Description

Farmers & Merchant’s Bank of Long-Beach (FMBL), is an under-the radar, odd-ball, OTC listed small-cap bank operating in the prosperous Long-Beach area of Southern California. The bank is family run,  overcapitalized, safe, and has a track record of conservative lending that spans over 100 years. Which each share costs as much as a used car (~$5k), shares are cheap and should compound at 20%+ IRR over next 5 years from this price. 

Shares of FMBL have seen a drastic fall YTD 2023, with shares down ~35%, outpacing the KRE’s decline of c. ~23% (worst performing sector in SPY), on heavier volumes than usual, suggesting a technical overhang on the stock. Book value per share as of 6/30/2023 was $10,498 per share, with shares available for $4,850, or ~46% of tangible book value. Current prices were last seen in the aftermath of the GFC, despite FMBL branding itself as “California’s strongest”, stemming from >100 years of sustained consistent profitability since inception.

FMBL operates only 26 branches, so it has an astoundingly high branch productivity of c. ~$345mn in deposits per branch, with ~35% of deposits still non-interest bearing, as of 6/30/2023, helping operating efficiency ratios. So why are shares of California’s strongest down so much?

In its misguided search for “safety”, FMBL, like the ill-fated Silicon Valley Bank, invested the rush of liquidity it saw during the 2020/2021 boom in “safe” long-term yielding mortgage backed securities/other long-dated treasury instruments backed by the full faith of the US Government for a small pick up in yield. While these investments are “safe” in the sense that they carry little credit risk, FMBL took on significant duration risk at this time, which has come home to roost in 2022/2023 as you have seen short/long-term interest rates move higher, pressuring liability costs for all banks, while FMBL is stuck holding long-dated, low-yielding MBS/treasuries, torpedoing NIMs for the bank. 61% of the securities book is in mortgage backed securities, 31% in munis, and the remaining in other government obligations, with the bulk of securities maturing after 10 years.

The impact of these losses is apparent in FMBL’s balance sheet – the fair market value of its HTM securities is significantly lower than GAAP carrying values – a look at recent FDIC call-report filings show almost ~$500mn of pre-tax losses on the 4.5bn HTM securities book (bulk of them maturing between 5-15 years, 72% due after 10 years), and another $400mn of losses on the loans, which is significant for a bank with only ~1.3bn in shareholders equity, though not fatal – unlike at SVB, where HTM/loan losses overshadowed shareholders equity.  Adjusted book value per share after adjusting for losses on the loan and securities book is still $5,008/share, so the stock currently trades at ~97% of “adjusted book”.   This is too simplistic, because it assigns zero value to the ~3.1bn of non-interest bearing deposits at FMBL, let alone any value to the remaining 5.8bn in low-interest-rate sleepy IB deposits, of which only ~1bn are time-deposits. This deposit base should be worth significant more in this high rate-environment, which isn’t factored into the adjusted BV calc above, which dings FMBL for high-rates in bond-marks, but doesn’t consider the corresponding increase in the value of its deposit base.

EPS for FMBL has thus fallen from $900/share in FY2021, to more like $855/share in FY2022. In FY23, Q1 and Q2 EPS saw a further drop, to more like $170/share and $143/share (MSD% ROE). Given the bank hasn’t yet fully repriced time-deposits, and other interest bearing savings instrument, I expect run-rate net-income to continue to fall in the upcoming quarters.

Assuming no initiatives are taken to reduce fixed costs, a back of the envelope calculation, suggests that EPS will bottom out at close to ~$240/share on an annual basis or a 2% ROE, assuming no repricing of assets and a full-repricing of deposits/liabilities to run-rate market levels.  With cost cuts, the bank may be able to eke out more like a MSD% ROE, as the bank has been family run and has not historically been too disciplined on OpEx. Importantly, this level of trough earnings covers the current dividend, which means that there is limited risk of a dividend cut, which could be negative catalyst for an OTC listed stock with a wide retail ownership base. I expect ROEs to trend higher from this trough number, eventually reaching historical averages of 8-10% ROE 

Unlike Silicon Valley Bank, FMBL has a few things going for it – 1) a high quality, sticky/sleepy deposit base with a strong mix of non-interest bearing and low-interest rate beta deposits, 2) strong capital and liquidity position allowing the company to theoretically restructure their underwater securities book (“bail-money”) or grow out of NIM purgatory by expanding its loan book into higher-yielding loans originated in a high-rate environment.

While paying ~46% of TBV for a bank with a 2% near-term ROE doesn’t appear especially attractive, this low ROE is not a permanent state of affairs – given the banks’ deposit base, and asset mix, if the loans and securities were to be repriced, even at currently elevated deposit prices, FMBL should be back to earning its historical ~10% ROE that it has compounded at over decades or almost ~$1000/share in EPS. For contrast, run-rate ROE for SVB at run-rate deposit cost was negative, necessitating a capital raise/a point of concern for regulators and investors – in contrast, FMBL just needs to grow slower over next 3-5 years as its assets majorly repriced/mature. Given the low-mark to market losses on the loan portfolio relative to face-value (400mn versus 6.7bn in loans), I expect the loans to reprice in next 3-5 years, with the bulk of securities book repricing in next 5-10 years, so after 5 years, more than >50% of the asset side of the balance sheet should have repriced.

Assuming 4% average BVPS compounding over next 5 years as assets reprice, and an exit at 1x P/BV given ROEs should be largely normalized by then, you can earn a ~2.6x MoM in 5 years from the current price ($12,775/share), a ~21% IRR

Another way to think about it is that if FMBL were to restructure their securities book and mark down loans to fair-market value (“full-mark to market”), BVPS would fall to $5000/share (i.e. stock trading at ~97% of adjusted book), but FMBL would be earning about ~$950/share in EPS thanks to higher interest income, or a high-teens/nearly 20% ROE. Such a bank should trade at a valuation of at least 1.5x P/BV, or ~55% upside from the CMP today.  Over 5 years, between ~17% BVPS compounding and a 1.3x P/BV exit multiple, you can see a ~3.1x MoM, or a 25% IRR. 

Should the Fed cut rates sooner, this should reduce the pressure for FMBL on liability costs, helping restore normalized ROEs faster than the 5 ish years I think it would take to see HSD% ROEs under the current level of interest rates. 

Thus FMBL Is “cheap” on normalized earnings and book value, no matter how you look at it – you will see normalized EPS return faster if management chooses to take their medicine early and restructures their underwater securities book, at the cost of a 1-off hit to book value, and slower if management chooses the “do-nothing route” – either way, IRR is >20% over a 5 year period.

F&M has been profitable “ever year” since inception 115 years ago, which management boasts about in almost every shareholder communique – this suggests to me that they would be unwilling to blemish their track record of profitability by taking a large one-off loss on their securities book. In this case of the world, shareholders would need to wait for either 1) loans to reprice or 2) Fed to cut rates for FMBL to return to normalized levels of EPS.   Loan repricing over next 3-5 years should bring the bank back to HSD% type ROEs, with a return to 8-10% over 5-7 years if rates stay elevated. In this case, book value will continue to slowly compound of today’s $10,500 value, with strong earnings once ROEs normalize.

Other than interest rate risk, I view FMBL as being as a conservatively managed bank with respect to asset quality, leverage and expenses. The bank is family owned and run by the Walker family, has had a strong track record of low-net charge offs since inception, and mains a tier-1 RBC ratio and a CET-1 of c. 15.7%, well above regulatory minimums of 8.0% and 6.5% respectively. Despite a strong track record of profitable lending, allowance for credit losses is strong at $99mn, or 1.45% of all loans held for investments, which should be more than enough to work through any credit related issues that crop up as the economy slows. Loan to deposit ratio is low at ~76%, and a sign of strong liquidity, which should help FMBL originate new loans at higher, market interest rates. ~66% of the loan book is in commercial real estate (o/w ~15% is owner occupied), ~16% is in residential mortgages, ~12% in construction loans, with the remaining in C&I (4%) and other lines of business (equity lines, installment loans, etc), so the bank is exposed to worries around CRE prices, but given the bank’s track-record of conservative underwriting and history of writing loans in its home-geography of California, I don’t expect there to be a high-degree of losses even if the economy worsens.   

Assuming a weighted average ~70% LTV on the CRE loan portfolio, even if there was a 30-40% decline in broad-based California CRE prices, there would be a 0-500mn pre-tax requirement of incremental provisions on FMBL’s CRE book, which over 5 years would be a ~3pt drag on annual ROE so the bank should still remain profitable even in the case of the world where there is a GFC esque crash in the California RE market, though there is a risk that ROEs over the near term stay depressed if credit issues pick up. In reality, there is likely to be lower losses on the CRE loan portfolio than this math would suggest (lower LTVs on retail/office etc. and higher LTVs on multi-fam resi, conservative underwriting), but it is good to know that CRE is a potential risk here. Some of this CRE risk is already priced into the low-bank peer multiples we use to underwrite the investment, as this is a key topic for bank investors, and many banks are exposed to similar levels of CRE or other credit risk.

FMBL is also an attractive holding as part of a broader equity portfolio in that it represents a leveraged long-bet on bonds which should perform well should the Fed cut rates to zero in a downturn.  I expect the stock to re-rate to more like 0.6-0.8x P/BV once ROEs trough and start to increase again, with visbility to 1x P/BV in next 2-3 years if the bank-run fears fade and interest rate outlook normalizes, with BVPS continuing to compound at LSD-MSD%s, with re-rating pace in line with ROE recovery. In case management takes actions to recover ROE faster, shares could re-rate quicker, such as a restructuring of the bank's securities book or aggresive loan-growth/branch additions  

Risks:

CRE outlook in FMBL's home markets continues to worsen 

Short term interest rates continue to rise

Continued deposit competition in FMBL's home markets leading to NIB outflows/rise in cost of deposits

Catalyst

Fed cuts rates

Management restructures their HTM securities book 

KRE recovers from its currently depressed P/E ratio v/s the SPY (near historical extremes)