Growth Opportunities for Small Banks in the Northeast and Mid-Atlantic
TWST: Please tell us about your coverage universe and how the Northeast and Mid-Atlantic banks fit.
Mr. Schultheis: I follow 30 banks in the Mid-Atlantic and Northeast, ranging in market cap from about $4.2 billion down to some $100 million. I have a couple of outliers that are either not in that geography or more internationally focused, even though they may be headquartered there. So about 25 of my banks clearly fit into the Northeast and Mid-Atlantic.
TWST: What are the key themes you’re focusing on right now in that space?
Mr. Schultheis: There are a lot of submarkets within both of those geographies, and not all of the stories carry into all of the submarkets. In general, the main factors that are affecting the industry as a whole are affecting these banks, at least in certain geographies. Those include net interest margin compression, questions about the absolute levels of capital when the regulators finalize the capital rules and the ability to generate any type of revenue offset against the margin-compression issue. Those are general industry trends. Within these two regions, there are a couple of really strong markets. New York’s size and consistency means that smaller banks, relative to some of the big money center banks that are headquartered there, can experience really strong growth. The District of Columbia is an area that has a combination of size and growth that’s only really matched by Dallas in the U.S. As a result, there is a lot of opportunity for relatively small banks to have significant growth opportunities.
TWST: When you talk about the interest rate squeeze, what kinds of things are the successful banks doing to manage that better than others?
Mr. Schultheis: I think the companies that are least exposed to margin compression are the companies that have loan growth, because over the last five years or so, deposit growth has greatly outstripped loan growth and the companies have moved to lower-yielding securities. If they haven’t had loan growth, as those securities are continuing to mature and get reinvested at lower rates, it can really cause a strain on their margins. Companies that have had loan growth have been able to basically add credit spread to their margin, which helps offset the influence of the interest rate environment. I think that’s the real differentiator between the companies that are able to maintain or even expand their margins versus those that are more at the mercy of the shape of the yield curve.
TWST: What’s the latest on the capital rules and the regulatory front as you look ahead to 2013?
Mr. Schultheis: I think we have a pretty good sense of the levels that are going to be required with the capital buffer, but the devil is in the details. They were supposed to finalize the capital rules this year, but they delayed that. Banks gave a lot of input regarding things like whether the mark-to-market adjustments on available-for-sale portfolio should be included or excluded from capital. Currently, they are excluded, and banks want them excluded, because inclusion adds a lot of volatility to the capital. I think we’re going to get a little bit of horse trading, where some of those things banks want stripped out of the original guidelines will be removed, but I don’t think we’re going to see the regulators shy away from implementing the capital rules overall. I think it’s going to be marginal changes, not necessarily wholesale changes, on that side.
I think the other regulatory issue is going to be the Consumer Finance Protection Bureau. Just because of the way it’s set up, whichever way they turn their gaze at any point in time, it could have a real impact on the way banks do business, the type of products they offer and the pricing of those products. I think there were a lot of banks that went through the election cycle hoping changes in the White House or the makeup of Congress would make it possible that the Consumer Finance Protection Bureau would not be funded and would die a quiet death. Obviously that’s not going to happen, so we’re going to start to see this organization take even more of a lead than it has in the way it approaches banking products, fees and disclosures. They’ve started with disclosures, but I think they are going to get into what’s fair and what’s not from a fee perspective.
TWST: How about M&A? We have heard now for several years about a wave of M&A. Is that a big piece of your thinking as you look at this space?
Mr. Schultheis: I’m a little bit different from those who say the M&A wave is coming. I think the M&A wave is here, but we don’t recognize it for what it is because the multiples haven’t expanded as much. Prior to the Great Recession, banks were being acquired for 2.5 or three times tangible book; now they are selling for 1.6 times tangible book. It’s a lot less exciting. But the truth is, in the Mid-Atlantic region, we were actually on pace at September 30 to do the average number of deals in 2012, going back to 1994. So if we live in a mean-reverting world, we’re at the mean in that geography. We’re approaching the mean for the nation as a whole and in the Northeast. So it’s clearly picked up off the bottom; it’s clearly arrived. My guess is that we get a gradual build in the number of deals from here. I think we’re going to go from 150 deals to 180 per year, and then maybe 180 to 215. I think that’s going to be the way this wave will grow, rather than going from a 150 to 500 in a year.
Right now, the M&A focus is on banks with less than $1 billion in assets. The size of institutions selling will likely build gradually with $10 billion and $20 billion banks starting to sell in the latter portion of 2013.
TWST: What’s the overall investor interest level in this space and how has that been trending?
Mr. Schultheis: I would argue that the institutional investor is back in the bank space, has been back in the bank space for some time and shows continued interest. They understand the space, they want to know which names they should be buying for whatever fits their particular investment strategy. Back a couple of years ago, the people who were willing to look at the bank space sort of fell into three categories: you had some deep value investors; you had some special-situation people who wanted to learn about banks, because there were a lot of broken toys out there; and you had bank-specialist investors — that’s basically all they do. Now, what we see is a more generalized approach from investors. The bank specialists are still there. The special-situation guys are still there. The value guys have been squeezed some as bank stocks have come up above tangible book. Now, we’re starting to see more interest from growth-at-the-right-price, GARP, investors and straight-growth investors who weren’t looking here a couple of years ago. That’s probably a good thing, to have a larger audience for these names.
TWST: What’s your broad outlook for next year?
Mr. Schultheis: Well, it’s a challenging outlook for earnings and for earnings growth in particular, especially when we start to look past 2013 into 2014. A lot of the past earnings growth for these companies has come from reserve releases as asset quality improved. The rate of reserve release is likely to slow, which is likely to drag on earnings. Net interest margin compression is likely to continue for the industry, which will also be a drag on earnings. As offsets to these, I think a lot of companies are being fairly aggressive about containing their noninterest expenses, which will help. They may not be actually reducing expenses, but they are being very careful about containing them. The other positive is mortgage banking, which was obviously a huge boon in the third quarter of 2012. It looks to be that way for the fourth quarter, and I suspect it will be here through 2013.
TWST: Where are you pointing investors now? What are some of your favorite stories?
Mr. Schultheis: As I said before, I like some of these markets that are growth driven, where there is opportunity for growth, and I also like the mortgage story along with that. Right now I’m focused on those stronger core markets and on areas where banks have a lot of exposure to mortgage banking activity. I think we have enough lead time to get excited by this, and that if things start to dissipate in the mortgage banking market, we can get out of the way, if you will. In no particular order, I’d mention Webster Financial (WBS), based out of Connecticut. It’s a strong bank, and I think they have some reserve releases to go through in 2013, and I think that they’ll probably manage that to smooth the earnings impact when they have to start putting reserves away for loan growth. They have reasonable loan growth; I expect it will be high single digit in 2013. Basically, the company spent the downturn focusing on cleaning up and getting a little more focused in their core geography. Now I think they are positioned to really take that focus and continue to grow the company there without having to take a lot of risk. The company just issued preferred stock and announced a share repurchase program for $100 million worth of their stock, and I would argue that will at least provide a nice base for the stock. I have a $25 target on it, and it closed at $20.43 yesterday. I think it has a nice upside and a good risk-adjusted return for investors looking for a stable company in solid markets.
TWST: What are some of your other favorites?
Mr. Schultheis: I have First Niagara (FNFG) as a top pick. I have a $10 target on it, and it closed yesterday at $7.78. This is a company that has had its challenges. They made a large acquisition that took them more time to digest than they were anticipating. They had to issue stock to do it, and it was not necessarily handled ideally. But I think now that the company has reached the point where the best news over the next three quarters or so is no news, and they can focus on loan growth. They have adequate deposits, and they have basically been redeploying securities into loans, which should help with margin a little bit. It’s a good story from the tangible book build perspective. Tangible book is about $5.50, and I’m looking for the company to do $0.70 to $0.75 a share for this year and next year, so I think they can build their tangible book faster than most. As long as they don’t go out and try to do another acquisition, even mundane earnings over a couple of quarters will drive this upside.
I would also draw attention to Northern Virginia-based Cardinal Financial (CFNL). They are growing their core bank at roughly 15% a year because of the loan growth they are generating. A lot of this is relatively low risk, because they have done a good job of staying in close to the Beltway. As we all know, the bureaucracy basically stays in place no matter how D.C.’s political decisions may affect the retiree in Kansas or the person who is working for a defense contractor in California. Cardinal has been able to stay close to the District proper, which allowed them to avoid a lot of the real estate exposure that caused problems for a lot of Northern Virginia banks. Simultaneously, they have a very large mortgage-origination arm, and it’s also a highly efficient one. As the mortgage market has stayed strong, Cardinal has been able to really ramp up their fee income there. Right now, we have a target price for Cardinal of $18, and it closed at about $16 yesterday. Obviously we would rather buy it on a little bit of weakness, but I still think there is a good run left in this stock if they continue to meet or exceed Street expectations.
TWST: Great. Anyone else?
Mr. Schultheis: I’d like to draw attention to the fact that fourth-quarter earnings in some areas are going to be affected by Hurricane Sandy. When we compare what happened to the banks in the Gulf after Katrina with the banks in the Northern Jersey metro market, I’m willing to say that the fourth-quarter earnings are probably going to be somewhat disappointing. Quantifying the type of losses they might have in the loan book is going to be extremely difficult. So when I’m looking at names like Signature Bank New York (SBNY), Valley National (VLY), Provident Financial Services (PFS), I anticipate that fourth quarter are probably not going to meet expectations. Their provision for loan-loss expenses are going to be elevated, largely, in some cases, due to the uncertainty. In other words, a person whose house or business is damaged may go into delinquency, and since the banks can’t quantify the losses yet, they will provision a little bit more than they really have to to build up a buffer in the allowance. But it’s a short-term phenomenon when we look at the banks that were impacted by Katrina in 2005. Their third-quarter earnings got absolutely obliterated, but then they snapped right back. I think there is an opportunity here, depending on market reaction compared to expectations. If these banks miss on their earnings estimates and the stocks get cheap, there will be a nice short-term play in the event for investors with some very attractive entry points. I’m not saying that’s going to happen, but I think it’s something to have on your radar. A lot of high frequency trading is being driven by algorithms, and that may mean some of these stocks get crushed in a day, investors could take advantage of that disconnect.
TWST: Thank you. (MJW)
Note: Opinions and recommendations are as of 12/14/12.
Matthew C. Schultheis, CFA
Boenning & Scattergood, Inc.
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