Executive Summary
- Simplicity continues to focus on increasing their asset quality while at the same time managing costs to continue profitability
- Deposit mix is trending towards core deposits and savings instead of CDs leading to lower deposit costs
- Management has proven to be shrewd capital allocators by repurchasing ~19% of shares since Nov 2011 and are authorized to buy another 5% of shares; meanwhile, Simplicity continues to pay a dividend
- Management and directors are aligned with minority share holders and the CEO has significant portion of ownership in options expiring in 2 years at strike prices near take out value
- Peer valuation indicates that a 1x tangible book multiple is appropriate for Simplicity indicating short term gains of 16%
- Takeout valuation indicates that a 1.4x tangible book multiple is appropriate which could send shares 60% higher in the next couple of years
Company Description
Simplicity Bancorp, Inc. (SMPL) is a Maryland corporation that owns all of the outstanding common stock of Simplicity Bank. It was formerly known as Kaiser Federal Financial Group, Inc,. the successor to K-Fed Bancorp at the completion of the second-step conversion and offering in November 2010. Simplicity Bank is a federally-chartered savings bank headquartered in Covina, California. It was originally founded in 1953 as a credit union to serve employees of the Kaiser Foundation Hospital in Los Angeles, California and converted to a federal mutual savings bank in 1999 under the name Kaiser Federal Bank. In November 2012, it was renamed Simplicity Bank as part of a broader business strategy to operate as a community bank serving the financial needs of all customers within its communities.
Business Strategy
Management has devised a plan to focus on retail banking and intends to be the top performing retail bank in their markets. Management has highlighted that they will continue to emphasize expanding customer relationships through e-commerce and Traditional Delivery. Such a small bank does have an advantage over the larger competitors in their customer support and it seems like management is trying to focus on that edge.
Management also has highlighted their intent to expand wallet share with their current customers. I do like management's decision to expand wallet share through core deposits. Simplicity has in the past focused on attracting customers with CDs. By focusing on lower cost core deposits and increasing other non-interest income, Simplicity will be much more profitable. Simplicity historically has had a majority of loans as Single/Multifamily Real Estate and has also stressed the need to be opportunistic with Commercial Real Estate. Though slightly riskier, Commercial Real Estate does offer higher rates and competition from peers is not as significant.
Loan Portfolio
Loan Mix
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Source: Company presentation
Simplicity once was a credit union and then turned into a mutual savings and loan company (thrift), so it makes sense that the loan portfolio has primarily focused on 1-4 family and multifamily real estate loans. According to Federal Thrift Charter of 1933 thrifts are depository institutions that must have 65% of their assets invested in real estate mortgages or mortgage backed securities. Of the four loan types it is the single-family and multifamily residential that are the least risky and face the highest competition. Lower risk means that those loans have lower yields and calls for management to have great control on operating expenses, funding costs and credit costs. Since 2010 Simplicity has been growing their residential real estate loans while also maintaining their net interest margins, so I would conclude that management has been adept at controlling costs.
Asset Quality and Reserve Coverage
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Source: Company Presentation
Asset quality is the single most critical determinant of any bank's success or failure. Only a small portion of loans that turn bad could potentially wipe out income that the bank generates.
It is difficult for investors to fully assess a bank's asset quality because we don't have access to individual loan files, but we can look at trends and relative sizes of asset quality ratios to get a somewhat objective assessment of asset quality. Clearly from the above chart we can see that Simplicity has been reducing their non-performing assets by a significant margin since 2010. Simplicity currently has an NPA/Total Assets of 1.8% which is slightly above a normal range of a bank in good economic times: usually 0.4% - 1.25%. Currently the economy would still not be considered the best of economic times for banks as they recover from one of the worst financial crises ever, and we can see from the peer sheet in the appendix that the average NPA/assets of peers is 3.55 well above Simplicity.
Additionally, the peer sheet (in the appendix) shows us that Simplicity's 15.3% Texas ratio is also below the peer average of 26.6%, which is a good sign.
Sources of Noninterest Income
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Source: Company Reports
Deposit Base And Branch Network
Deposit Mix
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Source: Company Presentation
Simplicity's funding mix is fairly common amongst thrifts, which tend to have a higher percentage of deposits in CDs compared to lower cost accounts; it's not surprising to see CDs at 70% or more of total deposits. The main problem with this is that CDs have a much higher cost than other deposits. What I do like seeing is that since the conversion from a mutual to a community bank, Simplicity has been focusing on growing their checking and savings & money market deposits while letting CD deposits decline as they come due. Along with the lower costs, the core deposits have a stickier relationship as most customers interested in CDs are focused on the highest yield and will move from one bank to another pretty quickly.
Franchise Area
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Deposit Market Share Summary
While Simplicity doesn't have a large share in the Los Angeles area, it does have some decent market share positions in Panorama City, Pasedena and Covina. Deposit trends have been declining in almost all their markets, which does cause some alarm, however, their branch in Panorama City shows that they can retain relationships and their market position in key markets.
As a potential take over target, Simplicity does seem to have some desirable branches with relationships, but their smaller scale would necessitate a lower valuation in the case of a takeover.
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Source: Company Website
Management
Management does own a somewhat sizable portion of the company's shares with directors and executive officers owning 4.51% of the company. Of that, the President, Director and CEO Dustin Luton owns 1.18% of the company aligning himself close with minority shareholders. The only thing that I am nit picky about is that he hasn't bought a majority of his shares with his own money but has received a sizable portion from restricted grants and stock options (refer to Catalysts for positives of his options). Another positive is that management and the board realizes that the company is undervalued and is allocating capital back to shareholders via dividends and sizable share repurchases.
To be more specific Simplicity has authorized four 5% repurchase plans since November 2011 and has repurchased 1,784,448 shares up thru November 2013. That means that ~18.6% of the company has been devoured in a short two year time frame, all while dividends were still paid. Keep in mind that Simplicity announced on November 4, 2013 another intent to repurchase up to 5% or 394,003 shares. Repurchasing shares at today's prices is certainly accretive.
Valuation
Peer Group Comparison
The banking industry, especially community banks, still has the lingering negative stigma attached from the financial crisis. This means that industry wide low valuations are common now. Looking at practically any community bank we see that all are trading well below historical multiples to tangible book value. In a sense the valuations are somewhat deserved because higher liquidity has driven down return on assets and return on equity, but neither does it mean that banks will continue to be overly capitalized and returns will be low into the future.
Anyway, even looking at a peer comparison Simplicity is trading below its peers. I do not believe that Simplicity's valuation is justified because their returns and asset quality are on par with peers. Their loan portfolio is also not full of extremely risky loans and management has been giving back cash to share holders through significant buybacks at low valuations. Also, management has been taking steps to focus on lower cost deposits and continually building asset quality on their books.
From the peer chart in the appendix, the average tangible book value multiple for a community bank with average returns and asset quality should be 1x. Simplicity is trading for ~0.86x tangible book and a reversion to the norm would mean that shares could rise to in the short run to ~$18.40 or an increase of ~16%.
Takeout Value
Over the past 20 years commercial banks with assets between $500m - $1billion have averaged around 1.5x tangible book.
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Source: Monroe Securities Presentation
Recent buyouts of small community banks with between $500 million and $1 billion in assets have been priced in a range of 0.79x - 1.41x book.
Source: CB Resource
The recent buyout prices indicates that acquirers are more interested in buying slightly larger banks with greater scale and will pay more for them. Shareholders and management would expect a higher valuation than today for an acquirer to buy Simplicity. Given the data, I would conservatively estimate that Simplicity could be bought out for 1.4x tangible book and potentially higher. Such a valuation would mean that Simplicity could be bought out at ~$25.50 or ~60% higher than today's prices.
Investment Risks
Banking consolidation has been happening at a great pace in the last decade and at an even greater pace since the recession, highlighted in this recent article. One thing that I haven't heard mentioned too much in some investment thesis are banking executive concerns over M&A regulation.
In a recently published survey by KPMG, one hundred banking executives were asked about the likelihood that their bank would be involved in M&A over the next year. Only 35% responded they might be potential buyers and only 8% responded they might be potential sellers, well below the prior year responses. Mainly, fifty-seven percent of respondents cited regulatory issues as the biggest barrier to mergers and acquisitions. One key note is that the survey was highly weighted to banks with assets above $10billion while there was only 19% of respondents from the $100 million to $1 billion range.
If banks are less likely to sell, then that is one less driver of shareholder value. I believe regulation barriers won't be too much of a hindrance to Simplicity. Regulators are concerned with a bank acquiring another bank that would add to the acquiring bank's risk. Simplicity has asset quality ratios that are not in the realm of too risky when compared with peers.
Another detail that would cause Simplicity not to sell could be found in the age of the CEO. According to Keefe Bruyette & Woods and my own observations, banks tend to sell when CEOs get old. Keefe Bruyette & Woords says that the average CEO of small banks sell at 58. Dustin Lutin is only 43 years old but one important factor that negates this trend is if the younger CEO owns a sizable amount of stock that can be cashed out in a merger.
Catalysts
President/CEO Dustin Luton and Chief Administrative Officer Jeanne R. Thompson have a big portion of their ownership currently tied to out of the money stock options with strike prices significantly higher than today and will be expiring within the next 2 years. For Luton, nearly 30% of his total ownership in the bank is exercisable at $24.19. To put that into perspective, Luton's unexercised 28,776 shares are equal to $696,091 (at $24.19), which is ~178% of Luton's 2013 salary. The options will expire in 2016 so Luton has a reason to do what he can to get the share price above $24.19. For Jeanne Thompson 15,826 option shares have an exercise price of $20.16 and expire Nov 2014. These shares equal 23% of her total ownership and would equal $319,052 or ~156% of her 2013 salary.
One way, of course, for management to realize all of their options and their full ownership in Simplicity is to sell the company to another bank. Otherwise, management can continue to run the business well and buy back as many shares as possible at these depressed values.
Now, if management was feeling like mavericks, they could suspend the dividend and management could allocate all capital to buying back shares. That's what I'd do, but I am not management!
Summary
Although you can pretty much close your eyes and throw a dart to find some alpha in the small community bank space, Simplicity is above average when compared to peers and has shrewd capital allocators for management. Simplicity is a wise investment for those willing to wait for the catalysts to work out.
Appendix
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Source: Company Presentation (Valuation My Calculations)
Sources
KPMG Survey: Regulation Top of Mind For Banking Execs
Simplicity Bancorp Oct 2013 Presentation
Monroe Securities Presentation
M&A for Community Banks: Dead or Alive?
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SMPL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
Additional disclosure: This article is meant for instructional purposes and not meant as a recommendation to buy or sell. The only kind of intelligent investing is through your own due diligence.
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