A small, niche sector that has done incredibly well over 2022 was that of small, local banks which were eligible for the so-called Emergency Capital Investment Program (ECIP). Under the ECIP, the US Treasury provided capital injections into certified Community Development Financial Institutions (CDFIs) or minority depository institutions (MDIs) with the end-goal to support small businesses and consumers in their communities. Following this program, ECIP recipients have been provided with new capital, sometimes in extremely generous amounts compared to the bank’s equity. Besides the relatively large injections, the terms of these funds have been very attractively structured for recipients. Consequently, it is no surprise that the share price of listed recipients performed very well. Nonetheless, I believe there is still plenty to go; the share price of many banks has yet to fully reflect the sheer magnitude of the capital injections. In addition, most of the recipients are still deploying the new capital which is yet to be reflected in the earnings.
I started to write my thesis up for the site, but I recently stumbled upon a write-up of @dirtcheapstocks on Twitter on exactly this topic. The write-up is from October last year, but is still very much relevant. More importantly, I believe this write-up does a much better job at describing the opportunity set than what I’ve been working on. So with Dirtcheapstocks’ permission, I’m publishing the write-up here (I know, lazy – but it really is better than what I was preparing). If you appreciate it, make sure you let @dirtcheapstocks know.
Something for Nothing – @dirtcheapstocks
Imagine this. You buy a house for $500,000. You close, you get the keys and from this day forward everything in that house is yours. You walk into the basement and find an unlocked safe with $1,000,000 inside. This is the closest metaphor I can think of to describe what is happening to certain banks across the United States.
The U.S. Treasury, through its Emergency Capital Investment Program (ECIP), is injecting small banks with non-cumulative perpetual preferred stock with a super low dividend rate. What does that mean exactly? Non-cumulative means that unpaid dividends do not accrue. Perpetual means forever. The investment does not mature. And the dividend rate will be somewhere between 0-2% based on how funds are deployed.
Effectively, banks have been gifted a giant basket of cash. And the economics of this gift ensures that common shareholders will realize the majority of its value.
Example: Citizens Bancshares (Ticker: CZBS) is an Atlanta based bank. It has a market cap of $40MM and just received $95.7MM from the U.S. Treasury. Citizens has booked net profits for 25 consecutive years and has a strong history of dividends and buybacks. And CZBS isn’t the only publicly traded recipient. There are several.
For the most part, these banks just received gifts from the government equal to, or in excess of their market cap. And they are largely trading at cheap earnings multiples.
How to Think About the ECIP
So how should an investor consider this cash infusion from the Treasury? It’s technically considered non-cumulative perpetual preferred stock. Preferred stock is often considered a quasi-equity instrument. It has properties of equity and properties of debt.
This preferred is different, though. It’s not dilutive to common shareholders. The shares are only entitled to a small dividend payment. But if a dividend payment is missed it does not accrue. And the ECIP investor has virtually no recourse. Treasury can, at most, elect two directors to a Company’s board if a certain number of dividend payments are missed. Failure to pay the dividend on the preferred would prevent dividends from being paid on the common for a given period, but beyond that there is no real repercussion. When preferred dividends resume, common dividends and buybacks can resume too. Since the preferred shareholders do not participate in the profits to the common shareholder, this capital isn’t really equity. If the ECIP investment isn’t equity, is it debt? Not really. While the preferred shares have a stated rate that they are owed, failure to pay this coupon doesn’t result in default. And the shares never mature – they are perpetual. So, I don’t think the shares should be considered debt either.
If this cash infusion isn’t equity and it isn’t debt, what is it? I believe it’s most similar to a grant. The Treasury showered these banks with tons of cash and put only a few minor restrictions on how the capital could be used. Dividends and buybacks of common stock are capped at the total of the sum of prior two years net income and executive compensation is capped. But as the above table shows, most of these banks could still pay large yields to common shareholders as the P/E ratios are so low. If your bank is trading at 7x the prior two years net income, your bank could pay a 28% dividend this year, and a 14% yield next year – assuming earnings are stagnant.
But Wait, There’s More
But isn’t the preferred considered senior to common shareholders? Won’t it have to get redeemed in the event of a sale or merger? Doesn’t this effectively make these banks unable to sell themselves? This is where it gets even better. Treasury will transfer its preferred investment in a merger/acquisition as long as the buyer is a CDFI (Community Development Financial Institution) or MDI (Minority Depository Institution). If the buyer is not a CDFI or MDI then Treasury may still transfer its investment, but prior approval is required. Back to the analogy of the home purchase that I made in the first paragraph. You buy a house for $500,000 and find $1,000,000 in the basement. Now you can turn around and sell your house with the cash reflected in the purchase price. And better yet, this preferred stock is considered Tier 1 capital for regulators. How many banks out there would like to acquire 0-2% equity capital in perpetuity?
There is one additional wrinkle that makes this security even more attractive. The Treasury may wish to sell this security in the future. There is an ecosystem of aligned supporters of CDFI’s and MDI’s through various different programs. But who in their right mind would pay face value for a maximum yield of 2%? Especially when the investor has no ability to force payment and no recourse for non-payment. The short answer is – nobody. And Treasury understands this. When Treasury goes to sell this security, it is first required to be valued by an independent third party. Then, the issuing bank has first right of refusal to buy back the preferred at that valuation. So, what is fair market value of a 0-2% perpetual preferred where the investor has basically no ability to enforce payment? My best guess is 10-20 cents on the dollar.
Let’s say your bank issued $100MM of preferred shares to the Treasury through ECIP. And let’s say your dividend is averaging 1%. You’re paying $1MM annually. And earnings are capped. If I were to come in and offer to buy that $1MM stream of earnings, I’d maybe be willing to pay 10x, understanding that I could generate a 10% yield. But when you introduce the fact that you, as the bank, can stop payment on my stream of earnings at any time and I have basically zero recourse when that happens, I’d be willing to pay much less, maybe nothing. But let’s just assume that I would pay $20MM as a conservative estimate.
So, Treasury has the preferred marked to fair market value, and then banks have the option to buy back the security. What does the accounting look like when you do this? In our $100MM ECIP example above, the bank would buy back the security for $20MM and book an $80MM gain on extinguishment.
This kind of sounds too good to be true. Is 10-20% of face really the FMV of this preferred? A simple DCF would say so. But Treasury also tips its hand to its idea of fair value in the ECIP Senior Preferred Securities Purchase Agreement posted on its website. Buried deep inside this 60-page document, Treasury states that shares may be transferred at a price no less than 10% of the liquidation preference. They don’t set the baseline at 50% or 30% of face. They set it at 10%. I think they did this because they know this security is basically a gift to recipient banks.
It’s worth noting that the cash economics of retiring the preferred stock are different than the timing of booking the gain under GAAP accounting. In effect, banks received the economic benefit on the day they received the capital. So why go through the exercise of ponying up capital to retire the stock when it has such a low rate attached? I can think of a couple reasons.
The optics of having the Government as a business partner are unappealing to many. And many bank management teams are measured on their ability to increase common book value per share. If and when the preferred is retired, the gain should run through the income statement, making its way to retained earnings and increasing common book value per share. The appeal of boosting common book value by 100% or more, may be too good for some to turn down.
Additionally, banks must maintain capital ratios based on common equity. While the preferred stock represents tier one capital, it is not considered common equity. The easiest way for these banks to create common book value is to turn preferred capital into common capital.
Now, it’s important to realize that Treasury is still in the driver’s seat when it comes to repurchasing the preferred. Banks cannot redeem the preferred at a time of their choosing. But instead, they must wait until the Treasury wishes to sell the security and then banks will have first right of refusal to buy it back. In structuring the redemption/buyback this way, Treasury keeps the power. If a bank takes $100MM of ECIP from the government and, instead of lending/investing in their community, chooses to clip a riskfree profit by investing in low-rate bonds – Treasury may be less likely to offer the preferred for sale. This may be Treasury’s way of saying “if you want to get the big reward, you need to use this capital for its intended purpose”. At the same time, Treasury can assist a bank that has taken a string of losses. If an ECIP recipient were to run into trouble down the road and book losses, common equity could get into trouble and banks would risk running afoul of common capital ratios with regulators. Treasury could use the buyback of the preferred to get common equity back in line.
To be clear, I’m not sure how a buyback of the preferred might play out. Fortunately, it doesn’t matter all that much at today’s prices. Banks still have a huge slug of capital with only a tiny dividend payment attached. Whether or not the preferred is retired, the lion’s share of the cash gift should be realized by common shareholders.
What is the ECIP?
The ECIP was established by the Consolidated Appropriations Act of 2021 with the intent of encouraging lower and moderate-income community financial institutions to support small businesses and consumers in the communities they serve. Treasury will inject $9 billion into CDFI’s and MDI’s to help communities that disproportionately experienced the economic effects of Covid-19.
For banks, the investment is in the form or noncumulative, perpetual preferred stock. The rate on the preferred stock will be 0% in years one and two. From years 3-10, the rate will be between 0.5% and 2.0% based on how it’s deployed. After year 10 the dividend rate will be fixed in perpetuity equal to the average rate paid from years 3-10. Here is a breakdown of how rates will be determined:
A full breakdown of the ECIP can be found at the following link.
How This Might Play Out
What will banks do with this massive capital injection? I think there are basically three options. 1) buy other banks, 2) sell themselves, 3) use capital for internal purposes.
Buy Other Banks:
The easiest way to put the most capital to use is to purchase another bank. Of the ECIP recipients I’ve followed, the most acquisitive has been BankFirst Capital Corporation (Ticker: BFCC). BFCC has a $200MM market cap and received $175MM of ECIP. It was basically gifted its entire market cap from Treasury. It’s trading at 10-11x earnings before accounting for any additional earnings that will accrue from banks acquired this year. BFCC has announced three separate acquisitions since the ECIP recipients were named. The most recent acquisition announcement was something I’ve been waiting for. BFCC was the first ECIP recipient to buy another ECIP recipient, when it acquired Mechanics Bank in Water Valley, Mississippi. Mechanics Bank has a $27MM common book value prior to receiving $43.6MM of ECIP from the Treasury – all of which was held at the parent company in cash as of 6/30/2022. While BFCC has not disclosed the price paid for Mechanics, we know that whatever the price was, there was a $43.6MM instant cash rebate received as Treasury transfers its investment to BFCC. If BFCC paid 2x common book (typically a rich valuation for a small bank), it effectively received an 80% cash rebate. If an ECIP recipient can go on a buying spree, scooping up other ECIP recipients for favorable prices, the outcome could be very strong.
Sell Yourself:
For many small banks, acquiring someone else is an insurmountable task. Small banks often fight just to get through the day-to-day of managing their operations. There isn’t infrastructure to acquire and integrate another bank, even if the deal were appetizing. So, what can you do if you just received a windfall of cash that can be transferred in a sale? Sell yourself for a rich price. Here is a potential example.
Citizens Bancshares (Ticker: CZBS) has a $40MM market cap. It recently received $95.7MM of ECIP. CZBS has been profitable for 25 consecutive years. It earned $4MM in 2021. CZBS is a little bit complicated because it also issued $22MM of noncumulative, perpetual preferred stock in 2021 at a 1% fixed rate. I’m not sure if that investment is transferrable in a sale. Let’s just be conservative and assume it’s not. Luckily, CZBS has more than enough cash at the operating company to retire that $22MM of preferred. As of 6/30/2022, CZBS has $109MM of cash sitting on the parent company balance sheet. That’s nearly 3x the market cap. CZBS is trading at ~70% of its common book value, before reflecting any additional cash at the parent company. If a buyer were to pay $80MM for CZBS, which is double today’s stock price, it would effectively be paying a negative enterprise value. For an $80MM purchase price, a buyer is getting $109MM of cash in return, along with a bank that is consistently profitable and has a $56MM common book value. And the bank is earning more than enough to cover the dividend burden of the preferred without requiring any additional capital from the parent company.
CZBS has other unique advantages that I intend to cover in a later write up. I just use this example to illustrate the level of mispricing that exists, as I see it.
Internal Uses of Capital:
Banks can simply use this cash windfall to grow operations and/or return capital to shareholders. The ability to grow organically is normally easier said than done, but this additional firepower is as good a catalyst as any to bolster growth. Returning capital to shareholders is a bit more straightforward. UBAB and CBOBA are two examples of intelligent capital allocation. CBOBA announced it repurchased ~3% of its common stock in one transaction in August 2022. UBAB did them one better. Prior to receiving the ECIP funds in July, UBAB repurchased ~5% of its shares.
Summing it All Up
I believe the ECIP will have substantial impacts on the recipient banks and their common stock valuations. One CEO of an ECIP recipient bank recently said, “This isn’t a once in a lifetime event, it’s a once in forever event”. As I’m a concentrated investor with a small capital base, I’ve focused my investments on the smallest banks with the biggest variance between valuation and ECIP received. The bulk of my efforts have been focused in CZBS, MFBP and HRBK. Sometimes crazy things happen in capital markets, and I believe this is one of those times. I’ll end this write up with one more example. HRBK is a Baltimore-based bank, with a somewhat rocky performance history. It has a $15MM market cap. It received $75MM of ECIP from Treasury.
Disclaimer @dirtcheapstocks: I own shares in some of the companies discussed in this write up. If the stock price increases, I will benefit. I may sell my shares at some future point. Some of the data and opinions introduced in the write up may prove to be incorrect. This is not investment advice. Do your own due diligence