The case for First Security Group (FSGI) is interesting. It is bank holding company that is obscure, cheap and unloved. As the company completed the recapitalization earlier this year, I think the market has been under-appreciating its potential to return to growth and profitability as a result of the much-needed recapitalization.
Business and History:
First Security Group is a bank holding company headerquartered in Chattanooga, Tennessee. It was founded in 1999 and its bank subsidiary, FSGBank has 30 full-service banking offices along the interstate corridors of eastern and middle Tennessee and northern Georgia. In Dalton, Georgia, FSG Bank operates under the name "Dalton Whitfield Bank," and along the Interestate 40 corridor in Tennssee, FSGBank operates under the nmae "Jackson Bank & Trust."
FSGBank offers a range of lending services that are primarily secured by single and multi-family real estate, residential construction and owner-occupied commercial buildings. The bank focuses on serving the needs of small-to-medium-sized businesses, by offering a range of lending, deposit and wealth management services to these businesses and their owners.
FSGBank's principle source of funds for loans and securities is core deposits gathered through its branch network. The bank offers a wide range of deposit services including checking, savings, money market accounts and certificates of deposits, and obtain most of its deposits from individuals and businesses in its market areas, including the vast majority of loan customers
The Bank has a wealth management division that offers private client services, financial planning, trust administration, investment management and estate planning services. It also provides mortgage banking and electronic banking services such as internet banking, on-line bill payment, cash management, ACH originations, and remote deposit capture.
FSGI's financial strength was very poor prior to the recapitalization. Banks' financial strength can be evaluated using capital ratios.
- A “well capitalized” bank is one that is not required to meet and maintain a specific capital level for any capital measure, pursuant to any written agreement, order, capital directive, or other remediation, and significantly exceeds all of its capital requirements, which include maintaining a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, and a Tier 1 leverage ratio of at least 5%.
- An “adequately capitalized” bank meets the required minimum level for each relevant capital measure, including a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a Tier 1 leverage ratio of at least 4%.
- Banks that fail to meet the required minimum levels for either “undercapitalized” and "significantly undercapitalized" are subject to various additional operating and managerial restrictions.
|Return on average assets, excluding goodwill impairment1||-3.57%|
|Return on average common equity, excluding goodwill impairment1||-170.65%|
|Return on average tangible assets, excluding goodwill impairment1||-3.57%|
|Return on average tangible common equity, excluding goodwill impairment1||-176.59%|
|Capital & Liquidity:|
|Total equity to total assets||2.74%|
|Tangible equity to tangible assets||2.68%|
|Tangible common equity to tangible assets||-0.38%|
|Tier 1 risk-based capital ratio||4.23%|
|Total risk-based capital ratio||5.49%|
|Tier 1 leverage ratio||2.31%|
|Dividend payout ratio||nm|
|Total loans to total deposits||53.68%|
After the recapitalization, the Bank's financial strength has improved significantly as seen from the following table from the most recent 10-Q.
June 30, 2013
FSGBank Consent Order
Minimum Capital Requirements under Prompt Corrective Action Provisions
Tier 1 capital to risk adjusted assets
Total capital to risk adjusted assets
Why Has It Been Cheap?
Spend an hour or two going through FSGI's latest annual report and you will likely to find why nobody wants to own this bank holding company. Here are my summaries:
1. It is rooted in the deep southern countryside, not exciting metro New York or LA. The bank has branches in places like Dalton, Ga., and Jefferson City, Tenn., where people are super nice, but there's not a lot going on. I used to live in Atlanta, Ga. and I personally like the countryside in Northern Georgia and Southern Tennessee. However, most of my friends in the metro Atlanta areas have no interest in such places.
2. The bank was hit hard by the financial crisis and was rescued by the government under the TARP program. Even though the U.S economy has made significant progresses since the crisis and big banks such as Bank of America and Citibank have improved balance sheets dramatically, FSGBank is still suffering. The 2012 financial results are horrible:
Net loss per share: $24.58
Book value per common share: -$1.94
Tangible book value per common share: -2.28
ROA: - 3.57%.
ROE: - 170.65%
Efficiency ratio: 148.47%
Total loans to total deposits: 53.68%
Net loan charged-off to average loans: 4.52%
Net interest margin: 2.45%
Tier 1 ratio: 4.2%
Total capital ratio: 5.5%
Tier 1 Leverage ratio: 2.3%
3. Regulatory non-compliance pre-recapitalization:
First Security entered into a Consent Order with the Bank's primary regulator, the Office of the Comptroller of the Currency (OCC) during April 2010 and a Written Agreement with the Federal Reserve Bank during September 2010.
The Consent Order requires the bank to achieve and thereafter maintain total capital ratio of at least 13% and Tier 1 capital ratio of at least 9% within 120 days of the order. However, as we can tell from the above financial information, the bank was not even close to meeting those requirements.
At Dec. 31, 2012, the bank's Tier I leverage ratio fell below 3% and was reclassified from "undercapitalized" to "significantly undercapitalized." This status severely restricted its ability to take deposits and give out loans.A few years ago the bank has a total loan to total deposit ratio of over 90% and it as only 53.68% at Dec. 31, 2012. However, as a result of the recapitalization (to be discussed later), the bank has been able to meet most of the requirements and should be able expand its loan portfolio further.
4. Too small to be noticed:
The market cap of First Security is only $129 million as of Oct. 4, 2013. FSGBank has an asset base that is just over a billion USD, which is very small even for regional banks. It is very unlikely institutional investors will spare any time analyzing a bank as small as FSGBank located in the deep south.
Before proceeding any further, an explanation of a bank recapitalization seems warranted in order to fully understand the implications of such events. In simple terms, recapitalizing a bank means restoring the bank's balance sheet to a healthy level such that the equity (capital) provides a decent cushion for possible future declines in asset values.
Going back to accounting basics, assets minus liabilities equal equity. In the case for banks, as they are usually highly leveraged with asset/equity ratio often more than 10 times, a 1% decline in assets value can be disastrous to equity value. Specifically for FSGBank, at Dec. 31, 2012, it has $1.06 billion worth of assets and only $29 million worth of equity. Of the $1.06 billion assets, only $527 million was net loans. The majority of other assets are cash and investments that are earning very low returns. If the bank does not recapitalize and wants to shore up its higher earning loan assets to say $900 million, a 3% decline in loan value will almost wipe out all the equity. Of course the regulators won't let the bank take such risks.
In a recapitalization process, banks usually go out to institutional investors and ask for injection of equity capitals at possibly a very low price in exchange of ownership. The equity investors take on the risk of a failing bank but will also get massive rewards if the recapitalization is successful. The banks will get more core capital and have more cushion for potential decline in assets value. Let's say FSGBank was able to raise $60 million total capital net of all fees, it will then have a post-recapitalization equity of $89 million - a very notable improvement of $29 million. Again assuming the Bank want to increase the loan balance to $900 million, now it will take a 10% decline in loan value to eliminate the equity value.
Of course in a recapitalization process like this, existing shareholders' ownership percentage in the bank will be drastically diluted. However, without the dilution, these equity investors financial interests face the real possibility of a complete wipe-out.
The recapitalization plan was announced at the end of February. As detailed in a company press release, a definitive stock purchase agreement was entered with institutional investors as part of an approximately $90 million recapitalization. Four investors led the recapitalization, which also included a conversion of the Company's TARP CPP preferred stock to common stock and the sale of under- and non-performing loans. The lead investors each invested approximately $9 million to acquire pro-forma ownership of approximately 9.9% of the total outstanding common stock, respectively.
FSGI's plan was to "downstream a majority of the net proceeds to FSGBank in order to support future balance sheet growth as well as fund the losses associated with the completed loan sales. The combined effects of the additional capital and the loan sale are expected to result in an improved risk profile, enhanced profitability and compliance with most, if not all, aspects of the regulatory orders of the Company and FSGBank."
The following information from the latest 10-Q illustrated the effect on capital ratios as a result of the recapitalization:
On April 23, 2013, FSGBank filed a cash contribution to capital notice with the OCC certifying a $65 million capital contribution by First Security Group into FSGBank. With the capital contribution, FSGBank's proforma regulatory capital ratios as of March 31, 2013 changed as follows: Tier 1 leverage ratio from less than 2.0% to 8.1%, Tier 1 risk-based capital from 3.4% to 14.5% and total risk-based capital from 4.7% to 15.8%. All proforma regulatory capital exceed the percentages of a well capitalized institution as defined under applicable regulatory guidelines. FSGBank will continue to be classified as adequately capitalized due to the capital requirement in the order.
The following table compares the required capital ratios maintained by the company and FSGBank:
June 30, 2013
FSGBank Consent Order
Minimum Capital Requirements under Prompt Corrective Action Provisions
Tier 1 capital to risk adjusted assets
Total capital to risk adjusted assets
As we can tell, the resultant capital ratios have improved dramatically from those at Dec. 31, 2012, and now FSGBank is considered to be adequately capitalized. This has cleared the way for the bank to lending out more loans in the future as the economy keeps muddling through and non-performing loans as well as net charge-off ratios are improving.
There are a few other catalysts that will help the recapitalized FSGBank to grow its loan portfolio and return to growth and profitability.
1. The recapitalization will remove most of the restrictions on the bank so that the asset mix will improve considerably from current levels.
2. The bank's balance sheet is asset-sensitive, which means that earning assets reprice faster than interest bearing liabilities and thus interest income increases faster than interest expense in a rising interest rate environment. As the Fed has to start tapering sooner or late, the bank will benefit from rising interest rates in the coming years.
3. More than 10% of the bank's market is affected by the home furnishing and carpet industry (Mohawk Industries, a leading carpet manufacturer is located close to the Dalton, Ga., area). As the housing market continues its recovery, the related home furnishing and carpet industry should see continuous improvement as well, which should benefit the Bank eventually.
4. Favorable local economic trends as a result of investments by large multi-national companies. These investments will likely stabilize and possibly increase real estate values within the bank's market area.
- Amazon.com opened two distribution centers in FSGBank's market in 2011. The $139 million investments created more than 2,000 full-time jobs and additional 2,000 seasonal jobs in two counties that FSGBank has a presence in. Amazon has also expanded its Chattanooga facility, and the expansion has translated into additional hiring of approximately 5,000 in 2012.
- Volkswagen automotive production facility has produced more than 100,000 Passats since May 2011. VW has invested $1 billion in the local economy for the Chattanooga plant and created more than 2,200 direct jobs in the region. According to independent studies, the VW plant is expected to generate $12 billion income growth and an additional 9,500 jobs related to the project.
- Wacker Chemical is building a $1.8 billion poly-silicon production plant for the solar power industry near Cleveland, Tenn. The plant is expected to create an additional 600 jobs with the current staffing level of 280.
6. The bank currently has a large portion of brokered deposits, which bear higher interest rates than regular deposits. These broker deposits are expected to mature in the following year so interest expenses should be lower in the future.
FSGBank recruited Michael Kramer as its chief executive officer of First Security since December 2011. What's interesting is that Mr. Kramer was president and CEO of Ohio Legacy Corporation, a bank holding company based in Wooster, Ohio. During his five-year tenure, he led a board and management reorganization, executed a credit turnaround strategy and balance sheet transformation, which resulted in the recapitalization of the company by Excel Bancorp. His experience in a previous recapitalization situations could be valuable to the bank.
Another noteworthy point is that as a result of the recapitalization, MFP Partners LP and Ulysses Partners LP would each designate an individual to serve as a director of the company, each subject to regulatory non-objection. MFP Partners is led by legendary value investor Michael Price. His deep knowledge of the banking industry will most likely turn out to be beneficial to the post-recapitalization of the bank.
I am not a fan of using Excel to build up complex valuation models based on numerous key assumptions. If the stock is cheap, ideally it should be proven so using a back-of-the-envelope calculation.
Currently, FSGI has a book value of $1.57 per share. Coming out of the recapitalization, book value is likely to grow 10% to 15% per year. My investment horizon for FSGI is three years. Using the lower end of 10%, FSGI's book value in three years will be approximate $2.10. In normal times, banking stocks typically trade at anywhere between two and three times book value. Even though most banks are trading either below book value or slightly above book value currently, in three years, the banking industry will likely be in a better shape despite a more stringent regulatory environment. Therefore, a P/B multiple of 2 seems justified.
Applying a P/B of 2 to terminal book value of $2.10, I get $4.2 per share. I normally use a 10% discount rate to get to the present value. In this case, my present value calculation ends up $3.16 per common share.
FSGI is trading at $2.04 as of Oct. 4, 2013, which implies the margin of safety is 35%.
Of course we have to consider alternative scenarios. The above is the most likely scenario to me. However, a bear case can also be built for FSGI.
In a bear case, book value may stay stagnant despite the recapitalization, and the P/B multiple of regional and small banks may stay around 1.2 times book value. In this case, the terminal value is reduced to $1.88 and present value is reduced to $1.42 per share.
The risk reward ratio thus is ($3.16-$2.04)/($2.04 - $1.42)= $1.81 rewards for every $1 of risk.
- A dysfunctional D.C. can hurt the U.S economy, which will in turn negatively impact the markets in which FSGI operates.
- Larger commercial banks may erode FSGI's territory and steal customers away.
- Investors' perception for the banking industry may stay negative to neutral and multiple expansion may not happen in a few years.
- Local economic recession may occur in Northern Georgia, Eastern and Middle Tennessee.
- Further decline in loan portfolio value may restrict the bank's ability to expand.
The following definitions are taken from S&P Capital IQ's Industry Survey - Banking
Leverage ratio:Tier 1 capital (mainly comprised of common stock, retained earnings and perpetual preferred stock) divided by average total consolidated assets.
Tier 1 capital ratio: Tier 1 capital divided by risk-weighted assets. Each asset is assigned a different risk level. For example, cash and short term investments are considered to be almost risk-less whereas non-secured loans are of higher risk.
Total capital ratio: This ratio is calculated by dividing total capital (Tier 1 plus Tier 2 capital, which includes loan loss allowances and subordinated debt) by risk-weighted assets.
Net interest margin (NIM): The NIM is calculated by dividing net interest income by average earning
assets. The NIM can vary with the particular business mix and risk taken.
Provision for loan losses: The provision, which appears on the income statement, is a quarterly charge taken against earnings; the charge then goes into an allowance to cover possible loan losses.
Noninterest expenses and the efficiency ratio: Noninterest expenses represent all expenses incurred in operations, including such items as personnel and occupancy costs. To calculate the efficiency ratio, add back foreclosure and repossession expenses, amortization of intangibles, and impairment of goodwill to noninterest expenses; then divide that figure by total revenues (calculated by adding tax equivalent net interest income and noninterest income).
Net charge-offs: Net charge-offs consist of gross charge-offs netted against recoveries. Gross charge-offs represent impairments in the value of loans and leases deemed uncollectible by management. Recoveries represent the value of amounts collected in excess of the carrying value on previously impaired loans and leases. Net charge-offs are usually measured as a percentage of average loans outstanding during a given period. For banks, annualized net charge-offs typically range between 0.1% and 2.0% of total loans. A higher percentage of net charge-offs implies that a bank has a risky loan portfolio.
Nonperforming loans: Loans on which income is no longer being accrued and repayment has been
rescheduled are considered nonperforming.
Disclosure: Long FSGI.