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Berkshire Bancorp: Undervalued and Overcapitalized

August 30, 2011 | About:
John Emerson

John Emerson

147 followers
Berkshire Bancorp (BERK) is a tiny regional bank holding company which consists of 12 bank outlets which cover metropolitan New York City and its suburbs. The company also holds several small subsidiaries which engage in title insurance business and tax exchange consulting.

In the fall of 2008, the bank's balance sheet was capitalized by the issuance of Class A preferred shares which provided 60 million in cash. In return, the shareholders of the preferred (which includes the controlling shareholder for the bank) received interest payments of 8% per annum which amounts to an interest expense of $4.8 million per year. On Oct. 31, 2011, the preferred shares will convert into common shares. The conversion will leave the bank with a fully diluted share count of around 14.44 million shares. That figure will be the basis of all further analysis in regard to the valuation metrics of the bank.

I will explain later in the article how this mandatory conversion will provide a powerful catalyst which will likely result in a quick realization of shareholder value. (See the section on Putting the Pieces Together.)

Overcapitalization of Berkshire Bancorp

The current value proposition and substantial overcapitalization in BERK is a direct result of an auction rate security arbitration settlement of $42.5 million which the bank pursued through the Financial Industry Regulatory Authority (FIRA). The case was settled in May 2011. http://investing.money.msn.com/investments/sec-filings/?symbol=BERK

The combination of the $60 million in cash supplied by the preferred stock coupled with the $42.5 million FIRA settlement has resulted in the following capitalization ratios for the bank:



Actual


For capital

adequacy purposes


To be well

Capitalized under

Prompt corrective

Action provisions


Amount


Ratio


Amount


Ratio


Amount


Ratio


June 30, 2011


Total Capital (to Risk-Weighted Assets)


Company


150,084
34.9 34,380 ≥ 8.0%


Bank


137,880
32.7 33,686 ≥8.0% 42,108 ≥10.0%


Tier I Capital (to Risk-Weighted Assets)


Company


144,712
33.7 17,190 ≥ 4.0%


Bank


132,463
31.5 16,843 ≥ 4.0% 25,265 ≥6.0%


Tier I Capital (to Average Assets)


Company


144,712
16.8 34,470 ≥ 4.0%


Bank


132,463
15.5 34,236 ≥ 4.0% 42,795 ≥5.0%




Using the most conservative ratios provided by prompt corrective actions provisions set forth by the government; the bank is overcapitalized by anywhere from 310% to 525%. It will become apparent later on in the discussion that the excess cash of the bank will likely be returned to the shareholders in some fashion following the mandatory conversion date on Oct. 31, 2011.

Controlling Ownership, Conversion of the Preferred shares and Recent Insider Buying

The controlling shareholder for Berkshire Bankcorp is Moses Marx who serves as the chairman of the board for the company. Mr. Marx owns 56.76% of the common shares and is one of the three investors who hold all the preferred shares. Marx owns 50% of the outstanding preferred shares.

Marx purchased additional common shares as recently as May 25, 2011, paying an average of slightly for than 6.7 per share while accumulating an additional 98,223 share lot.

The current share count for the common stock is 7.054 million shares of that total Marx currently holds slightly over 4 million shares. On Oct. 31, 2011, all preferred shares will undergo a mandatory conversion to common stock. At that point the total outstanding common share count will increase to approximately 14.44 million. Of that amount Marx will control just fewer than 7.7 million shares or slightly over 53% of the company. Following the conversion of the preferred stock, insiders will control approximately 80% of the total outstanding shares.

The recent 10K explains the details of the preferred stock:

Series A Preferred Shares. On Oct. 31, 2008, the Company sold an aggregate of 60,000 shares of its 8% Non-Cumulative Mandatorily Convertible Perpetual Series A Preferred Stock (the "Series A Preferred Shares") at $1,000 per share, or $60 million in the aggregate, to the Company's Chairman of the Board and majority stockholder, and two non-affiliated investors. Each Series A Preferred Share bears non-cumulative cash dividends at the rate of 8% per annum, payable quarterly, is mandatorily convertible into 123.153 shares of our Common Stock on October 31, 2011 and was redeemable at the option of the Company between April 30, 2009 and November 1, 2010 at a redemption price of $1,100. No Series A Preferred Shares were redeemed during the redemption period. So long as any share of Series A Preferred Shares remains outstanding, unless the full dividends for the most recent dividend payment date have been paid or declared, no dividends may be paid or declared on the Company's Common Stock. No Series A Preferred Shares have been redeemed to date. [/i]

The following is a profile of Marx:

Mr. Marx, 75, has been the Managing Member of United Equities Company LLC since 2000 and General Partner of its predecessor, United Equities Company since 1954 and General Partner of United Equities Commodities Company since 1972. He is also President of Momar Corp. All of these are private investment companies. Mr. Marx served as a director of The Cooper Companies, Inc. (a developer and manufacturer of healthcare products) from 1995 to March 2010.

Valuation: Tangible Book Value per Share

As of the last quarter, BERK had tangible equity of 8.2 per share fully diluted. The true equity is likely higher due to a level-three valuation of part of the companies' investment portfolio and an apparent over-reserve created for loan loss provisions (see the following paragraphs). That places the current price to tangible book for BERK at around .77. Of that amount approximately 114 million is cash and cash equivalents representing about 12.8% of the companies' assets.

An examination of the bank's investment portfolio reveals that the company is currently listing a $9.570 million dollar gross unrealized loss on its auction rate security portfolio. It is unlikely that the loss will actually be realized; however, it must be listed as such on the companies’ balance sheet. That amount would translate into an additional 66 cents per share in tangible equity fully diluted. Here is the explanation from the recent 10-Q:

In accordance with ASC 320-10, Investment - Debt and Equity Securities, Management's impairment analysis for the corporate and auction rate securities that were in a loss position as of June 30, 2011 began with management's determination that it had the intent to hold these securities for sufficient time to recover the cost basis. Management also concluded that it was unlikely that it would be required to sell any of the securities before recovery of the cost basis.

At June 30, 2011, and December 31, 2010, the amortized cost of our auction rate securities was $70.0 million and $74.0 million, respectively. The fair value of the auction rate securities was $60.4 million and $62.1 million at June 30, 2011 and December 31, 2010, respectively.

An examination of the loan loss allowance for the bank reveals the following:



For The Three Months Ended


For The Six Months Ended


June 30, 2011


June 30, 2010


June 30, 2011


June 30, 2010


(In thousands)


Balance at beginning of period
17,324 11,900 16,105 11,416


Provision charged to operations
400 1,500 1,600 2,750


Loans charged-off
(300) (2 (1,066)


Recoveries
6 5 27 5


Balance at end of period
17,730 13,105 17,730 13,105


Note the increase in the allowance to slightly over $17.7 million. However the recent 10-Q reveals that the bank has only experienced around $3.6 million in impaired loans as of the first six months of 2011.

Impaired Loans

For the Six Months Ended June 30, 2011

(In thousands)



Recorded

Loan


Unpaid

Principal

Balance


Related

Allowance


Average

Recorded

Loan


Interest

Income

Recognized


Interest

Income

Foregone


With no related allowance recorded:


Commercial & industrial


$


Construction


Commercial real estate
1,350 1,350 1,354 45


Consumer


Residential – prime
2,257 2,257 2,262 54 6


Residential - multi family


Finance leases


Total
3,607 3,607 3,616 99 6


Commercial
1,350 1,350 1,354 45


Consumer


Residential
2,257 2,257 2,262 54 6




It appears that the company is extremely conservative in estimating its allowance for loan losses; therefore, it is highly probably that the current balance sheet is understating the legitimate tangible book value of the company. Tangible book value per share would increase by 10 cents for every $1.44 million in loan loss allowance reversals should they occur.

Valuation: Earnings Power

The mandatory conversion of the convertible shares on Oct. 31, 2011, will result in a yearly pretax earnings boost of slightly over 33 cents per share. BERK currently pays a preferred dividend of $4.8 million per annum, following the conversion that expense will be eliminated. The 33-cent figure is derived by dividing the $4.8 million in interest expense by the fully diluted share count of $14.44 million. (See section on Putting the Pieces Together and Other Catalysts.)

The follow table depicts the 10-year earnings results for BERK:

Income Statement - 10 Year Summary (in millions)



Sales


EBIT


Depreciation


Total Net Income


EPS


Tax Rate (%)


12/10


0.0


-14.98


0.51


-13.49


-2.59


0.0


12/09


0.0


-15.46


0.53


-2.24


-1.0


0.0


12/08


0.0


-85.7


0.6


-79.91


-11.33


0.0


12/07


0.0


7.73


0.74


5.35


0.76


30.72


12/06


0.0


8.74


0.73


4.88


0.7


44.14


12/05


0.0


10.54


0.65


5.54


0.8


47.45


12/04


0.0


13.64


0.59


7.5


1.1


44.98


12/03


0.0


13.06


0.61


7.42


1.1


43.22


12/02


0.0


9.95


0.28


5.6


0.81


43.73


12/01


0.0


5.43


1.18


3.3


0.47


39.21




Note that BERK was profitable until the onset of the housing crisis which began in 2008. In the prior seven years the company averaged pretax income of $9.87 million per year.

It is also important to note that BERK returned to profitability in the first six months of 2011 despite the slow housing recovery and the high interest expense incurred by the preferred stock. The bank has been operationally profitably in five of the last six quarters.

Unlike many investors I do not attempt to project future earnings numbers, although in the case of BERK I find it highly likely that the company will generate significant forward earnings increases considering their past history. Certainly the elimination of the interest on the preferred shares will largely transfer to the companies' bottom line. As previously stated, the effect will be slightly over 33 cents per share in pretax savings when the shares are fully diluted.

A look at the current net interest spreads as compared to their historic mean is also enlightening.



For The Three Months Ended June 30,


2011


2010


Average



Balance


Interest



and



Dividends


Average



Yield/Rate


Average



Balance


Interest



and



Dividends


Average



Yield/Rate


INTEREST-EARNING ASSETS:


Loans (1)
346,118 5,498 6.35 392,714 6,473 6.59


Investment securities
387,685 3,480 3.59 362,001 3,720 4.11


Other (2)(5)
96,914 73 0.30 80,695 65 0.32


Total interest-earning assets
830,717 9,051 4.36 835,410 10,258 4.91


Noninterest-earning assets
31,032 61,140


Total Assets
861,749 896,550


INTEREST-BEARING LIABILITIES:


Interest bearing deposits
212,469 238 0.45 231,187 396 0.68


Time deposits
386,614 1,305 1.35 402,726 1,557 1.55


Other borrowings
81,582 745 3.65 94,287 924 3.92


Total interest-bearing liabilities
680,665 2,288 1.34 728,200 2,877 1.58


Demand deposits
80,293 71,398


Noninterest-bearing liabilities
6,241 8,551


Stockholders' equity (5)
94,550 88,401


Total liabilities and stockholders' equity
861,749 896,550


Net interest income
6,763 7,381


Interest-rate spread (3)
3.02 3.33


Net interest margin (4)
3.26 3.53


Ratio of average interest-earning assets to average interest bearing liabilities
1.22 1.15




The 10-year average for net interest spread for BERK is approximately 2.44%. The spread has ranged from a low in 2007 of 1.49% to a high of 3.33% in 2009. The current spread of 3.02% is near the bank's historical high range. The number represents the spread between the companies’ borrowing rate compared to it lending rate. Mortgage spreads are particularly attractive at this point in time; although yields on investment portfolios have been contracting due to nearly universal yield declines on all fixed income investments.

The extremely favorable mortgage spreads bode well for the companies' future earnings power; particularly as non-performing mortgages are worked through. A slowdown or an abatement of loan loss allowances coupled with the extinction of the 4.8 million dollar preferred interest charge which ends on Oct. 31, 2011, should propel the future earnings of the bank. Although the increased share count will somewhat mitigate the increase in earnings per share.

The Loan Book of the Bank

The following tables describe the outstanding loan book of BERK and the age analysis of the past due loans:



June 30, 2011
December 31, 2010


Amount


% of

Total


Amount


% of

Total


(Dollars in thousands)


Commercial and Industrial and Finance Leases Secured by real estate
20,991 6.0 19,321 5.3


Residential
111,316 32.0 114,594 31.2


Multi family
8,434 2.4 5,865 1.6


Commercial real estate and construction
206,049 59.4 226,667 61.7


Consumer
793 0.2 795 0.2


Total loans
347,583 100.0 367,242 100.0


Deferred loan fees
(860 (937


Allowance for loan losses
(17,730 (16,105


Loans, net
328,993 350,200




Age Analysis of Past-Due Loans

As of June 30, 2011

(In thousands)



30-59 Days

Past Due


60-89 Days

Past Due


Greater

Than

90 Days


Total

Past Due


Current


Total

Loans


Recorded

Loans >

90 Days and

Accruing


Commercial & industrial
125 125 14,203 14,328


Construction
20,397 20,397


Commercial real estate
26 2,000 2,026 183,626 185,652


Consumer
5 5 618 623


Overdrafts
170 170


Residential - prime
29 74 165 268 111,048 111,316


Residential - multi family
8,434 8,434


Finance leases
6,663 6,663


Total
60 74 2,290 2,424 345,159 347,583




The table illustrates that .7% of the current loan portfolio is currently past due; the majority of that amount is in the commercial real estate sector where slightly over 1% of outstanding loans are currently past due.

Below is the table of past due loan from six months prior. Note the large improvement in loan collection for accounts which are less than ninety days past due. Past-due loans of less than ninety days have virtually disappeared while overall past due accounts have reduced by around $3.75 million. Past-due loans in excess of 90 days have risen by about $1.41 million; however, overall past due loans have dropped from a rate of 1.7% to about .7% as a percentage of total loans outstanding.

Age Analysis of Past-Due Loans

As of Dec. 31, 2010

(In thousands)



30-59 Days

Past Due


60-89 Days

Past Due


Greater

Than

90 Days




Total

Past Due


Current




Total

Loans


Recorded

Loans >

90 Days and

Accruing


Commercial & industrial
251 166

$
417 10,081 10,498 29


Construction
900 900 32,267 33,167


Commercial real estate
1,356 2,000 3,356 190,144 193,500


Consumer
15 15 780 795 11


Residential - prime
404 387 695 1,486 113,108 114,594 451


Residential - multi family
5,865 5,865


Finance leases
8,823 8,823


Total
2,911 2,387 876

$
6,174 361,068 367,242 495




The Investment Portfolio of the Company

The follow table summarizes the investment portfolio of BERK as of June 30, 2011:

At June 30, 2011 Fair Value Measurement Using
Quoted Prices in Active Markets for Identical Assets/Liabilities (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Balance June 30, 2011
(Dollars in thousands)
Assets
Impaired Loans (1) 3,607 3,607
Investment securities available for sale: (2)
U.S. Treasury Notes 70,205 70,205
U.S. Government Agencies 115,084 115,084
Mortgage-backed securities 143,667 143,667
Corporate notes 12,071 12,071
Municipal securities 2,551 2,551
Auction rate securities 60,430 60,430
Marketable equity securities and other 1,140 1,503 2,643
Total Investment securities available for sale 85,967 260,254 60,430 406,651
Total assets 85,967 260,254 64,037 410,258




The interest yield on the portfolio for the most recent quarter was 3.54%. The largest holdings for the portfolio are U.S. government agencies (Freddie Mac, Fannie Mae, and Ginny Mae) and mortgage backed securities. The main Level 3 investment (not valued on a mark to market basis) is $60.43 million auction rate securities.

The following is the company criteria for Level 1, 2 and 3 investments:

Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.

Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities in active markets; quoted prices in markets that are not active for identical or similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 - Unobservable inputs that are supported by little or no market activity and significant to the fair value of the assets or liabilities that are developed using the reporting entities' estimates and assumptions, which reflect those that market participants would use.



The majority (84%) of the Bank's fixed income investments are reasonably liquid and can be creditably assessed on a mark to market basis.

Risks

The main risk to BERK like other banks is a decrease in economic activity, particularly in the New York City area where their banks located. Additionally, the recent flooding by hurricane Irene might have damaged some of the real estate properties in their mortgage portfolio, particularly in the Brooklyn area. Uninsured flood damage might lower the market value of the real estate for which they hold outstanding loans.

Putting the Pieces Together

As previously noted the controlling shareholder of BERK is Moses Marx, age 75. Mr. Marx has been accumulating the companies' stock for the better part of the last decade and most of his purchases were accumulated at a cost significantly higher than the current price per share. His last purchase of common stock was conducted in May of the current year approximately 5% higher than the current share price.

Following the mandatory conversion of the preferred stock on Oct. 31, 2001, Mr. Marx will control 53% of the outstanding common stock. At that point he will no longer draw an annual interest rate of 8% on the 30 million which he invested in the companies preferred shares. In essence, Mr. Marx investment in BERK preferred stock was consummate to a three-year bond which will converts to common stock. The problem for Marx is that the $30 million in principle which he invested will soon be dead money (the coupon will expire on October 31).

The table at the top of the article depicted the extreme overcapitalization of the bank which resulted from the preferred capital infusion of $60 million in 2008 and the FIRA arbitration settlement of $42.5 million earlier in the year.

Just how overcapitalized is the bank considering the new Basel 3 requirements which will be put into effect beginning at the end of 2012? Basel 3 phases in additional capital requirements; by 2019 the total Tier One requirements will amount to 11% for banks without systemic risk. Currently BERK has a Tier One capital to risk-weighted asset ratio of 31.5%, using only the equity of their banks. In other words, BERK could issue a special dividend of around $82 million ($5.68 per share fully diluted) and still have a Tier One capital ratio of around 12%.

In light of the massive overcapitalization of BERK and the likelihood that controlling shareholder Moses Marx will want to recoup his $30 preferred payment which will soon convert to common shares; the following scenarios exist:

1) The bank issues a large special dividend.

2) The bank is sold.

3) The bank uses the excess cash for acquisitions.

4) The bank is taken private.

5) Shares are tendered in a dutch auction.

6) The bank massively increases its current loan portfolio.

7) The bank sits on the excess capital.

Of the five possible scenarios, No. 7 is the least tenable since Marx will own 53% of the shares outstanding, and it is unlikely that he would choose to hold the $30 million he injected into the institution in the form of preferred shares when it quits drawing a rate of return on October 31.

No. 6 is also highly unlikely; considering the current lending environment, it would not be feasible to extend sufficient loans through the companies' 12 bank outlets, to bring down the Tier One ratio to a more reasonable level.

That leaves us with five plausible alternatives. Of the remaining alternatives I believe No. 3 is the least likely due to the age of Mr. Marx. At 75, he seems a bit old to be attempting to build a banking empire. He is entering the age where most investors begin to cash out and generally elect to shift a higher percentage of their investments into fixed income vehicles.

I believe that either scenario No. 1 or 2 will unfold. I lean towards the issuance of a large special dividend and a reinstatement of a regular dividend on the common stock. Selling the bank is a viable option but the current environment for the regional banks does not lend itself to an acceptable price for the bank. Marx would likely demand a price substantially over tangible book value and the current M&A environment is not likely to fetch such a price.

Scenarios No. 4 and 5 are also viable options since they would allow the controlling shareholder and other insiders to acquire the entire bank holding company (insiders own 80% of the company) or at least many of the remaining shares at a reasonable price. The controlling interest could then hold the bank until such a time that the lending environment improved which would likely trigger M&A interest. However a take private action would likely lead to class action suits as angry shareholders would maintain that they are being low-balled. Does an aging man really need that type of aggravation and delay?

Scenarios No. 1, 2, 4 or 5 will result in a rapid realization of value for BERK shareholders. The least favorable for common shareholders would be scenario 4 or 5.

Further Catalysts

Two other potential catalysts exist for BERK when preferred shares convert on October 31. First of all, if the company is not sold or taken private, it is almost certain that a dividend on common shares will be reinstated.

Secondly, the elimination of the $4.8 million annual preferred dividend will virtually assure a dramatic upswing in earnings per share. As previously stated, the dividend translates into 33 cents per share in pretax earnings.

I can not find a tax loss carry forward in any of their filings but it appears that a significant amount of carry forward should still exist on the books. The bank showed around $116 million in accrual losses in the past three fiscal years. The first six months of 2011 has produced net income of about $44 million, largely as a result of the ARS settlement. It would appear that the company still has a large amount of losses to carry forward which would offset future income taxes.

Summary

Berkshire Bancorp is a tiny undervalued bank holding company which is massively overcapitalized, even in light of future Basel 3 requirements which will not be fully realized until 2019.

The bank trades at sizable discount to tangible book value with a large cash hoard which was produced as a result of a $60 million preferred stock injection and a $42.5 million FIRA arbitration settlement.

On October 31, the preferred stock will undergo a mandatory conversion into common shares. That will likely trigger an event which will unlock the value in the bank as the aging, controlling shareholder and his co-investors will want to recover the $60 million which they invested in the preferred stock. The most likely method the principle will be recovered would be through a large special dividend. The bank is sufficiently capitalized and holds a large enough cash horde to pay such a dividend.

The elimination of the interest expense on the preferred shares will likely result in a reinstatement of the dividend on the common shares and result in a sizable boost in forward earnings. Both of the events will likely act as catalysts if the bank is not sold or taken private.

Finally, the current investment spreads are near historical highs and any increase in the loan portfolio would further increase the net income of the company.

Disclosure: I hold BERK shares in all my accounts.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 3.8/5 (16 votes)

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