Description

Investment Overview

 

United Western Bancorp (UWBK) is an under-followed, misunderstood small cap.  Few people even look at this company at all, while those who do often fail to realize that there is a hidden asset – Sterling Trust – that is worth more than the market cap of the entire company.  In a way you can’t blame investors for this oversight, since UWBK’s presentations and financial reporting are so focused on the community bank conversion that you wouldn’t even know Sterling exists.

  

UWBK is made up of two distinct businesses, Sterling Trust and United Western Bank.  Sterling Trust is a very profitable growing business that is relatively easy to value on cash flow.  United Western Bank is a former wholesale bank going through a major strategic transition to a commercial bank, and is, therefore, best analyzed on tangible book value and probability of success as a commercial bank.  The stock trades currently around $20/share, equating to a market cap of $147mm.  Below is a chart that depicts an overview of our valuations for the two businesses.

 

Shares	7.34
Price	20
Market Value	146.8
			Multiple			Valuation
Business	Book Value	Earnings	Conservative	Base	Upside	Conservative	Base	Upside
Sterling Trust	2.4	8.9	12X PE	18X PE	25X PE	106.9	160.3	222.6
United Western Bank	102.4		.8X BV	2.0X BV	3.0X BV	81.9	204.8	307.2
UWBK	104.8	8.9				188.8	365.1	529.8
% Increase						28.60%	148.80%	261.00%

 

 

Sterling Trust

Sterling Trust is a Texas-based Trust Company that offers self-directed retirement administration and custodial services.  In other words, people use Sterling to house their IRA accounts.  Unlike many household names in the IRA business, Sterling does not provide investment advice and has absolutely no agenda as to how you invest your money.  They let customers put virtually anything into their IRA accounts, rather than limiting them to stocks, bonds and funds that get purchased through Sterling.  This flexibility allows Sterling customers to keep private investment assets, real estate assets, stamps, and other collectibles in their tax-advantaged IRA account.  Sterling acquires its customers through word of mouth, its website, and through connections with professional money managers.  The money manager relationships are important, as Sterling is a home for alternative investments. 

 

Sterling offers its custodial services in exchange for an annual fee, ranging from $55 to a few hundred dollars depending on the type of account, and the right to invest the idle cash in a customer’s account.  Cash remains idle in client’s accounts for many reasons, including dividend payments, interest payments, sale of securities, and client flexibility.  The level of idle cash per account has remained relatively consistent at about 9% of client assets.  On the cost side, Sterling pays their clients an interest rate of 60bp on this idle cash.  Of course, Sterling (or anyone for that matter) can invest that cash at a much higher yield than 60bps.  It is this access to 60bps funds that makes Sterling such a valuable enterprise; even a treasury yield on that cash leads to a net-interest-margin that would make other banks salivate.  As of the end of 3Q06, Sterling had 48,517 customer accounts that totaled 3.57B in assets and produced $323mm of idle cash. 

 

While the reality is that Sterling is creating these extremely valuable low cost deposits, UWBK’s segment analysis gives the bank segment credit for this rather than Sterling.  In the segment analysis United Western Bank pays Sterling a fraction of the real value of its deposits in the way of a small inter-company subaccounting fee.  The bank then gets credit for the remaining spread that Sterling has earned, which just happens to be the bulk of the spread income.  We can, therefore, get to a true Sterling earnings number by unwinding the inter-company fee as well as letting Sterling earn the deposit spread.  In 3Q06, Sterling Trust had operating income of $148k and inter-segment revenue of $395k.  Therefore, Sterling Trust is losing $247k per quarter, or approximately $1mm per year, before the deposit spread earnings.  Sterling does not receive any corporate overhead charge in this breakout, which in our opinion is fair considering it operates completely independent of United Western Bank with its own management team in Waco, Texas.  Therefore, the true earnings for Sterling Trust are the $1mm operating loss plus the difference between the 60bp it pays its clients for idle cash and the amount Sterling can earn on this idle cash.  For our analysis we assume Sterling can invest at 1-month Libor, which is currently 5.32%.  That is a 4.72% spread on 60bps which leads to $15.2mm of spread income when applied to the current $323mm of idle cash.  All together that gives Sterling $14.2mm of annual pre-tax profits or $8.9mm of after tax profits, assuming no leverage. 

 

We estimate Sterling has grown accounts, assets, and idle deposits by over 20% for the last few years.  In the last twelve months, these metrics have grown by 13%, 16%, and 17% respectively.  Management at Sterling believes there is no reason why the company can not continue to grow at a nice clip for several more years.   Considering the company has a rapidly growing and diverse customer base with no need for additional capital, we believe that Sterling should receive a substantial multiple (its inverse interest rate correlation is arguably worth some premium as well). For this analysis we use 12X, 18X, and 25X earnings for our conservative, base case, and upside scenarios.  The key variable in determining the proper multiple will be Sterling’s ability to grow assets under management.

 

Note that our base-case for Sterling’s value is in excess of UWBK’s market cap despite Sterling taking up virtually no bank capital.  We believe that this has more to do with people overlooking Sterling’s existence rather than any negative view about Sterling or the bank.  

 

 

Sterling Valuation

 

Sterling Trust Earnings
	3Q06	3Q06
	Average	Run Rate
Idle Deposits	313	323
1-Month Libor	5.35%	5.32%
Sterling Funding Cost	0.60%	0.60%
Spread	4.75%	4.72%
Interest Spread Income	14.9	15.2
Non Interest Spread Income (3Q06 Annualized)	-1	-1
EBIT	13.9	14.2
Taxes	5.2	5.3
Net Income	8.7	8.9
Base Case Multiple		18X
Value		160.3

 

 

United Western Bank

United Western Bank is a Colorado bank that has historically gathered wholesale deposits and dabbled in other financial businesses.  At the beginning of 2006, new management, plus one of the bank’s founders (and largest shareholders), took over the company through a buyout of old management.  New management then began selling off all of the company’s non-banking financial businesses (except Sterling) and at the same time started building out a Colorado community bank.  Currently, only the portfolio of Mortgage Servicing Rights (MSRs) remains from these businesses.  Below is a description of today’s United Western Bank.  We break it into wholesale deposits, community bank, and mortgage banking (servicing).

 

Wholesale Deposits

While wholesale deposits might sound like high cost, hot money CDs, United Western’s deposits actually come from a small number of deeply ingrained, high service relationships that often include termed out contracts. The clients are typically trust companies, clearing companies and other financial institutions that produce substantial idle cash that can than be swept by United Western Bank.  Both the service relationship and the contracts make it operationally difficult, as well as financially penalizing, for these accounts to leave United Western Bank, as long as the bank offers them reasonable terms.  Generally speaking, United Western Bank technologically integrates with a client’s IT system so that they can sweep idle cash daily from the client’s accounts.  This feature actually creates a great niche for UWBK: the market for these deposits is too small for most big banks, and the technology to process the accounts might be too much up-front investment for small banks.  According to management, UWBK was only able to create this technology because it is the same technology that was originally created to support Sterling Trust.

 

Whether or not that niche sounds credible (we were skeptical), it is true that for many years now UWBK has had a very reasonable all-in cost on steadily growing deposits.  The combined cost for these wholesale banking funds is currently 4.6% (excluding the very low cost Sterling Trust deposits and including subaccounting fees described below).  An advantage of these accounts over community or residential deposits is that there isn’t the big branch expense related to these accounts.  In other words, the wholesale deposits might be a higher rate, but still have a similar all-in cost.  Furthermore, the 4.6% cost is arguably overstated as United Western Bank’s deposits are not all created equal; the customers with the deepest ties to the bank have a lower deposit cost.  Consequently, management believes it will be able to reduce the average cost of these deposits as the higher cost, lower relationship customers are replaced by new wholesale and community bank deposits.

 

Interest expense on the wholesale deposits shows up on both the interest expense line and on the non interest expense line as a subaccounting fee.  The latter expense exists because the wholesale deposits are typically a large number of smaller accounts that are bundled together from one company into one account.  United Western Bank pays the end client interest on these accounts and a subaccounting fee that is tied to short term interest rates to the institution that houses the end client for access to the end client’s deposits.  Therefore, to determine the true interest expense of these accounts you need to use the interest expense and the subaccounting fee.  This all-in cost of 4.6% isn’t exceptionally low like Sterling’s, but it does leave room for spread income.  Given the existence of $900mm of wholesale deposits, the spread doesn’t have to be that large to drop a lot of money to the bottom line.

                                                                     

Community Bank

A community bank is essentially a branch network of bankers servicing the local business community with loans and deposits.  As you might imagine, building a de novo community bank is very expensive initially as the costs pre-date the revenue.  This is especially true if you take United Western Bank’s approach of hiring bankers and building out branches at an accelerated pace. 

 

UWBK has a few major advantages in building the community bank.  First, the new management team consists of experienced Colorado bankers who came in exactly for this purpose.  In addition, UWBK already is an established bank with a considerable equity balance.  This allows UWBK’s bankers to underwrite much larger loans than a traditional start up community bank and was essential to allowing those bankers to bring over their established community relationships.   Finally, the low valuation on UWBK created an exciting opportunity for talented bankers to receive stock options with substantial upside. 

 

Management believes it has already hired all the senior bankers and many of the junior bankers it needs to convert successfully to a community bank.  Furthermore, management believes it can completely offset the remaining community banking costs through rationalizing current operations.  We believe these expense cuts make sense, as several divisions were sold off in 2006, and management has yet to efficiently streamline the bank’s overhead.  Furthermore, by all accounts, previous management ran a generally inefficient business.

 

While the legacy wholesale deposit gathering business and the new community bank are very different businesses, they are actually very good complements to one another.  Typically, community banks have a harder time building up low cost deposits than they do making high yielding loans.  Therefore, the current wholesale banking deposits can replace the generally less efficient liabilities.  Furthermore, the two businesses will be able to share the operating costs of being a bank.

 

Mortgage Banking

United Western Bank’s mortgage banking segment at this point is simply made up of a dwindling Mortgage Servicing Rights (MSR) portfolio and a few bankers located in Arizona to manage this portfolio.  This business has been unprofitable for a few years now due to United Western Bank’s lack of scale.  The mortgage banking segment reported an operating loss of $752k in 3Q06, which should continue to decrease every quarter as the MSR portfolio runs-off.  Management is currently trying to sell off these assets to someone who can manage them more efficiently, but to date they have been unsuccessful in this endeavor.

 

Earnings

UWBK had earnings in 3Q06 of $0.8mm after making a few adjustments for both positive and negative one time items.  Since we have already determined that Sterling Trust earned $2.2mm in 3Q06 it is clear that the bank as a whole is losing $1.4mm per quarter and losing $0.9mm per quarter ex mortgage banking losses.  Note that this loss is despite having $900mm of profitable wholesale deposits.  Below is a breakdown of United Western Bank’s earnings.

 

 

As noted above, the loss at the community bank is expected in the early part of a build-out.  In addition to the strategic transition, the bank has two other factors that are causing earnings to be weak: expensive junior subordinated debentures and underperforming single family mortgages.  As we’ll describe, the negative earnings drag from these should diminish over time. 

 

At the end of 3Q06 UWBK had 7 junior subordinated debentures outstanding totaling $61.3mm.  $43.3mm of these junior subordinated debentures have current interest rates between 9% and 10.25%.  These securities were issued by former management and are clearly above market debt.  The positive news is that $30.9mm of this debt is callable by July of 2007 and the rest is callable in 2011.  $15.5mm of debt callable before June of 2007 and the $12.4mm of debt callable in 2011 have 6% call premiums with the remainder callable at par.  Even with these call premiums, the high interest rates make paying off these securities an easy decision. 

 

During its wholesale banking days, former management purchased a large amount of 1-4 family Libor ARM mortgages.  Unfortunately, former management paid 102% of par and these loans are repaying at extreme rates creating a depressed yield on the assets (yield is reduced for lost premiums paid at time of pre-payment).    The company currently has approximately $130mm of these assets remaining.  The good news is that since these loans are repaying so quickly they should be off the books in a few years.  In addition to the rapidly prepaying loans, the balance sheet holds other loans that prepay over time, but are currently under-earning.  Right now UWBK gets double hit for these bad loans as the company has operating costs associated with holding them.  In the future these operating costs will go away as new management is focused on buying MBS rather than whole loans. 

 

While the aforementioned negative factors should ease over time, in Q4 the company will start receiving a positive earnings benefit from the sale of their corporate head quarters for a pre tax gain of $11mm.  Because the company is leasing back a portion of the building, GAAP rules require them to recognize this gain on its income statement over the next ten years rather than upfront.

 

 

It is difficult to determine United Western Bank’s normalized earnings on the wholesale bank because management does not break out costs between the wholesale bank and the community bank.  Consequently, we believe it is appropriate to value both entities together using a multiple of book since current earnings are depressed from the strategic transition.  Small cap community banks in the west trade on average at 3.3X tangible book value.  The only small cap community bank in Colorado is Centennial Bank (CBHI), which also trades at 3.3X. On the next page is chart of comparable community banks. 

 

 

Clearly, since UWBK hasn’t completed the transition it doesn’t deserve the same valuation as existing ones.  However, once a successful transition is made the value of the bank (and the ROE) is arguably greater than these comps due to United Western Bank also having $900mm of wholesale deposits.  While we certainly aren’t arguing for anything like these comp valuations, we did want to show the upside potential if management is successful in transforming the company into a community bank. 

 

When considering the discount United Western Bank should receive vs. other small cap community banks, we analyze the likelihood of success and the time it will take to achieve this success.  Management believes it can completely convert the bank in 4 years.  If this is the case, only a small time discount is warranted.  Therefore, the key determinant in assigning the proper discount is the likelihood of the conversion being successful.  While we don’t have a crystal ball to handicap that, our meetings with management and the senior bankers have provided us high degree of confidence that they have assembled a successful and capable team with great Denver experience.   In addition, the company has shown early success putting on loans and deposits despite just recently hiring the bankers and establishing a couple of new branches.  Our analysis uses a 2X multiple on tangible book for our base case.  However, you can say it is worth less than tangible book and the math still works out just fine.   

 

Management

 

Management is lead by Scot Wetzel, formerly president of the Colorado division of Compass Bancshares from 2000 to 2005.  Scot is a born salesman, which can turn some Wall Street people off and potentially leave them with the impression that he might not truly understand the financial side of banking.  Having pressed him, we believe Scot does in fact have a strong banking intellect.  In addition, we can’t help but be somewhat taken by Scot’s enthusiasm and confidence that the community bank will be successful.  Unfortunately, Scot is so excited about the bank that he usually ignores mentioning Sterling Trust and barely brings up the wholesale bank deposits.

 

Management also includes Executive Chairman Guy Gibson.  Guy is an entrepreneur who founded a UWBK predecessor and has been the leading driver in bringing in the new team and strategy.  Guy also puts his money where his mouth is by owning 18% of the stock.  

 

Outside of the transition, we give management a good initial score for taking advantage of the stock price via a stock buyback. The company announced a share buy back plan of 5% at end of 3Q06 and has already repurchased 4% of its stock.

 

Liquidity

 

The one area UWBK comes up far short of an ideal investment is in the liquidity department.  Even though the company has averaged over 40k shares per day over the last 3 months, the vast majority of those shares have been transacted in large blocks.  Consequently, to accumulate a substantial position in the company one will have to either find a large block or purchase shares over an extended period of time.

 

Conclusion

 

UWBK will most likely be successful in converting to a community bank.  Yet, what we love about this investment is that it’s largely undervalued even if they do a bad job.  The strong earnings from Sterling Trust lead us to calculate the stock has 28.6% upside to fair value in our conservative case.  In this case we assume the bank somehow isn’t even worth book value and the Sterling business is far worse than we think.  Our analysis using less draconian assumptions provides greater then 2X the current stock price.

 

Catalyst

Management emphasizing Sterling Trust when they talk to analysts and investors.
The bank growing commercial loans and deposits to make the commercial bank profitable.
Run off of low yielding assets and high cost liabilities.