LSBK - Lake Shore Bancorp Priced Optimistically Not An Opportunity

Summary

• Lake Shore Bancorp is a nationally chartered bank with a strong local operation in northern New York. The bank concentrates 15% of deposits in Chautauqua county.
• The bank has grown deposits, increased efficiencies, and its interest margin. The results are profits growing above assets.
• However, the bank has been found at fault regarding BSA/AML regulations by the OCC. Compliance costs will be a long-term drag on profitability.
• Further, the reputational costs of the OCC issue could increase the company's cost of funding or lead to higher redemptions. These redemptions must be covered with a small securities book at heavy capital losses.
• LSBK stock can offer forward earnings multiple of 15x only under an optimistic scenario. Although I believe the company deserves a premium, the stock price provides no margin of safety at these levels.

Lake Shore Bancorp ( LSBK ) is the bank holding company of the Lake Shore Savings Bank, a federally chartered bank from the Buffalo area.

The bank has sustained a high market share in a concentrated market. It has grown deposits, improved profitability, and increased EPS above assets.

Further, the company did very well during the GFC. It is mostly deposit financed, has a resilient loan book, and a successful mortgage origination operation.

Unfortunately, the company has received a cease and desist order from the OCC related to failures in its fraud prevention and anti-money laundering systems. The company has effected several key management changes in the past few months and has recorded extra expenses related to this compliance.

Although I do not believe the OCC orders imply a significant risk, compliance requires higher future expenses. If the bank's interest costs also increase, profitability will suffer in the medium term. I do not consider LSBK an opportunity at these prices.

Note: Unless otherwise stated, all information has been obtained from LSBK's filings with the SEC . LSBK is used interchangeably for the bank and the bank holding company.

Business description

A local federally chartered bank : LSBK is a national bank, but the company only operates in the area surrounding Buffalo in New York. In particular, the company obtains more than half of its deposits from the county of Chautauqua. According to the FDIC , the company has maintained a 15% deposit share in this area since 2000. However, it is only the 5th in the ranking because other two banks have 15% as well, and the remaining two have 20% and 25%. It is a concentrated market. When the county of Erie is incorporated, LSBK's share falls to less than 1% because Buffalo is part of Erie.

Demographic data not great : The Jamestown-Dunkirk-Fredonia MSA, which includes Chautauqua county, has been declining in working population significantly and consistently. Its median age (43) is above the national average, but its median household income is below. The larger city of Buffalo suffers a similar situation, losing population. New York is one of the heaviest taxed states , both at the individual and corporate level, and has suffered from net emigration.

Growing profitably : LSBK has been nonetheless able to grow its deposits (first chart below). Most importantly, it has done so while maintaining efficiencies (second chart below) and growing its net interest margins (third chart below).

This has resulted in net interest income and EPS that grow faster than assets, a sign of managerial ability (first chart below).

Mortgage origination business : LSBK is an originator and reseller of FHLMC-qualifying mortgages. This provides an additional source of income, although this channel has dried up in the last year.

Strong ownership : The bank holding company is owned by Lake Shore Mutual Holding Company, concentrating 62% of the shares of LSBK. I prefer companies with strong owners because they have more agency than small shareholders to direct the company's business.

An interesting aspect of LSBK is that its holding company, LSMHC, has waived its right to receive dividends. There is no counter payment in the form of shares or special rights for this waiver.

Capital allocation

Mostly variable, commercial real estate loans : LSBK's loan book is relatively well prepared for the higher rate scenario ahead because a significant part of its loans is variable-rate. As of FY21, 53% of its loans were adjustable-rate, most in the commercial real estate segment, making up 51% of the book.

Adjustable rates are a double-edged sword, particularly for commercial real estate, because they protect the lender at the borrower's expense. If a fixed-rate commercial real estate loan is at risk in the context of rising interest rates because its income sources are restricted, that risk is increased by a higher interest burden.

Therefore, variable rates protect against rising interest costs, but only at the expense of higher borrower default probabilities.

GFC risk management : LSBK did very well during the GFC. Between 2007 and 2014 , net charge-offs amounted to $3.6 million. The company did not register other types of losses like property sales either.

The truth is, though, that at the time, the company had a book comprised of qualifying residential mortgages, the safest type of real estate loan. Today, the book is of a different kind.

Small securities book : LSBK had a small securities book of only $70 million as of 3Q22 . These were mostly municipal bonds. Unfortunately, the amortized cost of $86 million carried $16 million in unrealized losses, all generated in FY22. This is difficult to understand because the bank's securities were yielding 2.3% on average in FY21. They should not show such enormous losses. LSBK's book shows 20% losses on its amortized cost, while municipal bond ETFs show average losses of 10% until September 2022.

Regulatory risks

In November 2021, LSBK recognized a cyber-security breach that, according to the company, did not compromise client information.

Then, the company announced that it had reached an agreement with the Office of the Comptroller of the Currency (one of the regulators for federal banks), regarding a plan for improvements in its IT processes to prevent violations to the Bank Secrecy Act and anti-money laundering regulations.

The agreement caused the inclusion of a new executive, a COO, with a background in fraud prevention . Then the CEO and President of the company announced his retirement (although he is 64, so the issue is probably unrelated).

Finally, in February 2023, the OCC issued a Consent Order , equivalent to a cease-and-desist order, intimating the bank to comply with the BSA/AML improvement plan. The Board of Directors suspended the company's dividend on that date . The latest news is that the company's Chief Accounting Officer resigned a few days later.

I believe these developments do not represent a case of fraud or significant risks for the company. In my opinion, they represent management's lack of attention to the regulatory burdens required from federal banks.

However, compliance will probably increase the bank's costs, and fines could be applied to the bank, either because it does not comply in time or because previous non-compliance is found.

Also, depositors may take the issue differently. Several news pieces have been published in local media with titles citing the bank's 'troubled condition' or 'unsound practices . Although these have a specific meaning in the context of the OCC Consent Order, readers might interpret them in a very different form.

Valuation

The company recently released data for 4Q22 and FY22 earnings .

This data shows that regulatory costs are making a dent in the company's profits. Non-interest expenses increased 30% YoY for the quarter. The result is the fourth quarter with the lowest profitability since 2019.

At its current market cap of $65 million, the company is offering a P/E ratio of 11.7x to FY22 earnings. We have to answer two questions: first, are earnings sustainable, and second, is the multiple justified?

On the first front, I believe earnings will be difficult to sustain in the short and medium term. The company will face higher costs from compliance with the OCC, without considering fines or reputational damage. Further, if the company faces redemption of deposits, it will have to sell securities at substantial losses. Its securities book is relatively small, at a fair-value of only $70 million. Loans cannot be sold as easily to redeem deposits.

Finally, although recently the company has increased its interest margin and has not reported more nonaccrual loans or the foreclosure of properties, its variable-rate commercial real estate is risky, which could lead to higher allowances.

Therefore the multiple should be adjusted for lower profitability in the future. I believe a multiple of 15x is acceptable, considering that the company has a strong position in Chautauqua county and has shown the ability to grow profitability through efficiencies and risk management.

Annualizing 4Q22 net income yields a net income of $4.8 million for next year. Applying the 30% fall in net income YoY to the FY21 net income yields a net income of $4 million. I believe these estimates are optimistic because they do not incorporate a rise in interest costs for LSBK nor a further increase in (at least transitory) earnings. Anyway, these estimates would only leave the company fairly valued using the 15x multiple and current market cap. There would be no margin of safety and no opportunity to be realized.

Conclusion

LSBK has several interesting qualities: a strong position in its market, efficiency improvement, profitability growth above asset growth, and a strong shareholder.

However, the company trades at a barely acceptable multiple, considering a relatively optimistic scenario, of relatively stable costs, both on the interest and operational fronts. If the company is fairly valued only under the optimistic scenario, then the stock is not an opportunity. Further, the company has significant risks ahead, particularly higher-than-average deposit redemptions that must be covered by realizing losses on the securities book.

Still, I believe LSBK's headwinds will be temporary, and the company will eventually recover profitability while hopefully maintaining its long-term positive qualities.

For those reasons, I think LSBK is an interesting stock, although not an opportunity at these prices.

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