Simplicity Bancorp: An Overcapitalized Bank Ripe For A Takeover

Investment Thesis

Simplicity Bancorp (SMPL) formerly known as "Kaiser Federal Financial Group" is the holding company of a small community bank. SMPL is trading at a 13% discount to its BV and while it may not be obvious, it is significantly undervalued relative to its private market value.

Here are the reasons why Simplicity deserves a higher valuation:

• SMPL is trading at $15.79/share which is slightly below its BV of $18. It has a quite overcapitalized balance sheet with equity being 17.26% of assets (compared to an industry norm ~10%) and its 1 ratio being a very high 20%. Return on equity and net interest margin have languished due to the company's overcapitalized balance sheet but it can use its abundant financial resources to increase value by:

1. Continuing to return capital to shareholders as it has done over the last 3 years. Simplicity has reduced its share count from 10.6 million shares as of June 30, 2010 to 8 million as of September 30, 2013. That's a 24.5% decrease in shares outstanding in just three years. And that's going to continue as the company announced in its latest earnings release that it intends to buy another 5% of its shares.


2. Repositioning its balance sheet into higher earning assets. This could be done by changing the focus of its loan portfolio from 85%+ residential real estate to a more mixed and profitable structure.


3. Using its $85 million of cash and securities to buy a bank to increase its deposit market share in its markets.


4. Serving as an attractive acquisition target as a sophisticated acquirer could utilize its excess capital.

• Simplicity is doing business in the overbanked and highly active state of California. It has 8 branches, 7 of which are in the Los Angeles-Long Beach-Santa Ana MSA along with 76% of its deposit base. With median household income at $56K the Los Angeles area is well above the national average, but below California's average of $61K. Simplicity is ranked 42nd in terms of deposits in this market, which is a pretty insignificant 0.13% deposit market share.

• However while this may seem to be a negative for the bank's prospects as an acquisition target it is in fact a great positive. This is because it is pretty clear that Simplicity cannot grow except through M&A. Since it is too small to be the acquirer it is more likely to be the acquired especially because of its valuable overcapitalized balance sheet. A sophisticated acquirer (another bank) could use Simplicity's balance sheet to support twice the loans Simplicity has and generate at least double returns on capital employed.

• As far as management is concerned, insiders own 4.5% of the company's stock which means their interests are well-aligned with shareholders. Moreover Simplicity has a strong institutional shareholder base with accomplished thrift investors like Firefly Value Partners, whose presence could lead to a faster realization of the company's value through an M&A deal (with SMPL as the acquired party).

(click to enlarge) (Source: Simplicity's DEF 14A filling on September 9, 2013)

The Reasons Behind The Opportunity

But why does this opportunity even exists? Well, thrift conversions and small community banks, while known to value investors, are usually underfollowed by the market. However this isn't the whole story. Widely used metrics like ROA and ROE at first glance appear to be unattractive in community banks and especially Simplicity which earned an awfully low 4% ROE for the fiscal 2013 (ended June 30, 2013) because of its overcapitalized balance sheet.

Moreover Simplicity is a quite illiquid stock and given its sub $300 mil market cap and its lack of any significant sell-side coverage, it's most likely to be unknown to institutional investors. And since growth prospects are meager for small community banks, growth investors don't even bother to look at this part of the market.

Nevertheless our thesis is based on return of capital to shareholders and the continuous consolidation in the banking sector, caused by rising regulatory costs that has pushed many banks to sell-out, usually at prices significantly above BV.

Company Overview

Simplicity Bancorp is a Maryland corporation that was founded originally in 1953 as a credit union under the name K-Fed Bancorp. It was converted to a federal mutual savings bank in 1999 under the name Kaiser Federal Bank and it completed its two-step conversion and offering in November 2010. The bank changed its name to Simplicity Bank in November 2012 as part of a broader business strategy to operate as a bank devoted to serving the people within its communities.

Loans

Simplicity's loan portfolio is very concentrated and focused on residential real estate. Here are Simplicity's loans broken down by category:

1-4 Family & Multi-family residential: These are loans backed by residential real estate and are Simplicity's biggest loan classes. Combined they comprise about 87% of Simplicity's loan portfolio. Multi-family is 44% of the loan portfolio and 1-4 family 43%.

Commercial Real Estate: Commercial real estate is Simplicity's third biggest loan class comprising about 7% of the company's loan portfolio.

Auto loans: Next in line come auto-loans that comprise about 4% of the total.

Consumer & Home Equity loans: These loans are just 1.4% of Simplicity's portfolio and are issued mostly to existing customers to fund their various consumption needs.

Credit Health

Simplicity's asset quality has been improving significantly over the past years. It started with NPAs (excl. restructured loans) being 3.79% of assets as of June 30, 2010 and now is down to just 1.66%. Total NPAs per total assets went from 3.79% in June 2010 to 2.61% as of September 30, 2013.

Deposits

Simplicity's asset base is primarily funded by deposits and equity. Deposits comprise 90.8% of total liabilities and 75% of total assets. Despite the fact that 90.9% of Simplicity's deposits are interest bearing, Simplicity's annual interest expense on them is a mediocre 1%. Simplicity has no brokered deposits which makes its deposit base less volatile and less likely to migrate.

Investment Portfolio

Simplicity has an investment portfolio that as of September 30, 2013 was worth $48 million. The portfolio consists of residential mortgage backed securities and of collateralized mortgage obligations.

Market Area

Simplicity's main market is the Los Angeles County, CA where 76% of its deposit base rests. Its market is a growing one both in population and in wealth. The homeownership rate in this county is a low 42% which leaves a lot of potential for mortgage originators. Median household income was around $56K and growing. This is well above the national average but below the state's average of $62K.

Management

Management incentives in Simplicity's are based on the company's ROA and ROE but there are no specific numbers for them to eat and essentially management bonuses approval are left every year to the discretion of the board. This isn't a particularly robust compensation policy but given the fact that the management team and the board of directors own 4.5% of the company's stock and the strong institutional ownership it is safe to assume that management and shareholders' interests will be aligned for the foreseeable future.

Valuation

There are two reasonable ways to value Simplicity Bancorp. The first one as a standalone business and the second as a potential acquisition target.

Simplicity has grown its BV/share at average 5.24% over the last 3 years. Given that the company is a committed buyer of its shares and that it is very conservatively managed, this rate can only go up over time as either the shares outstanding declines or SMPL expands its loan portfolio. In that perspective I believe that Simplicity on a standalone basis is worth at least 1x its $18 BV which is 14% higher than its current valuation.

However to a sophisticated investor (aka another bank) Simplicity is worth significantly more. With its regulatory Tier 1 ratio just over 20, Simplicity offers the potential of carrying twice the loans it currently has on its balance sheet. This means that it can be twice as profitable and thus offer twice the returns it offered so far. However, this can be achieved only by having another bank manage SMPL or by changing its management. In both instances SMPL would worth up to 2 times the value we estimated as a "standalone" value.

However it is extremely unlikely for SMPL getting bought out at that price because acquiring banks aren't stupid, they will want to get it for less than it's worth. Thus in the case of SMPL getting acquired I believe that the acquirer would be willing to pay up to 1.5x the company's BV. That's a 70% upside gain from its current valuation.

Catalysts

• The first chart below demonstrates how powerful the consolidation within the banking industry has been over the years. The reasons behind the consolidation are simple. Regulatory costs have become more and more burdensome over the years and small banks in particular have seen their bottom line shrink because of this. In order to survive small banks are forced either to merge with each other or to sell operations. According to SNL, since 2010 there have been over 713 deals executed and below you can see how dramatically the number of banks/thrifts has declined over the past 30 years.

(click to enlarge)

• Simplicity trades at discount to its overcapitalized BV which will continue to grow due to share buybacks. Moreover, with average takeout multiples between 1.2x - 2.0x TBV Simplicity has an upside potential of 30% to 120% (1.2x - 2.0x $17.5).

• The company is significantly overcapitalized and small which means that every one of the 70 or so bigger banks in California have a strong incentive (increasing profits by redeploying SMPL's capital) to buy Simplicity sooner rather than later.

Risks

• Poor execution risk. The company's management may make poor capital allocation and/or lending decisions reducing the company's profitability and return on book value. However, this is unlikely for two reasons. First, the management has a sizeable stake in the company which aligns it with shareholder interests and second, management has been too conservative when deploying the bank's capital as it is evident by its overcapitalized balance sheet.

• Credit Health Risk. As mentioned it the credit health section Simplicity's non-performing assets are in a downward trend. Add to that the fact that the California's economy is improving and the risk for increasing NPAs is negligible.

Conclusion

Simplicity is a greatly undervalued bank with conservative management, a healthy and overcapitalized balance sheet and a private market valuation around $27 which is significantly higher from its current price. In today's extremely competitive environment banks have been forced to either become acquisition machines or roll-up targets.

Simplicity with its overcapitalized balance sheet represents a target too attractive for any larger bank to ignore and there are about 70 larger banks in its market that could easily step up to the plate. Simplicity being acquired in this market environment is just an issue of when not if. And with that company's per share value continually increasing due to buybacks investors are certainly compensated for their waiting time.

Source: Simplicity Bancorp: An Overcapitalized Bank Ripe For A Takeover

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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...)

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