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Beckley
Saturday, March 28, 2020 4:43pm

Great American Bancorp: A Justified Discount – Great American Bancorp, Inc. (OTCMKTS:GTPS)



Great American Bancorp (OTCPK:GTPS) is a two branch community bank serving Champaign-Urbana, Illinois. Great American has certain attractive features despite its small size, including an incredibly low cost deposit base, decently high proportion of noninterest income, and very modest valuation multiples on book value (less than 50%) and earnings (approximately 6 times on a trailing basis). However, the company also has some significant drawbacks, including a general lack of communication to shareholders, lack of growth, and a management that does not appear interested in or willing to take the actions necessary to leverage the company’s structural advantages for the benefit of shareholders.

Great American should remain profitable although weakness in net interest income and variability in noninterest income will likely result in ongoing volatility in earnings per share. Indeed, relatively modest changes in net income result in significant changes in earnings per share due to the small outstanding share base. The result is purely perceptual, of course, since earnings per share and net income are inherently linked, but some shareholders will be unsettled to see swings of more than a dollar in earnings per share from year to year based on the company’s performance on sales of loans and other volatile factors which don’t represent as high a proportion of net income at most other community banks.

Still, even if the company continues to accrue equity, past experience suggests it’s doubtful the company can (or will) deploy that equity to support growth. The current quotation well below book value and at a single digit price-to-earnings ratio aside, the bank’s appeal is tempered by no growth in loans and a management which has deployed more than $65 million – about 40% of the company’s interest earning assets – in cash deposits with other financial institutions.

On balance, certain investors willing to accept the low liquidity, concentrated ownership, and lackluster management performance may still find value in the company. Great American, for all its flaws, is at least not quite among that cohort of small community banks, often with significant insider and particularly family control, which struggle to operate profitably with returns on assets and equity in the low single digits. The risk does exist, though, that it could slide into such a position should management continue on a course which eschews effective investment of the company’s growing and virtually interest free deposit base. In a current condition scenario, we believe the company’s fair value is in the range of $22.00 to $26.00, approximately 5% to 24% above the current quotation. However, in the event the company were able to effectively deploy its large cash balance by expanding the loan portfolio, the company could be worth as much as $45.00 to $50.00, more than twice the current quotation. It’s debatable, though, whether the institution will ever achieve such performance.

Overview

Great American is the eighth largest financial institution in Champaign County by insured deposits. The company holds a 2.7% market share, slightly down over the last decade, in a very crowded market with 29 competing institutions.

Great American has essentially remained the same bank over much of that time with assets, deposits, and loans remaining virtually unchanged over the years. Remarkably, of the company’s $172 million in total assets, $69.9 million – more than 40% – is held in cash and cash equivalents including interest bearing deposits at other banks. The company’s loan portfolio, which declined to around $95 million at the end of the last year, is essentially all concentrated in real estate lending with 49% of loans in first lien residential mortgages and 38% in commercial real estate loans.

It’s not clear why the company has struggled to grow loans in its core market. Champaign County, Illinois, and the Champaign/Urbana metropolitan region is a reasonably good market with consistent population growth, large business presence, and an economy anchored by both the University of Illinois, the state’s flagship public university with 45,000 students, and healthcare which combined employ nearly 10% of the county’s population.

The cash and cash equivalents severely impair the company’s potential profitability. In the last year, the company earned an average interest rate of 5.0% on loans versus 2.1% on interest bearing deposits in other banks. The interest income from deposits in other institutions is not especially poor – it’s roughly comparable to the rates of return other small community banks, such as FNB, Inc. (OTCPK:FIDS), receive on their short-dated investment securities portfolios. Nonetheless, were the company able to leverage its deposit base to grow the loan portfolio, the company’s profitability would improve significantly. The current capital distribution, in the light of high noninterest expense, results in a consistently high efficiency ratio. The efficiency ratio for the last year, which was itself quite good for the company, remained stubbornly high at slightly under 80%.

Interestingly, the company’s income tax rate also remains quite high despite the reduction in corporate tax rates. The company’s effective combined tax rate of 30% is driven in part by high corporate income taxes in the state of Illinois.

Deposits

Great American’s key asset is the company’s extraordinarily low cost deposit base. In the year ended December 31, 2019, the company reported interest expense on deposits of a mere $110,000 on interest bearing deposits of $116 million, an effective cost of deposits less than 0.1%. The company’s entire deposit base of $150 million is, in essence, virtually all noninterest bearing.

The low cost of deposits is one of the company’s most remarkable features and is a large part of what allows the company to remain profitable despite its lackluster performance in deploying those deposits into interest earning assets. In the event the company were to leverage those deposits over a higher earning asset base, the company’s operating performance would be exceptional among small community banks.

On the other hand, the company’s exceptionally low cost deposits actually exposes the company to more net interest income volatility since it limits the company’s ability to leverage lower interest rates by offsetting declining average interest rate earned on assets through declining deposit rates. In a rising interest rate environment, the company would gain leverage as asset yields rose faster than yields on liabilities. Unfortunately, the short-term trajectory of interest rates was flat to downwards before the recent market crash which has resulted in the Federal Reserve targeting, effectively, benchmark interest rates at or just above zero.

Noninterest Income

The company’s other attractive attribute is a concentration of revenues in noninterest income much of which is generated from relatively stable and recurring sources such as insurance commissions and customer service charges. Noninterest income often provides a reliable revenue source for banks which can mitigate changes in net interest income. Banks with high proportions of net noninterest income relative to net interest income often trade at a premium to the overall sector due to the reliable and recurring nature of the revenues. Of course, this is not the case with respect to Great American.

Excess Cash

Great American’s greatest issue is the company’s persistent tendency to hold a significant amount of excess cash in lieu of deploying those funds into loans. The company has exhibited little ability to grow the loan portfolio over the last several years as loans have stagnated around $100 million before falling to $95 million at the end of the last year.

The impact on the company’s operating results associated with not deploying these funds to grow the loan portfolio is quite stark. The deployment of every $10 million that the company is able to shift from deposits at other banks to the loan portfolio would result in additional annual earnings per share in the range of $0.35-$0.37 depending on one’s average yield and tax rate assumptions. However, management has clearly demonstrated a lack of interest or ability in deploying these funds through lending despite operating in a growing market area.

Asset Quality

The bank’s asset quality is another source of concern. Great American’s asset quality and allowance for loan losses were generally typical for community banks in general up until the third quarter of the prior year. The company’s nonperforming loans jumped from $1.1 million to $3.6 million in the course of the quarter while the company maintained its allowance for loan losses and made no provisions for loan losses in the income statement. Nonaccrual loans, which are distinct from nonperforming loans, were $3.4 million with another $1.0 million in past due loans. The allowance for loan losses actually declined slightly to $944,000 at the end of the year, a mere 26% of nonperforming loans.

Remarkably, the company’s perfunctory (and generally uninformative) quarterly report and subsequent annual report didn’t even reference the threefold increase in nonperforming assets much less provide a reason for the sudden increase. The lack of any commentary is even more remarkable considering that $3.6 million represents 20% of the company’s shareholders equity – a not insignificant proportion far beyond that of most community banks. The largest increase in nonperforming assets over the course of the last year was concentrated in non owner occupied residential real estate, somewhat less secure asset than owner occupied properties.

Nonetheless, charge-offs have remained virtually nonexistent over the last two years despite the acceleration in nonperforming assets. The same is true for the allowance for loan losses. The company accrued no provisions for loan losses during the course of the year even as the allowance for loan losses declined from approximately 100% of nonperforming loans to a mere 27.5% of nonaccrual loans.

Insider Ownership and Voting Restrictions

The Rouse family holds a significant interest in the company’s outstanding shares – approximately 18.5% – giving the family significant influence if not control.

Interestingly, Great American Bancorp has a provision in its articles of incorporation which provides that shareholders holding more than 10% of the company’s outstanding shares are not entitled to vote shares held in excess of the 10% threshold. The limitation cuts both ways – while the Rouse family ownership is thus reduced in terms of its voting effectiveness, it also limits the potential influence of an activist investor.

The lack of liquidity would also make it difficult for an activist to acquire the company’s shares at a reasonable price. In the last six months, roughly 12,000 shares have traded, a mere 2.7% of the company’s outstanding shares.

Acquisition Potential

Great American would be a valuable addition to any bank looking to expand in the Champaign County region, of which there are several candidates, and would be a small acquisition for almost all of the other institutions in the market. However, while the company’s deposit base is quite attractive, the company’s low market share doesn’t provide a very strong base from which to expand operations and acquirers looking at the area may be more interested in acquiring a larger footing than trying to build from an already small base.

Ironically, the company’s incredibly low-cost deposit base may in fact be an impediment to an acquisition. The unique nature of the company makes it difficult to believe that an acquirer would be able to effectively retain the company’s deposit base – or integrate the company into its own operations – without experiencing an increase in interest expense related to deposits. The increase would erode at least some, and quite possibly a good deal, of the underlying value as deposits either abandoned the acquiring institution or were retained at much higher interest rates.

On the whole, we don’t think Great American will be an acquisition target in the foreseeable future unless the Rouse family decides to sell the bank. Ironically, on the other hand, the possibility of a sale may actually increase in the event the significant increase in nonperforming assets results in significant losses, impairing equity ratios, such that a sale is the most viable option. The sale of Peoples Bankshares (OTCPK:PBVA) in Virginia after a large loss on loans would be an example of such an outcome. In one of the more bizarre outcomes not entirely infrequent amongst community banks, the company’s shareholders could realize a meaningful profit from a significant loss.

Valuation

Typically, community banks with low cost deposit bases and high noninterest income often trade at a premium – and often a significant one – to their peers due to the structural advantages inherent in these attributes. However, this is not the case with Great American, largely due to management’s apparent inability or unwillingness to take full advantage of the opportunity to achieve a truly high performing institution.

The differential makes a valuation of the company somewhat difficult since, regardless of what comparable valuations would suggest, this discount associated with management inertia is more difficult to assess.

On the whole, we believe the current quotation, having declined by nearly a third in the last month, only slightly undervalues the company despite the discount to book value and low earnings per share multiple due to the significant exposure to declining interest rates and management’s unwillingness to change the bank’s trajectory. In the event operating performance declines in the face of shrinking net interest margin due to declining average interest rates earned on assets or additional loan loss provisions, it’s not unreasonable for the shares to trade closer to $22.00 to $26.00 per share. A valuation in this range would be equivalent to similarly poorly performing institutions, such as Southern Banc Company (OTCPK:SRNN), with below average returns on assets and equity and ineffective entrenched managements.

However, there is significant variability in the potential earnings estimates for the company depending on one’s base assumptions. For example, we estimate that a 50 basis point decline in the company’s average yield on loans would result in earnings per share declining by some $0.75 to $0.80 per share. In the current interest rate environment, it’s certainly not difficult to see such an impact and possibly a larger one on average yields over time. Operating performance on this level would justify the low end of the valuation range.

On the other hand, were the company to effectively deploy the large cash balance into new loans, even at a reduced average yield, we estimate earnings per share could be as high as $4.50, in which case a valuation of $45.00 to $50.00 may even prove slightly conservative. Clearly, the potential range of valuations under different circumstance is quite large for the company, though we consider this latter outcome a more remote possibility.

Conclusion

Great American, on first glance, appears to be a potentially appealing financial institution with a valuation well below book value and a single digit price-to-earnings ratio. However, despite its attractive features, the company has a management issue that will likely impede realization of the bank’s position for shareholders for the foreseeable future.

The company has the attributes necessary to make it a remarkably profitable – and valuable – financial institution. The company’s management, however, has clearly expressed no interest in taking the actions necessary to realize that potential. In other words, short of a sale of the institution or a radical change in operations, the company’s shares hold limited appeal.

Disclosure: I/we 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.





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