Financial institutions have seen drastic regulatory changes and record-low interest rates since the collapse of the U.S economy in 2008. In fact, the Fed is still buying $45 billion in bonds per month as a way to keep rates low and stimulate the economy. As the economy slowly recovers toward pre-crisis levels and the bond-buying program ceases, interest rates should begin to increase to normal levels. Even though most of the major banks predicted these rate increases, the 10-year Treasury rate still yields 2.6%, and the Fed has yet to increase short-term rates. As these interest rates normalize and begin to rise at a faster rate, how will banks be affected? I believe that this recovery period has been far from a normal interest rate environment. Therefore, certain high-quality banks become unappreciated and overlooked, creating opportunities for investors. I believe that QCR Holdings (QCRH) is one of those high-quality banks, given its incredibly cheap valuation and history in net income growth. I will explain why QCRH is unappreciated and why from a valuation perspective this bank provides an opportunity for capital appreciation.
Why the Stock is Unappreciated
QCRH is a multibank holding company headquartered in Moline, Illinois. It provides consumer and commercial banking, trust services, and asset management services for the Quad City, Cedar Rapids, and Rockford areas. Just as any traditional bank does, QCRH accepts deposits from its customers and invests in loans, leases, and securities. Its business model relies on net interest income, or the difference between interest income and interest expense, and the quality of its services. QCRH's net interest income has been quietly increasing since the crisis, and consequently the company's shareholders should be rewarded.
Investors looking for value in the banking sector may not look closely at a bank this small. This makes perfect sense for several reasons. First, investors are relatively uninformed about small companies compared to large companies. They likewise will prefer investing in large companies directly or in small companies via small-cap ETFs as opposed to investing in the small companies directly. Second, smaller companies are riskier than larger companies. However, with greater risk comes greater reward. Regardless, QCRH is a hidden gem, trading at a market cap of only $136 million. This is much smaller than its close competitors, including First Midwest Bancorp Inc. (FMBI), trading at a market cap of $1.3 billion, and U.S Bancorp (USB), trading at a market cap of $78.5 billion. QCRH's size is part of the reason as to why it is relatively unknown.
Additionally, the stock's average daily volume is approximately 8,700 shares. At a current share price of $17.18, this equates to roughly .11% of its market cap. Therefore, any significant buy or sell order can influence the stock price, and even compared to competitors of similar size, QCRH is underappreciated. Many small-cap banks have significantly higher volumes relative compared to QCRH. They also tend to have a larger percentage of their market cap trade daily. Consequently, this is yet another reason why QCRH is unappreciated.
($17.18 per share * 8700 shares) / ($136 M) = .11%
Why the Stock is Undervalued
It is very astonishing to me that a bank stock performing very well since the financial crisis can be so underappreciated. It would be a different story if the bank took a major hit during the crisis, as almost all banks did, and simply failed to recover. Over the past 5 years, earnings per share have increased by 57.7% per year. Especially considering that the company recorded EPS of $ -0.46 per share in 2009, this is an astonishing accomplishment. The bank is showing no signs of slowing down either, as Chairman James Brownson notes in his annual letter to shareholders:
"Despite an unsettled backdrop of an uncertain economy and an ever-challenging regulatory environment, our teams executed on our strategic initiatives for another record year.
For 2013, our annual earnings were up 18% from the prior year. For the year ended December 31, 2013, net income attributable to QCR Holdings Inc. was $14.9 million, resulting in diluted earnings per share of $2.08 after preferred stock dividends of $3.2 million. For the same period in 2012, we reported net income of $12.6 million, or diluted earnings per share of $1.85 after preferred stock dividends of $3.5 million."
Source: QCRH 2013 Annual Report
Net interest income grew by 7.5% per year since 2008 as loan growth and rising interest rates helped create more business opportunities. I expect this trend to continue as the improving economy creates more business and higher interest rates allow QCRH to lend at more profitable rates.
It is also important to note that QCRH acquired Community National Bank in Cedar Falls, Iowa, adding almost $280 million in assets and $1.8 million in purchase gains. QCRH incorporated this acquired business into its current Cedar Rapids entity, which should improve the entity's efficiency and financial results. This illustrates a successful acquisition that not only increased the bottom line but also reflected a smart strategic move by company management.
Additionally, QCRH converted all of its "Series E" preferred stock into common stock, which is consistent with the company's long-term capital plan. It increased their tangible common equity ratio by 100 basis points and eliminated preferred dividends on the balance sheet.
Now let's take a look at the company's valuation metrics. The following chart illustrates just how much of a bargain QCRH is trading for (Source).
As the green bars illustrate, QCRH is extremely undervalued in every category relative to both its industry and its own history. Despite QCRH's outstanding earnings growth during the past five years, the valuations simply have not taken this into account. Given that earnings have grown at a much faster pace than the banking industry as a whole and the company's close competitors, a more appropriate valuation would be closer if not higher than the industry average. Although depressed valuations may signal a bleak future in earnings growth, I believe that this is not the case. As the economy strengthens, the demand for loans will increase, and QCRH will be able to lend at higher rates, increasing net interest income and hence profitability. Simply put, the potential for QCRH's loan growth and rising interest rates should equate to a valuation more in line with the industry average.
The following chart compares QCRH to some of its peers and the U.S Regional Bank industry. Clearly, QCRH separates itself from everyone else.
|P/E (ttm)||P/B||5 Year EPS Growth|
|U.S Regional Bank Industry||15.7||1.23||8.30%|
Take West Bancorp (WTBA) as an example. It has grown its earnings at a double-digit pace during the past five years. It is appropriately valued to its growth, trading at a slight discount to the industry average. QCRH, on the other hand, is trading at a significant discount of nearly 55% compared to its industry but has been growing at a significantly faster pace. Should investors treat QCRH the same as its peers, there is large amounts of potential upside. In fact, an appropriate valuation at the industry average would equate to a price of $31, representing over 80% upside. Although QCRH certainly may not realize this potential upside, it is certainly trading at a bargain right now. Additionally, QCRH is trading at a bargain relative to its own history. Its valuation metrics were much more expensive before the crisis hit. At one point, its P/E ratio was 66 and its P/B ratio was more than twice what it is now.
Further, insiders have increased their ownership from 5% to 8% in during the past few years. This properly aligns the incentives of the insiders because they are betting their own money on their own company. This is a bullish sign for investors considering a purchase in the company's shares. Insiders clearly have the best perspective on the future of the company and its future stock performance. The following chart illustrates insider transactions over the past six months and over the past year. The first column shows the number of buy and sell transactions during each time frame. The second column shows the number of shares purchased and sold. Clearly, insiders are buying more shares than they are selling, and this is a very good sign for prospective investors.
I expect that QCRH will increase in value over the next several years given its cheap valuation and future growth prospects. The company's size is growing very rapidly, and this should attract more attention from large investors. As the company grows, the apparent mispricing between the current price and intrinsic value should become more apparent. Comparisons to the company's industry and history both illustrate this mispricing.
Risks and Concerns
Before making any investment, all investors should conduct their own proper, independent due diligence.
QCRH faces several risks that should be taken into consideration. First, although it is growing quickly, the company is still relatively small compared to most regional banks. A lack of growth will keep this company off investors' radar, which would prevent it from realizing its intrinsic value. Second, QCRH relies on rising interest rates to keep growing its net interest income. This will become a problem if rates stay unexpectedly low. Although the Fed recently announced that it would lower its monthly bond-buying program by $10 billion, it does not forecast short-term interest rates to increase significantly until 2015 or 2016. However, it is important to note that QCRH has been able to increase net interest income during this low-rate environment.
Third, QCRH's financial strength is mediocre. Its interest coverage ratio is at the industry's median of 1.1. This means that the company is able to cover its interest payments slightly more than once. I would like to see QCRH management increase this ratio to at least 2 or 3. Its Total Equity/Total Assets ratio currently stands at 6% compared to the industry average of 9%. According to Gurufocus.com, this ratio is higher than only 51% of the companies in its industry. However, management is aware of this problem and is making efforts to improve its financial strength. The following excerpt comes from the company's 2013 annual report:
"We remain committed to a strong capital position - not only with regard to total capital, but with regard to mix and cost as well. We remain strongly committed to our long-term capital plan of self-generating the capital necessary to grow tangible common equity to a target range of 6.00% to 7.00%.
Tangible common equity grew from 3.56% of total tangible assets at December 31, 2010 to 3.85% at December 31, 2011 to 4.02% at December 31, 2012 and to 4.71% at December 31, 2013."
QCRH still has room for improving its financial strength, but it is a very good sign to know that management is aware of the problem and committed to reaching set goals. This illustrates to me that company management has outstanding leadership capabilities.
The U.S economy is slowing returning to a period of normal interest rates. The Fed is slowly winding down its bond-buying program, which should increase rates in the next few years. Many banks predicted a Treasury 10-year yield of over 4% by the end of 2014. This may not happen, but I expect rates to increase significantly by the end of 2015. Also note that the Fed will begin to increase short-term rates either in 2015 or 2016.
QCRH is in a great position to take advantage of rising rates because business activity and lending rates will increase. This will increase net interest income and ultimately the bottom line. QCRH is trading at a significant bargain, and as the company continues to grow, I expect the mispricing between the current price and intrinsic value to narrow. By the end of 2015, I see potential upside of nearly 50%.