I have gotten a slew of emails today about Neutral Tandem’s latest earnings report, as well as a few comments on my last TNDM post here. Apologies I don’t have the time to respond to everyone individually, but, in short, my thoughts on the company have not significantly changed. Its valuation may now be a touch lower, but it would seem uncertainty and risk are both less now, too.
Not sure what else I can say that I haven’t already said about the company. There was noise in adjusted EBITDA. Wren’s tone on the call today was, finally, positive. The company’s main competitor, Peerless, appears desperate. Any company trading at five times cash flow is worthy of your attention. This one, doubly so. I continue to be okay waiting and averaging down.
It hasn’t even been near a full year that we’ve owned Tandem shares in Tarpon. I’m looking at two Post-It notes that have been stuck to my screen for longer. Some time ago, back when men were men and before boys ran hedge funds, it used to take time to make money when investing. TNDM will probably be no exception. I believe the wait will be worth it.
Investors can view this market’s casino mentality as the curse of our age, or treat certain days as if they were made to be taken advantage of. I basically did the latter today. I bought a ton of new TNDM shares in Tarpon, and I unloaded a ton that were at a higher cost basis, too. Fortunately, I can do this pretty efficiently and at zero cost through my custodian. So though our position size is the same, Tarpon investors now own a bushel of TNDM shares priced at all-time lows.
I can only hope it happens again tomorrow.
Where’s a good sovereign debt crisis when you need one?
This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.
Courtesy of a new friend, below is more info on Tarpon Folio holding Neutral Tandem, TNDM, which will report its second quarter earnings this Thursday. Also, here is more on TNDM from another investor that recently wrote-in, too.
The write-up below recently appeared on Value Investors Club. The author, who’d like to remain anonymous, reached out to me on some questions before he posted this. Although I believe TNDM is worth more than the author indicates, and have a few other comments I might add if time allowed, I nonetheless thought he did a solid job of analyzing the company. He gave me the okay to post the below here.
Ever since my interview on TNDM a few months back, I’ve had a pretty steady stream of emails and phone calls about the company from other portfolio managers, analysts, and individual investors. In short, while I cannot give specific investing advice here, I will say that I have been averaging down on TNDM in the Tarpon Folio over the past few months. The size of my position is a touch smaller than it was three months ago, but that’s much more a function of (a) other opportunities and (b) clearing out some higher cost-basis shares than being indicative of the company’s prospects in any way. I continue to maintain that the competitive threat from Peerless Networks is vastly overblown – it’s in a box canyon that the market doesn’t seem to recognize. I also continue to believe it is the number of switches and not per minute pricing that is the key variable when it comes to attracting new customers. At some point, the market will recognize this, and in the meantime, I continue to be okay just waiting.
The write-up follows. Please note that certain tables included in the original write-up weren’t translating well to HTML below, but you can download the entire write-up complete with those tables in PDF form here.
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Neutral Tandem (TNDM)
Neutral Tandem (TNDM) is a company whose stock has been oversold to all-time lows on fears of
slowing growth, increasing competition, and patent issues. This has driven shares to fall from a high of
$34.56 to $11.98 as of last close (7/12/2010). However, Neutral Tandem’s healthy free cash flows and
strong financial position (over $170M in cash and no debt) make the company an attractive investment
opportunity at these prices. Although headwinds such as competition are legitimate, I believe that TNDM
shares are currently priced for a worst-case scenario in the company’s future and should offer at least a
25-35% return at current prices.
Background
Some background is necessary to understand Neutral Tandem’s core business of interconnecting voice
carriers. Calls made from one voice carrier to a different voice carrier require either a tandem switch to
rout the call or a direct connection between the carriers in the relevant markets. Due to the high costs of
establishing direct connections, most voice carriers will choose to transit their calls with tandem switches.
Before Neutral Tandem entered the market, this meant most carriers used the network of tandem
switches owned by the “Baby Bells”, called the incumbent local exchange carriers (ILECs). By law, ILECs
were required to rout all traffic, including the calls of competing carriers, with their tandem switches.
ILECs charged competing carriers by the minute for calls requiring routing by their tandems at rates
regulated by state commissions and the FCC. Not only were the ILEC tandems inefficient for operating
with competing carriers since they had been designed by for a monopolistic carrier, but ILECs were in
general unhappy about having to give up use of their overburdened tandem networks to competitors and had an incentive to not “fully cooperate” in establishing the interconnections competing carriers required.
Neutral Tandem’s Operations
Neutral Tandem was founded in 2003 to provide an alternative to the ILEC tandem switching network. Over the course of 6-7 years, it has built its own national tandem switching network that offers three main advantages over the ILECs:
1. Neutrality. Its eponymous neutrality refers to the fact that it does not compete with voice carriers like an ILEC does, thus ensuring that carriers do not need to rout calls through their biggest competitors.
2. Cost savings. Since Neutral Tandem designed their tandem switch scheme to maximize efficiency for routing calls from many different carriers it is able to undercut the ILECs’ rates by 20-25%.
3. Quality and services. Finally, Neutral Tandem has built a higher quality product than the old ILEC tandems using new IP soft-switch tandems and offering features such as quality of service reporting,
traffic reports, and redundancies in the network to ensure more reliable service.
With its first mover advantage, Neutral Tandem has managed to grow its network into the largest
alternative tandem switching network in the US. Neutral Tandem routed 87.8 billion minutes of calls in
2009 and currently serves almost all of the major carriers, with the exception of the wireline ILECs such
as AT&T and Verizon wireline (although it does serve AT&T and Verizon wireless). Its network also
handles all types of voice carriers: wireline competitive local exchange carriers (CLECs), cable
companies, VoIP, wireless, and long-distance carriers interexchange carriers (IXC). Wireless carriers and
cable companies account for 65% of revenue, IXC carriers account for 20%, and the rest is from CLECs
and VoIP.
Like the ILECs, Neutral Tandem charges carriers on a per minute basis for calls that go through their
tandem switches. Revenue recognition is straightforward and is recorded each month based on the
number of minutes trafficked for each specific tandem switching service Neutral Tandem offers. The
tandem switching business is highly scalable and as Neutral Tandem’s network expands, operations
become more efficient, capex decreases as a percentage of sales, and margins increase. This had led to
rapid growth in the sales, profits, and margins in the past 3 years (see tables in original PDF here).
Future Growth
Neutral Tandem’s core business of voice tandem switching is benefiting from the secular trends of
consumers increasingly moving towards wireless, cable, and broadband carriers. As fewer consumers
use wireline ILEC services, more calls will be routed through Neutral Tandem’s network. Beyond these
secular trends, there are several services that are potential drivers of growth for Neutral Tandem (and
potential catalysts for the stock).
60-70% of Neutral Tandem’s revenues currently come from providing tandem routing services for local
calls. While Neutral Tandem is still expanding into new markets to grow its local call services, it is now
entering mainly smaller less profitable markets. Interconnections within larger existing markets also
provide room for Neutral Tandem’s local tandem services to grow. However, the drivers of Neutral
Tandem’s future growth in its core voice business are in two different areas: terminating switched access and originating services.
1. Terminating switched access. In the terminating switched access business, Neutral tandem uses its network to terminate long-distance calls for long-distance carriers, or interexchange carriers (IXC). This is currently 20% of Neutral Tandem’s revenue and management has stated that it may double within a year. Neutral Tandem is also seeking to grow its business by providing terminating services for international long-distance carriers. Neutral Tandem has recently solved the technology aspects of this international service, and is currently working to resolve the contractual aspects with international carriers.
2. Originating switched access. Originating switched access services essentially serve 800 number calls. 800 number calls need to be translated by a tandem to determine which carrier to send it to. Recently, TNDM has begun to offer originating services. However, management has said growth in this area is
currently stalled since Neutral Tandem cannot match the marketing fees often paid to carriers. Future
growth of originating services will depend on whether a number of current lawsuits filed by others will lead to the FCC restricting the marketing fee practice.
Neutral Tandem has also begun a service outside its core business of voice tandem switching in late
2009. It is a joint venture with TelX to launch an Ethernet exchange network. I won’t spend too much time describing this venture since it is a very new venture in a very young industry that will likely interest growth investors more than value investors. The basic concept of this service is to provide efficient interconnection services for companies using the Ethernet system. The Ethernet interconnection industry has been projected to be worth twice as much as the voice tandem business, but this remains to be seen.
Neutral Tandem is behind the main competitors in this new space, CENX and Equinix, by roughly 8
months. That being said, Neutral Tandem has two large advantages in the Ethernet interconnection
industry: 1) its existing network that it can leverage, and 2) existing business relationships with many of the potential Ethernet exchange customers. As a value investor, I would not necessarily invest in TNDM on the potential prospects of the Ethernet exchange network, but growth investors may, which I will discuss in the catalysts section.
Current Concerns
Three main concerns have been contributing to the recent sell-off of TNDM :
1. Competition. Over the past year, Neutral Tandem has seen increasing competitive pressure from firms such as Level 3 and Peerless Networks that has led to a large sell-off. While management has said
that they have retained all major customers, they have admitted that there has been increased price
pressure. This is reflected by the decreasing average rate per minute from 0.19c/minute in 2009 to
0.18c/minute in Q1 of 2010. (While this decrease is occurring partly because of competition, part of the
decrease can also be attributed to Neutral Tandem entering new smaller markets that generally yield
lower rates.) Management was quoted as saying that they had “seen some of the toughest pricing that I
pretty much expect to see”. Regardless of whether this is the case, management appears to be taking the competition seriously and stated that it is competing aggressively to retain customers and gain new ones with long-term contracts and leveraging its ability to provide comprehensive solutions to customers (e.g. broader geographic coverage, more capacity to handle call traffic).
Even with increasing competition, Neutral Tandem has several competitive advantages. First, no
competitor has a tandem network approaching Neutral Tandem’s network’s size. This means that
competitors can only offer a partial solution to carriers at best and makes it unlikely that Neutral Tandem will lose business with carriers that have a national presence (No major customers have been to competitors thus far). Second, Neutral Tandem has built a network with very few quality issues while it is reported that some competitors have had issues with their tandem switching quality. Therefore, large scale defections of Neutral Tandem’s customers are unlikely, and the main legitimate concern is margin compression in local markets.
However, as I’ll discuss in my valuation, even if the easy days of growth are over and margins decline, Neutral Tandem is priced so that in most scenarios is remains a compelling buy. Furthermore, as I discussed previously, the international long-distance, originating access services, and Ethernet exchange are both potential growth areas for Neutral Tandem that could counteract competition in the tandem market.
2. Patent Litigation. In June 2008, Neutral Tandem sued Peerless Networks for patent infringement of its tandem network design, but Peerless Network responded by questioning the validity of Neutral Tandem’s patent and calling for the USTPO to re-examine the patent. Initial action by the USTPO in
March 2010 has been to reject Neutral Tandem’s patent claims, although the USTPO’s final decision on
the re-examination and the Court’s final ruling will not likely be until this fall. This patent dispute and the unfavorable developments have contributed to the sell-off of TNDM in 2010. However, I believe that concerns regarding the patent are overblown.
First, remember that Peerless Networks and likely other competitors have already been infringing on
Neutral Tandem’s patent for over a year to date. An unfavorable ruling for Neutral Tandem would
therefore not materially alter the competitive environment. Second, the company’s balance sheet is
immune to an unfavorable ruling since the company does not appear to assign its patent any value on its books. (Or if they do, it is negligible and filed under “Other assets” which is valued at $511,000.) So while Neutral Tandem may lose its patent battle, it will not fundamentally change its competitive environment. Any favorable ruling on the patent case, while unlikely based on recent developments, will be a catalyst for TNDM and a deterrent against Neutral Tandem’s competition though.
3. Fear of Obsolescence. Similar to the issue of competition, I believe that growth investors have also steadily fallen out of favor with TNDM because of the fear of eventual obsolescence due to VoIP. VoIP
relies on IP-switching technology that greatly reduces the cost and complexity of creating direct
connections between carriers, thereby bypassing the need for tandem switches. However, even
assuming a constant high growth rate of 31.1% CAGR in residential VoIP lines, based on past growth in
VoIP lines, it will still be approximately 7-8 years before VoIP overtakes the number of current US
residential wirelines. This also assumes that there will be no slowdown in VoIP growth due to necessary
infrastructure investments or regulatory hurdles.
Even if adoption occurs at this high rate, it is important to remember that establishing direct connections between VoIP carriers will still take time and that tandem switching will still be necessary for connecting VoIP with wireless carriers and the remaining wireline carriers. Therefore, while the terminal value of Neutral Tandem’s core business of tandem switching should be discounted for the risks of VoIP adoption, an all-VoIP network that makes tandem switching obsolete is still years away.
Valuation
Based on 2009 results and today’s prices, TNDM is attractively valued with a 9.8% FCF yield, FCF/EV of
18.5%, and a low 2.6 EV/EBITDA multiple. (See tables here again.)
Note: EV and all following calculations use an adjusted cash measure that includes auction rate securities (ARS). Neutral Tandem currently has $171M in cash and cash equivalents and holds par value $12.9M of ARS. Beginning on 6/30/2010, it will have the right to sell these ARS back to UBS at par value. Therefore, I use an adjusted cash figure of $184M.
I consider two useful scenarios in valuing Neutral Tandem: 1.) “worst-case” scenario and 2.) a “normal”
scenario. Both scenarios use the low ends of management guidance given for FY2010. In the worst-case
scenario, I assume that revenue steadily declines and that EBITDA margins decline 17% by 2014
(compared to 2010) due to competition and pricing pressure. To approximate the risk of faster-than
expected VoIP adoption and competitive pressures I substantially discount the terminal value based on
2014 FCFs (as per the tables here).
After adding back cash to the DCFs, I estimate that this “worst-case” scenario implies a fair value for
TNDM at approximately $10.90-$11.20 per share. This implies a decent margin of safety with a 6%-9%
downside risk at current trading levels of $11.98.
In the more likely “normal scenario”, I model very modest growth occurring at declining rates until 2014 but that EBITDA margins will decline by 14% in 2014 (compared to 2010) from pricing pressure. Terminal value is increased from the worst-case scenario to approximate a more modest level of expected risk (again, as per the tables here):
After adding back cash to the DCFs, I conservatively estimate that under normal circumstances TNDM’s fair value should be at least $15-$16.20, representing a 25%-35% upside from the current price of $11.98.
Note that the 2010 guidance figures used in both valuations assume there is no sales contribution from
the Ethernet exchange project. These guidance figures do assume a $4M operations cost and $4M in
capex related to the Ethernet exchange project. Therefore, if the Ethernet exchange development is
stopped after 2010 (due to poor results or low revenue) actual EBITDA and FCFs will be higher than I
estimated. If the Ethernet exchange project is continued, one would hope that it provided enough FCF to
offset its costs though. Given the competent management of Neutral Tandem thus far, I feel the risk of a
serious capital budgeting mistake with respect to the Ethernet exchange is low though.
In summary, TNDM shares are oversold mainly due to fears of competition, lawsuits, and future growth.
These are all legitimate concerns, but TNDM shares are trading at worst-case scenario prices. Estimates
of the fair value of Neutral Tandem’s business suggest that TNDM shares are conservatively worth at
least $15-$16.20, representing a 25-35% upside from current prices.
Catalysts
1. Value/Activist investor attention. In a May 13, 2010 13D filing ValueAct Small Cap Partners
disclosed that they had purchased 6.2% of Neutral Tandem at an average price of $15.15. ValueAct has
a reputation for being long-term value-oriented investors with an activist bent. Barron’s reports that
ValueAct sits on roughly half of their holdings’ boards. While I do not know their exact plans for their
TNDM position, a potential board seat or further acquisitions of Neutral Tandem’s stock could be a
catalyst for the stock.
2. Growth in core business: Management has outlined how their terminating business and originating
businesses could see increased growth this year. Management has already set expectations low by
predicting results at the lower range of its guidance. If the core business can grow better than expected,
catalysts could include beating guidance expectations and analyst upgrades.
3. Positive Ethernet exchange news. There may be surprise revenues from the Ethernet exchange
being developed. Management has not factored in any potential Ethernet exchange revenue, but has
noted it is possible to see Ethernet revenue this year. Neutral Tandem has also been stressing the
exchange’s growth opportunities to growth investors recently, devoting an entire presentation and
conference call this May to the Ethernet exchange. If growth investors begin to buy TNDM based on
potentially favorable developments in this Ethernet venture, I believe that value investors could exit their
positions at share prices at or above the fair value of TNDM’s core tandem switching business.
4. Share buyback. With a mountain of cash, if TNDM decides not to aggressively pursue the Ethernet
exchange venture for whatever reason, another share buyback could occur. In the latest 10Q, the
company reported that $15.4M of shares was still available for repurchase as of 3/31/2010. Given the
high FCF and large cash position of Neutral Tandem, it is certainly possible that more buybacks could be
announced.
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This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.
Earlier posts in this series can be found here.
Background
Citizens Republic Bancorp, Inc (CRBC) is a regional bank in the midst of a turnaround, focused on growing its retail/consumer bank franchise in Michigan and neighboring Midwest states. In the latest quarter (Q1 of ’10), the bank posted an $85 million loss. So, you know, if the idea of owning a bank in Flint, Michigan, doesn’t do it for you, perhaps heavy losses might. More to the point, though – while plenty of investors are overlooking CRBC for obvious reasons, higher loan loss provisions and a strong capital base I believe help make a solid long-term investing case for CRBC at recent levels. More on this shortly.
CRBC offers banking and financial services through over 200 offices and 267 ATM locations throughout Michigan, Wisconsin, Ohio, Iowa, and Indiana. Ranked by assets, CRBC is the 49th largest bank holding company in the U.S.. containing year end 2009 assets of $11.7 billion assets and $8.5 billion in deposits. Citizens has no exposure to sub-prime loans, CDOs or CMOs.
The company offers these services:
Specialty Commercial – provides a wide range of lending and depository services to players in real estate market, middle-market companies and local government.
Regional Banking – provides banking and financial services to both commercial and retail clients with a focus towards consumer, residential mortgage, commercial and industrial, small business, private banking and treasury management.
Wealth Management – with $3 billion assets under administration the segment offers a broad array of asset management, financial planning, estate settlement and administration, credit and deposit products and services.
The company’s primary source of revenue is interest income, which constitutes 85% of total income, with the rest coming from non-interest revenue including fees and other charges related to financial services.
CRBC has a significant portion of loan portfolio tied up in commercial and residential real estate. About 70% of this portfolio comprises of borrowers located in Michigan, while the rest includes borrowers from Wisconsin and Northern Ohio. These states have, as you have probably heard, seen some tough times lately. Therefore CRBC on a precautionary basis recently increased its loan loss allowance to greater than 4%, almost double to the industry median of 2.2%.
The Investment Case
Consistent with the economic recovery, the bank’s credit quality and core earnings are improving. For instance, CRBC reported a 6.5% decline in total non-performing assets in the last quarter as well as lower delinquent loans. As the economy continues to improve, I expect CRBC to see an increase in lending. So one way to view CRBC is as a favorable bet on eventual credit recovery – providing you have a relatively high degree of confidence in its strategy to conserve capital, stabilize credit and return to profitability, as I do. Again, I believe the bank will become profitable again in Q1 of 2011, as per my model here.
Key Factors
Strong Capital Levels – CRBC has maintained approximately $400 million in capital above the minimum regulatory requirements. I view its strong capital base as not only a cushion but as having the potential to help CRBC better capitalize on an eventual increase in credit demand.
Improvement in Credit Quality – CRBC’s credit trends show continued signs of stability. As a percentage of loans, its reserve levels improved in Q1 ’10 by 500 bips. Delinquencies were down 7.3%, in line with an improvement in non-performing assets. While earnings losses will continue over the near term, I believe the improving macro environment will help the bank to cut down bad assets. CRBC also recently sold a portion of its nonperforming residential mortgages, which will further improve the company’s balance sheet.
CRBC trades at a significant discount to tangible common book value – Despite having an adequate capital base, CRBC is trading at one of the lowest price to book multiples in the sector. At around 0.6x TCBV, Citizens currently trades at a discount to peers, which trade closer to 1.25x TCBV. Short-hand relative valuations are always tricky, particular these days, but in conjunction with looking at core earnings, which I’ll mention later, they can nonetheless help underscore certain pricing discrepancies.
Returning to profitability early next year – As per the above, I believe the bank will become profitable in the first quarter of 2011 on the back of higher interest spreads and lower loan loss provisions. (For Q1 ’10 the bank earned an interest spread of 2.74%. All things being equal, I think the company will be able to post an improved interest spread of 3.09% by Q1 ’11.)
More importantly, though, I think improving asset quality will eventually provide CRBC with the ability to lower its provisioning requirement for bad assets (loan losses as a percent of NPL goes from the current 77.9% to 70% for Q1 ’11 in my model.) With an improving (read: slightly less horrific) real estate market, there should be a gradual decline in defaults, too, which translates into NPL as a percent of the loan portfolio dropping from the current levels of 5.56% to 4.75% by Q1 ’11.
And – more jargon coming – a note on TCBV. Generally, tangible book value is computed by deducting intangible assets, start-up expenses, and deferred financing costs from the firm’s normal book value (BV). Given the economic turmoil out there, though, I believe tangible common book value (TCBV) is a better measure to gauge what the common shareholders can expect to receive if the firm were to go bankrupt and all assets liquidated at book value. (This is strictly hypothetical and just to be conservative, mind you. I place a very low probability on this actually happening at CRBC.) So, I backed out preferred equity, intangible assets and all the assets from discontinued operations from book value to arrive at TCBV per share of approximately $1.60 for Q2 ’10E. We’ll see how that looks later today when Q2 earnings come out.
What’s it Worth?
The investment case for CRBC is fairly simple. That said, there is a high degree of uncertainty inherent in valuing CRBC shares.
Depending on your approach, values can range everywhere from $1.50 per share to $4.00 – though the latter seems to hinge on unrealistic assumptions. So what’s the real intrinsic value? Somewhere in between – and likely closer to the low end of that range.
Here’s a back-of-the-envelope approach to valuing shares that may ultimately be more useful than my earlier model:
If you annualize Q1 results, CRBC will produce $134M in pre-tax, pre-provision (“core”) earnings over the next twelve months. I believe (and Q2 results out later today should shed some light on this) that they’ll more realistically do $150M in core earnings over that same time.
So if you exclude loss provisions (and adjust for cash earnings and one-time expenses) then Citizens should earn $0.38 per share before tax.
Let’s say CRBC is unable to use its net operating loss as a tax shield and has to pay 35% tax on those earnings. On an after tax basis, then, CRBC would produce $0.25 per share in core earnings.
If the economy and real estate in particular recovers to a more normalized level, loan-loss provisions would probably decline to the adjusted average of $0.05 per share.
At that point, CRBC will be showing $0.20 per share in annualized after-tax, after-provision earnings. If we presume those shares deserve a P/E ratio of 11, then CRBC shares are worth $2.20 each.
Now, and this is an important point, management of the bank isn’t sitting around trying to figure out how they can someday reach $0.20 per share in after tax earnings. The bank is effectively already doing it – but it’s getting obscured by huge loan loss provisions. And what’s the right way to look at those?
I contend CRBC has been extremely conservative about classifying its loans, based on (1) the actions it has already taken, (2) comparisons with its peers, and (3) because its “swat team” approach to working with troubled borrowers appears to be working reasonably well. So while the Street appears to be assuming that most of the nonperforming loans on the company’s books won’t be recovered, the reality is that some will be. And that’s important to remember when considering this:
For the purposes of financial reporting, CRBC has already assumed the worst for its portfolio of nonperforming loans. In the first quarter, for instance, reserves for future loan losses stood at 4.3% of the bank’s total loan portfolio – more than two full percentage points above its peer group average. Since 5.6% percent of CRBC’s loans were classified as nonperforming, then before the 4.3% reserve becomes too light, nearly 80% of all loans currently classified as non-performing will have to become completely worthless – or new loans made during one of the best lending environments in recent history would have to suddenly go bad.
I believe either outcome is highly unlikely. In fact, the levels of non-performing assets, delinquent loans and watchlist loans have been decreasing sequentially at CRBC– trends I anticipate will continue.
In other words, CRBC should be through the worst of it in terms of impact to their earnings. The vast majority of those earnings are of good quality, mind you, as per the cash yield of 5.4% on its existing loan portfolio. And because the bank is asset-sensitive, earnings will improve further once interest rates start to rise.
And, yes, those back-of-the-envelope calcs above are a rough ballpark estimate based on assumptions that may or may not prove to be true. (Some could in fact be smashed to bits later this afternoon when Q2 earnings are released.) In conjunction with other valuations, however, including my semi-formal sell side model, peer analysis and plain old book value, I believe it’s safe to say that CRBC shares currently priced well below what they’re worth.
Then the question becomes:
Why are shares cheap?
For three years the price of CRBC shares could be pretty easily explained by business performance and the resulting negative sentiment. These days, however, performance is improving, albeit modestly, while poor sentiment remains. During the beginning of that three year snapshot, the stock’s price basically mimicked broad market and macroeconomic factors that resulted in, surprise, mounting bad loans and a deterioration in credit quality. The stock, which was trading at more than $10 per share until April of 2008, has been wallowing since, mostly for very good reason.
For instance, shares took it on the chin in early 2008 when management reiterated a weak outlook for the year. The broader sell-off, however, seemed to be triggered by Q2 2008 performance, which came in way below analysts’ estimates. Performance then was marked by lower than expected net interest income, higher expenses, flat fee income, and an approximate doubling in net charge-offs. At the same time, the company also suspended its quarterly cash dividends to preserve capital.
I think that was prudent, mind you, but management (and analyst) expectations nonetheless deteriorated materially as that year progressed – and which were brought to a head when management failed to meet its expectations to return to profitability later that year. In addition, the exit of Chairman and CEO Bill Hartman in February of 2009 seemed to go over like a fart in church on the Street.
Continued struggles with the loan book and a subsequent downgrade in CRBC’s long-term and short-term Issuer Default Ratings (IDRs) by Fitch in the second half of 2009 also added to the company’s woes.
That said, at this point in the cycle, and as mentioned above, things have changed and/or are in the process of changing for the positive. So why are shares still cheap right now, then?
Overblown Threat of Dilution
Of the rational concerns about the company’s shares floating around out there, I believe the most common is “the risk of dilution,” but I find even that a bit short-sighted. CRBC received TARP funding of $300 million in Q3 of 2008. So while the threat of dilution is certainly understandable, here’s why I don’t view it as an immediate concern:
Management has clearly stated in a recent analyst meeting that it does not anticipate repaying TARP funds in the near future. Further, they intend to “aggressively pursue” capital-enhancing opportunities that would be non-dilutive to its common shareholders. Like selling branches in Iowa, for instance. So, while the risk of dilution certainly exists, the risk of that dilution happening in 2010, for instance, is very low.
I’m not turning a blind eye to this issue, but I am trying to underscore that (1) dilution will most likely be much less severe that the Street currently believes and (2) trying to quantify the eventual impact right now is pointless. There is simply no rush to repay TARP over the next few years. Being able to capitalize on those funds during one of the best lending environments in recent memory is a very good thing for CRBC. I also happen to like that TARP shields the company from low-ball acquisition offers.
More to the point, though – one of the major factors that all banks keep in mind while evaluating when to repay TARP funds is the expectation of profitability going forward. Until CRBC reaches sustainable profitability again, the bank’s focus is on maintaining strong capital levels – to basically be on the lookout for ways to preserve cash and enhance liquidity. The company already suspended dividend payments for its trust-preferred securities and TARP-preferred stock, despite having the cash to pay for both on its books (saving about $5.0 million each quarter.) So it seems pretty clear that the company’s game plan is to make it through this downturn safely, and then look for conversion options once it is more obviously on the road to recovery – and presumably at what I believe should be a much higher stock price.
As a result, I don’t lose much sleep worrying about the risk of dilution at current price levels. Let’s see where we are this time next year. And while I can understand the short’s case for CRBC, which seems to hang on that risk of dilution, I suspect that issue will resolve itself as improved performance begins to become more evident.
Next in this series – why the Michigan economy is not as bad as you might think.
Supporting Charts & Graphs
Delinquency Rates by Loan Portfolio - click to enlarge
NPLs and Allowances - click to enlarge
NPAs and Delinquency Rates - click to enlarge
Capitalization Ratios and Notable Events - click to enlarge
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$TNDM This is the comp the mkt worries about? Peerless can't seem to raise VC $, more discounts & use credit lines...? http://bit.ly/bQo0Fd 2 days ago
