FMCB - Farmers & Merchants Bancorp: Take Advantage Of The Nearly 10-Year Low Valuation Level

2023-09-20 17:14:43 ET

Summary

• Farmers & Merchants Bancorp (F&M Bank) has outperformed the S&P 500 by 16% but remains undervalued.
• F&M Bank is well-managed, recognized for its safety, and has exhibited strong performance during all kinds of downturns, including the Great Recession and the pandemic.
• F&M Bank is trading at a nearly 10-year low price-to-earnings ratio of 8.7 due to the negative market sentiment over regional banks.

Almost three years ago, I recommended purchasing Farmers & Merchants Bancorp ( FMCB ) for its promising growth prospects and its depressed valuation level due to the coronavirus crisis. Since my article, the stock has outperformed the S&P 500 by a wide margin, as it has offered a total return of 39% whereas the index has gained only 23%. Despite its vast outperformance, the stock remains cheaply valued, as it is trading at a nearly 10-year low price-to-earnings ratio of 8.7x. In addition, the bank has exhibited exceptionally strong performance in the first half of the year, much better than the vast majority of banks. Given also its industry-leading financial metrics and its exemplary management, F&M Bank is likely to highly reward those who purchase it around its current stock price.

Business overview

F&M Bank is a small regional bank, which has a market capitalization of only $720 million and operates 32 branches across the Central Valley and East Bay areas in California. Due to its size, it passes under the radar of the vast majority of investors but this is a shame, as this is an exceptionally well managed bank, with unique characteristics.

F&M Bank is the 14 ^th largest bank lender to agriculture in the U.S. and has been awarded the best possible rating of “outstanding” by the FDIC. It has also been recognized by rating firms as one of the safest banks in the country for several years in a row. The company has received a 5-star rating from BauerFinancial for 31 consecutive years. The recognition of the safety of F&M Bank is not accidental, as the bank has maintained industry-leading financial metrics for years. To be sure, its loan delinquency ratio has remained around 0.02% of total loans for several years. In addition, all the capital ratios of F&M Bank currently exceed the requirements for being classified as “well capitalized”.

Thanks to its exemplary management, which has remained at the helm for more than 15 years, F&M Bank has proved exceptionally resilient to recessions. In the Great Recession, which was the most severe financial crisis of the last 90 years, most banks incurred excessive losses and slashed their dividends. On the contrary, F&M Bank posted just a 9% decrease in its earnings per share and continued raising its dividend.

F&M Bank also proved essentially immune to the coronavirus crisis. While most banks incurred a material decrease in their earnings in 2020, F&M Bank grew its earnings per share 4% in that year, to a new all-time high. Overall, F&M Bank has proved one of the most resilient banks to recessions. This is a testament to the rock-solid business model of the company and its exemplary management.

Regional banks are facing a rare downturn this year. Due to the collapse of Silicon Valley Bank, Credit Suisse and First Republic, there was a loss of confidence in regional banks early this year. Consequently, market sentiment became extremely negative and thus regional banks incurred an indiscriminate sell-off earlier this year. F&M Bank has shed 9% this year due to the ongoing financial turmoil but the stock has been unjustly punished by the market, as the bank has kept exhibiting rock-solid business performance this year in my opinion.

In the second quarter , F&M Bank saw its net interest margin slightly contract sequentially, from 4.55% to 4.27%. Nevertheless, the bank still posted one of the widest net interest margins in the entire financial sector. Most regional banks posted net interest margin of 2.2%-3.6% in the second quarter, as they incurred a significant increase in their cost of deposits amid heating competition for deposits among banks. For instance, First of Long Island (FLIC), Cullen/Frost Bankers (CFR), Enterprise Bancorp (EBTC), Community Trust Bancorp ( CTBI ) and Huntington Bancshares ( HBAN ) reported net interest margin of 2.25% , 3.45% , 3.55% , 3.35% and 3.11% , respectively. The superior net interest margin of F&M Bank reveals some sort of a competitive advantage of the bank in its markets.

It is also important to note that F&M bank grew its deposits 2.2% sequentially. It also has $587 million in cash, $953 million in investment securities and a borrowing capacity of $1.6 billion, without any outstanding borrowings. As the liquidity of the bank is extremely high compared to its market capitalization of $720 million, it is evident that the bank is far from facing liquidity issues. In other words, F&M Bank is essentially immune to the financial turmoil that a few regional banks faced earlier this year in my view.

Moreover, F&M Bank grew its loans 2% sequentially in the second quarter. Thanks to its wide net interest margin and its negligible non-performing loans, the bank grew its earnings per share 19% over the prior year’s quarter, from $23.58 to $28.03. In the first half of the year, F&M Bank has grown its earnings per share 30%, from $45.28 to a new all-time high of $58.83. Given its sustained business momentum, F&M bank is on track to grow its earnings per share at a double-digit rate in the full year, from $96.55 in 2022 to at least $110 this year.

Growth

F&M Bank has grown its earnings per share every single year for more than a decade. During the last nine years, the company has grown its bottom line at a 13.5% average annual rate. This outstanding performance record has resulted from a material reduction in corporate taxes in 2018, the acquisition of Delta National Bancorp in 2016 and Bank of Rio Vista in 2018 as well as the organic expansion of F&M Bank in its markets.

On the one hand, it may prove somewhat hard for F&M Bank to keep growing its bottom line at a double-digit rate in the future. On the other hand, given the impressively consistent performance record of the bank and its exemplary management, I believe it is reasonable to expect continued growth for many more years, possibly via acquisitions of smaller regional banks.

Valuation

Due to the negative market sentiment over regional banks, F&M Bank is currently trading at a nearly 10-year low trailing price-to-earnings ratio of 8.7x. This is an extremely cheap valuation level for this bank, which is one of the safest and most reliable in its sector. Whenever the market sentiment over regional banks reverts to normal, F&M Bank is likely to enjoy a significant expansion of its price-to-earnings ratio, from 8.7x towards the 10-year average of 13.1 of the stock. Therefore, even if F&M Bank does not grow its earnings per share in the upcoming years, I believe it has up to 50% upside potential (=13.1/8.7 – 1) thanks to an expected normalization of its valuation level.

Dividend

F&M Bank is offering a dividend yield of only 1.7% and hence it passes under the radar of most income-oriented investors. However, the company has a payout ratio of only 15% . This means that F&M Bank could offer a much more generous dividend, but it prefers to reinvest its earnings in its business. As this capital allocation strategy has proved highly rewarding, the shareholders should be satisfied with this strategy.

It is also remarkable that F&M Bank has paid dividends for 88 consecutive years and has grown its dividend for 58 consecutive years. As a result, it is a member of the best-of-breed group of Dividend Kings. Notably, F&M Bank has the 15 ^th longest dividend growth record in the stock market. The impressive dividend growth record is a testament to the consistent and reliable growth trajectory of this high-quality bank.

Risk

Just like most banks, F&M Bank is likely to be hurt in the event of a severe recession. In such a case, interest rates are likely to decrease significantly and thus they are likely to drive the net interest margin of the bank down. In such an unfavorable scenario, the stock of F&M Bank is likely to come under pressure, particularly given its low trading volume.

On the other hand, F&M Bank has proved one of the most defensive banks during all kinds of downturns, including the Great Recession, the pandemic and the downturn of regional banks earlier this year. Therefore, even if a recession shows up, F&M Bank is likely to endure it easily and emerge stronger whenever the economy recovers.

Final thoughts

F&M Bank is one of the highest-quality banks, with an outstanding performance record and proven resilience to recessions. Thanks to its nearly 10-year low valuation level, F&M Bank is likely to highly reward those who purchase the stock now and wait for the market sentiment over regional banks to normalize. I think the only reason that the stock passes under the radar of analysts and most investors is its small market capitalization and its low trading volume.

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