Saturday, February 10, 2018

For Banks, Acquire or Be Acquired Is a Hobson's Choice

Bank Director recently held their Acquire or Be Acquired (AOBA) conference in the Arizona desert. It is a well run, well attended conference. When not there, which I wasn't this year, I follow the hashtag on Twitter. But the title of the conference bugs me. It's a Hobson's Choice.

According to Wikipedia, which is how I might have written college papers had it been available, Thomas Hobson was an English horse stable owner that gave buyers the choice of taking the horse in the closest stall or none at all. Translated to AOBA, merge or die.

But is that your choice: acquire or be acquired? What if, I don't know, you want to execute your strategic plan without merging?

I often say that "it all comes down to a spreadsheet". It doesn't mean that I wish it so. I want financial institutions to build an enduring and independent future. For the benefit of their customers, communities, and employees. If you have accepted shareholder money, i.e. you are owned by stockholders, you must also function for their benefit. One reason for the continued decline in the number of financial institutions, in my opinion, is the lack of balance in serving constituencies. 

Ignore one constituency to focus on another leads to problems, or the lack of alternatives, i.e. Hobson's Choice. AOBA.

So here is how I propose you work your strategy for the benefit of constituencies while keeping your eye on shareholders at the same time.

Strategy and The Option to Sell

Build a strategic plan that is aspirational. Shoot to become the financial institution you want to be. Identify it, and set strategy to achieve it. When you target such a future, which should benefit all constituencies, develop financial projections on what success would look like, in financial terms, if you nailed it! 

How far out should you project? As far out as you estimate it would take for the full economic value of your plan to play out. This could be three, four, five or even more years. Long term projections allow management teams to make strategic investments to build an enduring future. Budgets allow management teams to think short term, and delay strategic investments.

Naturally, I have a spreadsheet for you from our hypothetical banking company, Schmidlap Bancorp. 

Full disclosure, I used Evans Bancorp in Hamburg, NY. A well run, $1.3 billion in assets financial institution near Buffalo. They are not a client, so I know no inside information about the bank. Although the base period are their 2017 numbers, the projections are my own, not theirs. But I will refer to them as my hypothetical bank name.

Schmidlap's strategic plan includes near-term strategic investments that will adversely impact their earnings in Years 1 and 2. Their strategy is to achieve a 1%+ ROA in four years. Their plan has them achieving their aspiration.

The board and management team, in balancing their duty to shareholders, developed the present value per share of implementing this strategy. The table above shows the per share results. Schmidlap currently trades at 18x earnings, and their per share price was $40.70 at last close. If they execute this plan, and maintain an 18x earnings multiple, then the present value of executing this plan is $42.97 using a 10% discount rate. Perhaps you think this is uninspiring. But we are discounting results by 10%. So this plan should result in a 10% plus compound annual growth rate in their stock price if they succeed. Note that Schmidlap pays a 2% dividend yield. So the annual total return of this plan would be 12%+, all things being equal.

Not too shabby. 

But wait. An investment banker presents to the board that Schmidlap could reasonably achieve $46 per share in a sale. A 13% premium to their current stock price of $40.70, and a 7% premium to the present value of their strategy. This is termed the "strategy gap". If the gap is beyond board tolerance levels, management could revisit their strategy and sharpen their pencils, seek a downsteam merger partner to stoke earnings growth, or some combination. If they can't bridge the strategy gap, then perhaps a sale is in their future. And the investment banker smiles.

Hold on though. By remaining independent, and assuming management does not do wild things to materially elevate risk, Schmidlap maintains the option to sell into the future if they are not successful in executing their strategic plan. In most instances you can achieve a premium in a sale due to the synergies of the combination with a buyer. The oft-cited "cost savings". 

But what is the value of that "option to sell". I have ideas, and they are in the spreadsheet below.

If, in year 4, Schmidlap was not able to achieve their strategy, and they decide to sell, the buyer and Schmidlap would split the benefit of "synergies". In the accompanying table, by 50% although merger negotiations may be more or less. In addition, those added earnings are tax effected, and a terminal multiple applied equal to the difference of Schmidlap's trading multiple, and the multiple currently prevailing if Schmidlap were to sell (23x minus 18x). This yields a per share value of Schmidlap's option to sell at $3.82.

So, the present value of Schmidlap's plan, if including their option to sell, is $46.79 ($42.97 + $3.82). And exceeds what they can reasonably achieve in a sale. 

Since strategic plans and merger multiples will always be estimates when a board makes a decision, I do believe there ought to be reasonable tolerance levels of the strategy gap. For example, if the above math resulted in less than $46, should Schmidlap sell? Probably not if within a board specified strategy gap tolerance level, such as 5% to 10%. There is so much uncertainty in predicting the future, and the bank is operating for customers, employees, and communities in addition to shareholders. 

But ignoring shareholder value... as one of my Navy captains once said, bad news doesn't get better with age.

And the AOBA false choice will be your only choice.

Do you apply these principles in strategic planning?

~ Jeff

Saturday, February 03, 2018

The State of Banking

Where are we and where have we been? Trends are telling. In 2013, there were 6,812 FDIC-insured financial institutions. At September 30, 2017 there were 5,737, a 16% decline. There were 166 mergers, and four new charters in the first three quarters of 2017. As an industry, the trend is down. Ski slope down.

What about the financial performance and condition of our industry? The Presidential State of the Union address was supposed to report to Congress the Administration's view of the condition and performance of our country. It has turned into a sea of words amounting to nothing more than a wish list and priorities. Because the nation's balance sheet and income statement is not improving.

But what of banking? 

I broke down banking's financial condition, performance, and trading multiples into thirteen charts, seen below. Charts 1-6 are financial condition trends, 7-10 are financial performance, and 11-13 are trading multiples.

The numbers are medians from all publicly traded financial institutions between $1 billion and $10 billion in total assets. That yielded 291 total institutions, broken down by region. 

Financial condition ratios are promising. So I will say to you that the condition of the industry is strong. Assets, Loans, and Deposits continue to grow, although at a more moderate pace. And capital ratios have held steady and strong. In fact, if you listen to some institutional investors, the industry is over-capitalized. Many view an 8% leverage ratio as the "right" number. Although this should depend on an institution's risk profile and growth trajectory. And I have never heard a regulator say the phrase "over capitalized".

Non-performing asset ratios are in a long term downward trend. They have leveled off in the 60-80 basis point range. Some regions are experiencing slightly elevated non-performers from the previous year. A trend to watch.

The challenge with industry balance sheets is that loans have grown faster than deposits over the past few years. And loan/deposit ratios are steadily increasing as liquidity positions steadily decrease. Many bankers are less concerned about this citing their access to wholesale funding to bridge any shortfalls, or that they have been mopping up excess liquidity.

But rates have been rising slowly, and I believe Fed rate increases will accelerate this year, perhaps crossing the rate threshold where depositors now care what you pay them, and dooming those Betas in your ALCO assumptions to irrelevance. My opinion is that one or two more rate increases will trigger more skirmishes on the deposit battlefield. Those that have not positioned their bank to have strong liquidity will have to compete, giving back deposit mix gains they have worked so hard to achieve.

Net interest margins have leveled off from long-term industry declines. Good news! In 2017, NIMs ranged from a high of 3.8% in the West and Southwest, to a low of 3.1% in the Northeast. Are these anomalies due to region, competition, or business models? I would argue a mix of all three. But if I were a Northeast bank, I would ask why other regions achieved between 3.5%-3.8% NIMs and we're at 3.1%. That's a tidy sum to leave on the table.

Efficiency ratio trends look fantastic! And since NIMs are holding steady, it leaves me to think that operating expense control or increased profitability in fee-based businesses are at work. Based on my firm's experience with the profitability of fee lines of business, I am guessing the former. As balance sheets grow, operating expenses grow less, creating greater efficiency. Positive operating leverage!

Both ROAA and ROAE declined 2016-17, although efficiency is better. So what doesn't the Efficiency Ratio measure? Provision, and income taxes. Most of the institutions, if not all of them, probably took a Deferred Tax Asset (DTA) writedown in the income tax line item, impacting these bottom line ratios. But this probably doesn't account for all of the decline. Are assets growing faster than profits, therefore reducing ROAA? Is equity accumulating faster than an institution's ability to deploy it, therefore reducing ROAE? Or, is provision expense up throughout the industry. I believe a combination of the three. But if provision expenses are rising, credits could be moving from pass, to watch, to substandard, and onward. Take note.

Trading mutliple trends are jolting. Banking is not a long-term growth industry. In a past blog post I wrote about the PEG ratio (P/E divided by EPS growth), and to keep an eye out for anything that moves too far from 1. I further deconstructed a bank's p/e ratio because the industry is more capital dependent than most, if not all industries. I estimate that a bank's p/e can be reduced by 5-7 times to calculate PEG due to high capitalization. If I took 7x, and applied it to the Mid Atlantic's 22.1x p/e (the lowest of the six regions), then those banks would have to achieve earnings growth rates of 15% to earn that valuation. Note that p/e measurements for the below charts were done on 12/31, after the new tax law passed, and after most bank's announced their DTA writedowns. But prior to their earnings releases, so the reduced earnings were not yet baked in the cake.

Banks might earn that valuation depending on how they take advantage of the new tax law. Do they take the one-time earnings injection, or make strategic investments for longer term earnings growth. If the former, I do not believe the p/e's will last long term. And therefore I believe, as an industry, bank stocks are likely at peak valuations.

Or as industry stock analysts put it: Neutral.

What are your thoughts on the state of banking?

~ Jeff

Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.

Source for all charts: S&P Global Market Intelligence

Friday, January 26, 2018

Guest Post: Managing to the Margin by Mike Higgins Jr.

It's that time of year when every CFO is trying to "predict" what is going to happen with rates as they construct their budgets for the new year. Rather than trying to predict rate changes in the budgeting process, consider a slightly different approach that manages to the margin.

In a nutshell, budget rates flat. Do allow assets and liabilities that are maturing to reprice at current offer rates, and budget growth at current offer rates too; just don't kick any rate hikes into the budget.

Here are the benefits of this approach:

1.  If budgeting rates flat, as described above, and margin is improving, then some of it could be due to repricing at current offer rates, but it also could be because of a strengthening product mix (i.e. higher mix of loans vs. investments and/or higher mix of low cost of funds vs. high cost of funds). Either way, it presents the truth about where you are at right now.

2.  If budgeting rates flat, and margin is declining, then it may signal a weakening in product mix, or simply a weak product mix to begin with, and that will lead to some very hard questions about the direction the bank is headed. It forces the bank to confront their financial reality and identify strategies and tactics to improve it. Banks that rely upon rate hikes to hit a number in their budget scare me. It's normally because they are covering up a weak or weakening product mix and that's akin to allowing a sickness to go on undetected.

3.  Lastly, budgeting rates flat makes things easier to explain to the board each month. If margin stays unchanged, then there is nothing to report. If margin changes, then you can simply explain why it happened, which is a lot easier than explaining why something did not happen. Remember, you report earnings to the board twelve times a year; you won't have to remind them in each meeting that your "prediction" about a rate hike was wrong.

On the flip-side, there is one benefit to including rate hikes in your budget; when they don't materialize as planned, and you miss your earnings target as a result, it gives you someone else to blame.

What are your thoughts on this topic?

Mike Higgins, Jr.

Mike Higgins, Jr. is managing partner in the firm of Mike Higgins & Associates (MHA). His consultants work with clients in the financial services industry. His primary areas of focus are performance management, performance-based compensation, board education and strategic financial planning. He can be reached at (913) 488-4506 or

Saturday, January 13, 2018

For Banks, What Is Top Quartile Performance?

What is top quartile financial performance? I am often asked this question, and top quartile performance appears as stretch goals in many strategic plans. And I say bravo! Nobody wants to be average.

Usually top quartile performance is compared to a bank's or thrift's pre-selected peer group. Executive compensation is often tied to it.

I won't belabor the point. A key benefit of being a blogger is that I can use research I perform for my own knowledge to benefit my readers. 

The below statistics are from all FDIC insured financial institutions either for the year-to-date ended or period ended September 30, 2017. This period end was largely driven by the significant number of financial institutions taking deferred tax asset write downs in the fourth quarter, which would have skewed ROAA/ROAE for the year ended 2017. I used Call Report data, so the calendar year is the fiscal year.

I also excluded extraneous performers by category, as noted in the footnotes of each table. For profitability numbers (ROAA, ROAE), I excluded Subchapter S financial institutions. Quite a large cohort at over 1,900. Sub S bankers can gross up those numbers to come up with their equivalents.

See where your financial institution ranks!

Saturday, January 06, 2018

BS: Focus On Execution First

Over 10 years ago Larry Bossidy, former CEO of Honeywell, and Ram Charan, an academic and consultant, wrote the book Execution, The Discipline of Getting Things Done. As a student of strategy, I read it quickly.

One thing kept gnawing at me, though, that still gnaws at me today. Get what done?

In November, Rosabeth Moss Kantor, a professor at Harvard Business School wrote an article in Harvard Business Review titled Smart Leaders Focus on Execution First and Strategy Second. The corollary being that stupid leaders focus on strategy first.

She ends the article with this bromide: "In short, encourage innovation, begin with execution, and name the strategy later." 

To which I say: bullshit!

In fact, if HBR bothered to search their own site, they would read a well thought out article called The Execution Trap. Perhaps the author, Roger Martin, a former University of Toronto professor and Dr. Kantor could battle it out in an educator's cage match. 

Let me tell you a true story of a recent soccer injury to my daughter. She was diagnosed by the team doctor with one condition, and the team trainers put together a program to reduce her pain during and after games. Their treatment did not work.

After the season, she went to our family practitioner. More tests. The result was a different diagnosis. She had been misdiagnosed by the team physician. No matter how well my daughter and the trainers executed on the treatment plan, they were treating the wrong ailment. 

Reminds me of Bain & Co.'s Michael Mankins quote:

"If you have a bad strategy, no amount of good execution will help."

When you get in your car in the morning to travel to a place where you do not know how to get there, what do you do? Punch in the address on your GPS, and build your route to that destination from your garage. Not so if you don't think the destination matters. So long as you execute turns, navigate traffic, and follow signs extremely well. No matter where you end up, it matters only if you drove there well. C'mon.

In more practical terms, if a bank's head of branches is building development plans for branch managers, they make choices. For example, should branch managers have small business banking in their curriculum, or retail wealth management? One would think that they would turn to their strategy to make the decision. If the bank's strategy is to be the top business bank in the markets where they have branches, the answer is clear. But without strategy, either can be correct, so long as the branch manager does well. 

There are areas of Dr. Kantor's article in which I agree with her. For example, "we found the perfect strategy" is a statement that has the credibility of "and they lived happily ever after". Chasing the perfect strategy is a fools game.

Chasing no strategy is the same, in my opinion. However, once a strategic direction is struck, the bank should build flexible processes to allow for alterations of course based on customer preferences, markets, and team capabilities. 

In fact, I agree with Dr. Kantor's four implementation imperatives:

1.  Question everything
2.  Inform everyone, then empower champions
3.  Keep relationships tight, and rules loose
4.  Modify quickly

All are execution imperatives. But without strategic direction, the zigging and zagging would waste resources to the point of ineffectiveness. 

Yes, Dr. Kantor, strategy matters.

~ Jeff

P.S. All this talk about execution reminds me of John McCay, former Tampa Bay Buccaneers coach. I couldn't find the YouTube video of his quote, but here is Rick Carlisle, former Dallas Mavericks head coach delivering it brilliantly.

Wednesday, December 27, 2017

Bankers: Ask What Customers Want. Then Do That.

Steve Jobs showed customers what he thought they would want, and convinced them that they wanted it. An unlikely scenario for bank products, wouldn’t you agree?

So what do your customers want?

This presumes you know who your target customers are. Bankers used to try and be everything banking to everyone in the towns where they had branches. This approach left the legacy of the General Bank. Where the answer to the question on what your bank is known for was “nothing in particular”. Or the most common bromide, “superior service”. We’re still either stuck on this legacy or are shedding it at tortoise pace.

Identifying your target customers does not mean you will not serve others. But who do you want your front line people focused on? What processes do you want to streamline first in your support functions to provide superior service? What technologies do you want implemented right away?

The answer to the above should be based on your strategy. And your strategy should be based on target customers. And target customers should provide sufficient quantity, growth, and margins to serve and meet your desired profitability. 

Next question… what do these customers want? 

Take SoFi as an example. Their desired customers are millennials with college degrees that typically result in higher paying jobs. Pretty specific. They started their company refinancing student loans, because their target audience was graduating college, and many of them with high impact degrees such as lawyers or accountants had mountains of student loans.

As their target audience ages, they are moving on to other financial needs, such as car loans and mortgages. In fact, SoFi applied for an industrial loan bank charter to offer banking services to their target customers. They later withdrew because their CEO left. But still, here is a company focused on their target customers and were building the lineup of products they demanded.

How about you? If your audience is small businesses, do you offer the lineup of products they want? Bankers frequently impose limits on their product set based on what they want to put on their balance sheet. Must this be so?

I marvel at the ROE of the New York City loan broker. Many if not most loans (other than the very large ones) in NYC are handled by loan brokers. They match borrowers and lenders. For a fee. Like 1.25% of the loan balance. So a $3 million loan deal, chump change in NYC, yields a $37,500 fee for a guy/gal that has a storefront in Astoria, Queens. 

Back to the small business. What if they want early stage funding and that type of lending doesn’t fit your bank’s risk appetite? Why can’t you broker it and match them with a partner that does? There are partnerships you can forge with non-competitors to meet this customer demand. It’s not like you haven’t done this before. How about SBA lending, or merchant services? You likely partner with someone to provide these services.

Why not identify all of the financial products and services your target customer segment demands. And figure out how to offer it.

Or, you could send them somewhere else.

How do you meet the financial needs of your target customers?

~ Jeff

Note: This is my last post of 2017. I want to let all of my readers know that I appreciate your readership and comments. Thank you! And have a safe New Year celebration and a blessed 2018!

Tuesday, December 12, 2017

Banking's Top 5 in Total Return to Shareholders: 2017 Edition

For the past six years I searched for the Top 5 financial institutions in five-year total return to shareholders because I am weary of the persistent "get big or get out" mentality of many bankers and industry pundits. If their platitudes about scale are correct, then the largest FIs should logically demonstrate better shareholder returns. Right?

Not so over the six years I have been keeping track.

My method was to search for the best banks based on total return to shareholders over the past five years. I chose five years because banks that focus on year over year returns tend to cut strategic investments come budget time, which hurts their market position, earnings power, and future relevance than those that make those investments.

Total return includes two components: capital appreciation and dividends. However, to exclude trading inefficiencies associated with illiquidity, I filtered for those FIs that trade over 1,000 shares per day. This, naturally, eliminated many of the smaller, illiquid FIs. I also filtered for anomalies such as recent merger announcements, mutual-to-stock conversions, and penny stocks. 

Before we begin and for comparison purposes, here are last year's top five, as measured in December 2016:

#1.  Independent Bank Corporation (Nasdaq: IBCP)
#2.  Waterstone Financial, Inc. (Nasdaq: WSBF)
#3.  Summit Financial Group, Inc. (Nasdaq: SMMF)
#4.  MBT Financial Corp. (Nasdaq: MBTF)

Here is this year's list:

#1. Old Second Bancorp, Inc. (Nasdaq: OSBC)

Old Second is a single-bank holding company headquartered in Aurora, Illinois. It has $2.4 billion of assets and operates twenty five branches in the western suburbs of Chicago.  The Bank, Old Second National Bank, lost a whopping $156 million in 2009 and 2010. Whopping because it went into those years with $247 million in tangible equity. How did they lose it? Bad loans. Their non-performing loans (NPL)/total loans ratio peaked at 12.54% in 2010, and between 2009-12, the Bank charged off over 11% of its loan portfolio. That got regulator's attention in the form of a May 2011 Consent Order
(CO). But they didn't bury their head in the proverbial sand. They hit their challenges hard, and had the CO lifted a little over two years later. Quite an accomplishment given the gravity of their problems. Today, NPL/total loans is a manageable 0.94%, and the Bank ROA/ROE year-to-date is 1.22% and 11.61% respectively. These comeback kids have delivered a 958% total return to shareholders over the past five years. Welcome to the list!

#2. Independent Bank Corporation (Nasdaq: IBCP)

Independent Bank dates back to 1864 as the First National Bank of Iona. Its size today, at $2.8 billion in assets, is smaller than it was a decade ago. It is a turnaround story because the bank was hammered with credit problems between 2008-11, when it lost over $200 million. In 2011, at the height of its problems, non-performing assets/assets was nine percent. Today that number is 2.6%. Exclude
performing restructured loans, and that number plummets to 0.38%. Net charge offs are negligible. In
fact, year to date they have a net recovery. Interestingly, IBCP recently announced an acquisition in northwest Michigan, five years after they sold 15 branches in the northeast part of the state. Times change. And IBCP has delivered a five-year total return to their shareholders of 620%. This is their third straight Top 5 recognition!

#3. Summit Financial Group, Inc. (Nasdaq: SMMF)

Summit Financial Group, Inc. is a $2.1 billion in asset company headquartered in West Virginia, providing community banking services primarily in the Eastern Panhandle and South Central regions of the state, and the Northern and Shenandoah Valley regions of Virginia. Summit also operates an insurance subsidiary. In 2012, the company had net income of $7.0 million on assets of $1.4 billion.
Today, the company has annualized net income of $13.2 million. Actually, the Bank had a one-time after tax litigation settlement (from a 2002-04 event) of $6.2 million. So their normalized net income is $19.4 million. A 50% growth in assets, and a 177% growth in net income. Positive operating leverage! And Summit has a couple of new acquisitions under their belt. One in 2016 and one this year. This marks Summit's second consecutive year in the Top 5! Well done!

#4. HMN Financial, Inc. (Nasdaq: HMNF)

Similar to Old Second, HMN is a turnaround story. It is the holding company for Home Federal Savings Bank, a $715 million in asset thrift headquartered in Rochester, Minnesota with retail banking and loan production offices in Minnesota, Iowa, and Wisconsin. In 2007, the Bank had $1.1 billion of assets, $11 million in net income, and a 1.01% ROA. Then, kaboom! Over the next four years the Bank lost $58 million. A princely some to a Bank with $107 million of capital at the time. In 2008, the Bank had $216 million of Construction & Land Development (CLD) loans, 12% of them were either past due or on non-accrual. As the saying goes, in CLD, when the music stops, you don't want to be the one without the chair. And HMN found itself without a chair. So they took TARP, and
aggressively dealt with their asset quality problems, and shrank their balance sheet quickly to bolster capital ratios. By 2014, they cut the balance sheet in half. And since that time have grown loans over $200 million and deposits over $130 million. Today, they earned an 0.89% ROA, although that number has been bolstered by negative loan loss provisions. Their NPL/Loans shrank to 0.56%. Quite a recovery indeed and their shareholders that jumped in during the bleak days were rewarded!

#5. Parke Bancorp, Inc. (Nasdaq: PKBK)

Parke Bancorp, Inc. is the holding company for Parke Bank, a $1.1 billion in assets commercially focused community bank based in southern New Jersey, serving Philadelphia and its suburbs. Unlike the three of the banks above, this is not a turnaround story. Their ROA has been greater than 1% the past five years. In fact, I can't explain exactly how they do it. I'm going to have to ask Vito Pantilione, their CEO. One strategy is limited branching. They have only seven, averaging $120 million in
deposits per branch, which is nearly twice The Kafafian Group (my firm) peer average for branch deposit size. Their cost of funds is slightly above average, at 86 basis points. But their non-interest expense/average assets was 1.40%. You read that right. Apparently, Vito is cheap. Their NPAs/Assets has always, to my recollection, been above their peers. But their charge offs are not. And they have a 5.02% yield on their loan portfolio. Pretty good. That's why they returned 580% to their shareholders the past five years!

Here's how total return looks for you chart geeks, with the lower green, and flat line being the S&P 500 Bank and Thrift Index.

There you have it! The JFB all stars in top 5, five-year total return. The largest of the lot is $2.8 billion in total assets. No SIFI banks on the list. Ask your investment banker why this is so.

Congratulations to all of the above that developed a specific strategy and is clearly executing well. Your shareholders have been rewarded!

Are you noticing themes that led to these banks' performance?

~ Jeff

Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.