As a headline in Grant's Interest Rate Observer recently stated,
"The Thrifts are Coming! The Thrifts are Coming !"
Wolverine Bancorp is a federally chartered savings bank located in "middle of the mitten" Midland, Michigan. Wolverine, formerly just a plain old bank located in "The City of Beautiful Churches", is now amongst the likes of GOOG and AAPL having IPO'd on the NASDAQ back on January 20, 2011 by selling 2,507,500 shares of its common stock at $10 per share in a subscription and community offering. That included 200,600 shares sold to the Wolverine Bank employee stock ownership plan. The bank has three locations in Midland and one in Frankenmuth, which by the way, is also home to the "World's Largest Christmas Store". Wolverine serves nearly 7,000 customers, which is almost 20% of the population of Midland and Frankenmuth combined. While it's return on equity can't hold a candle to the numbers put up by Wamu in its heyday, Wolverine sports fairly low levels of non-performing loans, managed to weather the financial crisis, and is way overcapitalized. Perhaps these are some of the reasons why unlike many others in the space, Wolverine is in its 78th year of business, having received its charter in 1933, shortly after Franklin D. Roosevelt took office.
Wolverine currently trades for $14.11 per share giving it a market cap of $35.37m. Tangible book value is $62.3m giving it a Price to Tangible Book ratio of around 56.7%.
Non-performing loans stand at 3.9% with tangible equity to assets of 16%. Around 50% of their loan portfolio is comprised of commercial real estate loans including multifamily loans and land loans. 33% of the loan book is comprised of one to four family residential mortgage loans. Wolverine also invests in mainly U.S. government and agency debt, and has traditionally avoided municipal obligations.
Other than obtaining the ability to write off their next visit to "The Top of the Rock" on their next NYC visit as a 'business expense', why would Wolverine management decide to take the Company public? It's not like they needed the capital. A short overview on what is happening to small banks is warranted. Pay attention. This is where things get interestng.
Sometime this summer, the Office of Thrift Supervision (OTS), which has served as the regulator of federally chartered thrifts like Wolverine for over 20 years, will disappear. We have seen this movie before. Established by Bush Sr. in the wake of the Savings and Loan Crisis, the OTS chugged along until the most recent financial crisis, becoming another victim of poor management or maybe just circumstance as institutions such as Indy Mac keeled over and died. Dodd, Frank, Obama and a few other financial geniuses went on to decide that The Federal Office of the Comptroller of the Currency (OCC) shall assume regulatory oversight for banks currently under the umbrella of the OTS. A moratorium on the future proliferation of Angelo Mozillos you say? Who knows. What we do know is that the OCC is seen as a far more stringent regulator than OTS. While this little covered event may be of little importance to the average depositor or shareholder, it's of great importance to the dozens of regional and community bank executives and board members who earn their living as managers and stewards of these assets.
Since regulators look after everything from capital levels and lending limits to dividend policy and stock based compensation, many banks are coming public now to avoid the proverbial poison they haven't yet tasted. It's probably a good guess that under the OCC banks will likely need to hold more capital, not less, and the watchful eye of the regulator may get even more watchful. Once again, nobody knows the specifics.
Law firm Paul Hastings put out a good piece on what changes could be in store for thrifts. The author of this piece is way smarter than me, having gone to law school and all. If you can stay awake through 25% of this document, you will certainly learn something:
I prefer the Layman's way of looking at it.
As mentioned in Grant's Interest Rate Observer (Oct 29, 2010 issue) with respect to thrifts' reasons for converting to stock ownership now...
"Better the sleepy devil you know than the possibly energetic devil you don't, the converting thrift managements seem to be reasoning. So they are seizing the opportunity of regulatory realignment to convert to stock ownership under the rules before they change, or may change..."
So what does this all mean and when am I going to get back to Wolverine? Bear with me.
Like Walmart shoppers on Black Friday, dozens of thrifts are lining up at the gates to come public before the OTS/OCC rule changes go into effect. Unlike a Facebook IPO or a Green Mountain Coffee Roasters secondary, there will be no roadshow, no slide deck, and no keynote speech or 'swag-bag' at the next UBS Conference at the Grand Hyatt for these companies. And for good reason. Many of these newly public banks are simply too small for large investors to care about and will suffer from illiquidity shortly after the offering.
Need some more reasons that nobody cares?
There are simply few buyers of these assets that are left standing. Small cap financials have been in a five year bear market. Investors have been burned on financial stocks over the last couple of years, and those that want financial exposure need only look (or have looked) to the sheer enormity of paper that's been issued by big names like Citi, Bank of America and others. There is simply no reason to even bother with the likes of a Wolverine. Furthermore, depositors, who are offered a first crack at shares, are not the rabid buyers of new issues that they used to be. Whereas pre crisis, many offerings enjoyed oversubscription by deposit holders, nowadays it is hard to get the average depositor interested in anything other than the safety of his deposit. In Wolverine's case, The Midland Daily News reported after the offering that "bank officials wanted to offer the stock to local depositors and employee plans first and had said they might increase the number of shares to as many as 3.9 million depending on demand for the shares or changes in the market for financial institution stocks. That increase, [no surprise], did not happen."
Let's be clear on what is happening. Small regional and community banks that don't need capital are coming public, and traditional buyers don't really care. However, not everybody is disinterested.
In almost every single one of these new issuances, Management is a significant buyer of stock in the offering, alongside investors. In Wolverine's case, Management personally bought just over 4% of the offering. This is not akin to Steve Ballmer picking up a few shares of MSFT stock. Wolverine's Chief Operating Officer, Rick Rosinski, who earned $125k in total comp in 2009, purchased $50,000 of Wolverine stock. CEO David Dunn, who took home $277k in 2009 comp, bought $300k worth of stock in the offering. These guys are either the worst investors of all time or they actually believe that the bank is in good shape. We will give them the benefit of the doubt for now, based on what we agree is a compelling valuation.
Not only are thrift Management teams buying in at the offering price, they generally receive stock options that strike at the offering price as well. This gives Management a strong incentive to have cleaned up the loan book prior to the offering. Remember, banks have had 3 years to work through their problem loans following the crisis. Many of these small community thrifts (as we note on Wolverine) never participated in toxic investments (e.g. subprime, Alt-A, negative amortization loans, out-of-market loans, etc.) to begin with. Out of the gate, Management is also incentivized to maximize earnings through expense reduction, e.g. improvement in the Efficiency Ratio (operating expenses as a percentage of revenues).
Time for another quote:
"Reading the excellent article today by John Reese on the Peter Lynch strategy reminds me of something I learned by studying Lynch's incredible performance over his years at the head of Magellan. We dissected his returns after he retired and poured through years of annual reports and commentaries. What we found that was although he talked a lot about growth stocks and PEG ratios it looked to us like all of his outperformance could be traced to his vast ownership of thrifts. He was especially astute in having deposits in virtually every mutual thrift in the country so he could participate in conversion IPO offerings."
~Tim Melvin, noted deep value investor and financial author~
Wolverine, like many thrifts that fit this mold, is overcapitalized. They were overcapitalized before the IPO, and now they really have too much capital. This will give them the ability to withstand a soft or even declining real estate market. It's hard to lose money investing in a financial institution sporting a double digit tangible equity to assets ratio. Substantially all of Wolverine's loans have been collateralized by real estate, with one- to four-family residential mortgage loans including home equity loans and lines of credit, commercial real estate loans including multifamily loans and land loans and construction loans, making up 95% of the total loan portfolio. Bank management has stated that they will continue to emphasize real estate lending following the IPO.
Wolverine does not offer loans that provide for negative amortization of principal, such as "Option ARM" loans, where the borrower can pay less than the interest owed on his or her loan, resulting in an increased principal balance during the life of the loan. In general, they do not offer loans dealing with low down-payments to borrowers that have had payment delinquencies, previous loan charge-offs, judgments and bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios. Same goes for or Alt-A loans (generally defined as loans having less than full documentation).
Here are some of the key historical financials:
| |
Jun-10
|
2009
|
2008
|
2007
|
2006
|
2005
|
|
Tot Assets
|
308
|
304
|
318
|
312
|
304
|
280
|
|
Cash
|
23
|
23
|
6
|
43
|
19
|
9
|
|
Loans Receivable
|
237
|
245
|
266
|
256
|
265
|
250
|
|
Deposits
|
176
|
167
|
179
|
178
|
176
|
185
|
|
FHLB Advances
|
85
|
90
|
92
|
86
|
82
|
51
|
|
Tot Equity
|
42
|
45
|
45
|
44
|
43
|
41
|
|
ROAA*
|
-0.248
|
0.03
|
0.33
|
0.53
|
0.71
|
0.77
|
|
ROAE*
|
-17.1
|
0.2
|
2.39
|
3.73
|
5.07
|
5.06
|
|
Efficiency Ratio*
|
156
|
66
|
69
|
68
|
64
|
64
|
|
Non Perf /Tot Assets*
|
3.8
|
2.74
|
1.42
|
0.93
|
0.62
|
0.43
|
| |
|
|
|
|
|
|
|
* '2010 data is for the 6 mo ended June 30 2010
|
|
|
|
|
Efficiency Ratio is non-int exp / (net int income + non int income)
|
|
|
|
Tot equity not inclusive of the IPO (Jan 2011) proceeds
|
|
|
|
The more recent numbers above require some explanation - note that the net loss during the 2010 period resulted primarily from a $4.0 million provision for loan losses charge taken during the period and a one-time charge of $2.9 million taken in connection with the freezing and funding of our multi-employer defined benefit pension plan. This goes back to 'cleaning it up' before coming public.
More on the loan book, if you are still interested:
At June 30, 2010:
Commercial Real Estate, Multifamily and Land Loans: $84.4 million, or 33.5% of the loan portfolio, consisted of commercial real estate loans, $34.6 million, or 13.7% of our loan portfolio, consisted of multifamily loans, and $15.6 million, or 6.2% of the total loan portfolio, consisted of land loans. Of the $84.4 million of commercial real estate loans, $24.5 million was secured by non-owner occupied one- to four-family rental properties.
One- to Four-Family Residential Mortgage Loans: $83.6m or 33.2% (of the portfolio)
Construction Loans: $10.7m or 4.2% (of the portfolio)
Home Equity Loans: $8.8m or 3.5% (of the portfolio)
Commercial Non Mortgage Loans: $10.5m or 4.2% (of the portfolio)
We always like to look at the biggest loan that a bank has made. For what it's worth, at June 30, 2010, Wolverine's largest commercial real estate loan had an outstanding balance of $4.3 million, was secured by commercial/industrial properties and condominiums, and was performing in accordance with its terms.
As you can see, while its ROA and ROE are nothing to get excited about (and ROE is going to look even worse now that the "E" portion is even higher), not a lot has to go right for Wolverine to be able to protect its capital, grow modestly, and eventually buy back its own shares if it cannot find better places to deploy funds. As the excesses of the housing bubble are worked off, a more normalized lending environment can develop, and the banks that are left standing will be sure to benefit. A substantially weaker dollar could also reignite rust belt based manufacturing, though we won't elaborate more on that other than to say it isn't an unreasonable thing to think about.
Quote time:
"What we're seeing now is almost too good to be true. Clean, overcapitalized thrifts, with less competition than they've faced in years, are coming public at less than one-half of their value to private buyers. And they seem to be coming en masse. " (also from Grant's Interest Rate Observer: Oct 29, 2010 issue)
The quote above was from noted bank activist Joseph Stilwell, who also appeared in Barron's late last year to discuss the same topic.
From Barron's Dec 18, 2010...
"Discounts of today's magnitude could represent a once-in-a-lifetime investment opportunity... The supply of new bank stock is enormous... But demand for thrift shares has withered. Depositors have little interest in the shares, while many institutional investors don't have the funds to participate."
Stilwell has spent the last 18 years investing in banks, and has a notable track record of activism in the space. The most cursory look at his public record (along with some media clippings) shows that his m.o. tends to be the same in each of these investments.
Stilwell buys reportable stakes in newly public or converted banks that are trading at a substantial discount to tangible book value.
He then encourages management to buy back shares, return capital to shareholders through increased dividends, and prudently grow the business, ie building new branches just for the sake of 'getting bigger' or buying a competitor with the IPO cash would be out of the question.
While not a prerequisite for investment, it does help to be alongside Stilwell as a shareholder. His reputation is common knowledge in most of the boardrooms of these small banks, and he will be "watching the store" to make sure that capital is not squandered. Stilwell filed his 13-D on Wolverine on Feb 7, 2011.
For the 13-D junkies, here is his "Item 4":
"Our purpose in acquiring shares of Common Stock of the Issuer is to profit from the appreciation in the market price of the shares of Common Stock through asserting shareholder rights. We do not believe the value of the Issuer's assets is adequately reflected in the current market price of the Issuer's Common Stock.
We hope to work with existing management and the board of directors to maximize shareholder value. We will encourage management and the board to pay dividends to shareholders and repurchase shares of outstanding Common Stock with excess capital when permitted by applicable regulations, and will support them if they do so. The market area in Michigan is problematic. We believe that until Michigan's real estate market shows meaningful improvement, significant growth of the Issuer will be a danger to its shareholders. We believe the Issuer has sufficient capital so shareholders and the Issuer will do well if management focuses on operating efficiently rather than growing. We strongly oppose using excess capital to "bulk up" on securities or to increase the size of the loan portfolio. We oppose the acquisition of financial institutions. We will only support a very limited increase in the branch network. If the Issuer pursues significant growth or any action that dilutes tangible book value per share, we will aggressively seek board representation."
(end of Item 4)
Is Wolverine an acquisition target? Probably not now, though we do think a wave of consolidation is coming.
Most people will agree, America's 8,000-odd banks make it one of the most overbanked places in the world. The next 3-5 years should spark a wave of consolidation. Even if Wolverine were to remain independent after its 3 year moratorium, a modest return on equity, coupled with buybacks and dividends and a conservative valuation more reflective of intrinsic value should produce an excellent risk adjusted return.
On Jan 24, 2011, Stern Agee published the results of a study they conducted which tracked all standard and second step conversions since 1982 through the present day. Stern discovered that standard conversions came public priced at 67% of TBV on average, while second step conversions issued shares at 90% of TBV. Subsequently, 60% of all 504 conversions analyzed by Stern Agee were sold. Converted banks were sold at an average deal price that was 164% of TBV. Unfortunately Stern didn't break the data out in great detail, but we have a hunch that even if the 40% of the 504 conversions analyzed that went unsold simply languished, the enormous gain going from the 67-90% of book purchase price to 167% of book sales price on the banks that DID get bought out, would pay for a lot of mistakes.
While the stats above are nice to think about, investors will have to wait for the buyout, and even the buyback, for that matter. Newly public banks like Wolverine cannot buy back their own stock until one year after the IPO. They are also not allowed to sell themselves to an acquirer until the three year anniversary of their IPO date.
We won't be overzealous either in awarding any more premium to the intrinsic values of these entities. A bank is worth its tangible book value plus some premium on their deposit franchise. Period. While Company owned assets such as real estate may be understated, we shouldn't pay a lot of attention to this, though it is nice to know that most of these small banks (again, Wolverine too) predominantly own their branches.
The fact is that a small, sleepy thrift can't really earn more than 7-8% on equity, even with the prodding of an Activist. It should however, be able to earn 4-5% (as Wolverine did pre-crisis), and Management has every incentive to get it there if they want their options to be worth anything. Let's be clear on another thing. We have highlighted Wolverine for the purposes of this write-up, but there are lots of names that also fit the bill. Investors may want to consider a 'portfolio' approach to this idea.
Here is a simple 5 year illustration of an investment in Wolverine using a 5% ROE on average over the next 5 years. (The illustration ignores dividends and buybacks).
Cost: $0.54 (as a percentage of tangible book value - ok it's now $0.57 since the stock moved, but you will get the idea...)
Average ROE: 5.00%
Starting Book Value: $1.00
Ending book value:
Year One: $1.05
Year Two: $1.10
Year Three: $1.16
Year Four: $1.21
Year Five: $1.28
Target Sale Price: 1.2x Book in Year 5
Sale Price = $1.53
Return = $0.99 ($1.53 - $0.54)
IRR ~ 23%
Keep in mind the average P/TBV exit multiple is historically much higher than the 1.2x that we use above. Stern arrived at 1.64x. We will be conservative and stick to the lower figure. If we get 1.64x we promise to mail Stern a fruit basket.
One last point on all of this. Though not central to our thesis on small banks, the financial industry is always a hot button topic, and it does help to be on the right side of the political equation.
As Stilwell says in Grant's...(yes, the same issue)
"These [small banks] are politically favored entities right now. People hate Wall Street. People hate Bank of America. Nobody hates First Federal Savings & Loan of Wichita."
Now that is something we can all agree on. After all, how many Chase branches can be found in the same town as "The World's Largest Christmas Store"?
Risks:
- The market continues to hate small cap financials.
- Real estate gets crushed again (though at this level of over-capitalization we could withstand a decent blow)
- Bank management goes willy nilly with the IPO proceeds and squanders the capital.
- These assets never trade again for anything close to book value.