
10- People’s Community is the Florida bank that SUPR announced it was buying this past January. If SUPR’s presentation on the deal is to be believed (http://ofccolo.snl.com/cache/1001132525.pdf
), they bought it for 14.5 times estimated 2007 earnings, which is a substantial discount to what most Florida banks have been going for (20 times or so). Rumor has it that this bank was on the block for over a year. Why would People’s sell for a 35% discount to the going rate? I bet it is a very low quality franchise.
11- In speaking to one sell-side analyst with a buy rating, I sensed his bullish conviction was wavering. We may see some downgrades in the near future.
SUPR closed deals in August and November of last year so the results of both quarters have been somewhat confusing. Q1/07 will give us a relatively clean look at the bank (although there may be more merger/integration charges) before Q2/07 is once again clouded by the closing of another deal. In Q4/06, they reported GAAP EPS results of $0.06, which included $0.02 of merger charges, so the core operating number is $0.08. Management notes that excluding the acquisitions, it grew loans organically by 21% for full year 2006 and deposits by 11%. These numbers are good, but hardly world beating, and the slow-down in the second half of the year is notable. Excluding the August 31st acquisition of Kensington, loans grew at a 15% annualized rate for Q3/06. Excluding the impact of the November 7th Community acquisition, loans grew at less than 6% annualized for Q4/06. With the subprime shake-out hitting in February and delinquencies rising in many parts of Florida, it seems likely that SUPR’s loan growth will slow down even further for the first half of 2007.
Abundance of Recent Negative Peer Announcements
As noted above, UCBI, a Atlanta bank with a heavy concentration of construction loans recently lowered 2007 earnings guidance on substantially lower loan growth estimates, quite a departure from what they were saying just 30 days ago. CBBO, an Oregon bank, also pre-announced lower earnings on a combination of credit issues and margin pressure. CACB of Oregon announced a Q1 earnings miss. WBS, a Connecticut bank, pre-announced a big miss on higher expenses and a bad loan in Florida. CBSH of Kansas City also announced a bad miss on margin pressure and higher expenses. MBWM of Michigan just announced a pretty bad miss on margin pressure, weak loan growth, and higher expenses. Even if SUPR manages to report a decent Q1/06, the trends for most banks across the country have been overwhelmingly negative. How sustainable will potentially decent results at SUPR be?
At $10.67, SUPR trades at 33 times Q4/06 annualized EPS, 24 times 2007 consensus of $0.45, and 18 times 2008 consensus of $0.60. The PE estimates are very rich even when based on estimates that include fantastic growth assumptions (for 2007, 41% off of a Q4/06 annualized operating figure and another 33% in 2008). SUPR’s tangible book per share is $4.30, putting it at a current 2.5 P/B multiple, leaving plenty of room for downside. Given the poor profitability (7% ROE and 0.5% ROA), the P/B can easily trade to 2.0 times or less. MBHI, a Chicago bank with a very similar story to SUPR (i.e. turn-around story; promotional CEO who says he will sell soon yet is doing tons of deals himself; Chicago viewed as great banking market; lots of M&A activity in region), has gotten crushed recently and now trades at 2.1 times tangible book (but still 20 times 2007 earnings). I think SUPR can trade to $8 per share or less, or down 25%, which still leaves the bank trading at a PE of over 20 times a more likely 2007 EPS of $0.38 and a P/B ratio of 1.9 times.
Tutorial on Loan Loss Reserve Accounting
Loan loss reserves are a balance sheet item, and technically occur as a contra-account to loans. Banks add to this reserve through the loan loss provision (LLP) line on the income statement. Often times, a small provision is taken when a new loan is booked, on the expectation that some percentage of loans booked today will default and be charged off in the future. When a loan runs into trouble and the bank actually has to recognize a loss, it charges off the loan (or part of it if some of the collateral is good), which results directly in a reduction of the loan loss reserve. The LLRR is often expressed as a % of the total loans outstanding. If you have $3 of reserves and $100 in loans, you have a 3.00% LLRR. This ratio will vary by bank and is affected by each bank’s own historical experience and often what type of loans they are making. i.e. Loans to a manufacturing company that is backed by plant, equipment and inventory might carry a reserve ratio of 1.50% while loans backed by prime residential housing often carry ratios of less than 0.50% because defaults are so rare. Across the industry, over the last 5 years or so, bank reserve ratios have declined from roughly1.50% to 1.10%. I often think of reserves as equity because that’s what they are.
Weak Q107 expected results; High valuation despite negative trends for regional banking industry