2023-05-01 15:41:20 ET
Summary
- Katahdin has largely met our expectations over the last five years.
- The current valuation is a significant discount to book value (tangible and total) and reflects a low forward price-to-earnings ratio.
- We believe the current valuation is unjustified and that Katahdin could provide long term shareholders with average annual returns in the range of 10%-12% over the next several years.
Katahdin Bankshares ( KTHN ), which serves northeastern Maine through its Katahdin Trust Company subsidiary, has been one of our favorite northeastern community banks since (and for that matter even before) our initial article on the company in 2017. In 2018, we stated in a subsequent article update that we anticipated as a base case forward average annual return to shareholders in the range of 9% barring an acquisition of the company:
We still foresee compelling potential returns associated with incremental growth in earnings and book value through the retention of earnings under a base case without any significant improvements in the company’s operations. We discussed this view in our earlier article and continue to believe the company on its current trajectory can generate consistent average annual total returns for shareholders in the range of 9% (emphasis added) .
Katahdin has met our expectations for base performance over the last five years. Indeed, the company slightly exceeded our expectations returning, including dividends, a compounded 9.2% per annum since 2018. Notably, this performance was after taking into account the significant market volatility over the five-year time period and the relatively recent decline in share valuations across the banking industry in the face of rising concerns about certain financial institutions.
However, the current valuation in absolute terms – and thus potential forward returns – is even more attractive today than when we made our initial projection in 2018. In 2018, Katahdin’s shares traded at a multiple of 1.1 times book value (1.2 times tangible book value) and a forward price-to-earnings ratio between 10 and 12. The current quotation, in comparison, results in the shares trading at a multiple of only 0.81 times book value (0.87 times tangible book value) and a forward price-to-earnings ratio likely between 6.0 and 8.0. The discounts are largely in line with recent broader market valuation discounts for banking institutions despite a lack of any significant change in the fundamental foundation of the business.
We continue to consider Katahdin one of our favorite northeastern community banks and believe the current valuation reflects broad market concerns that, in the long term, will prove largely unfounded. The present valuation presents an attractive long-term opportunity with our current expectation for long term forward average annual returns in the range of 10%-12%.
Net Interest Income
Katahdin has met our expectations with respect to the sensitivity of its asset portfolio to changes in benchmark interest rates. In our prior articles we assessed the company’s asset and liability sensitivity and detailed our view that Katahdin’s net interest income was more positively correlated with rising benchmark interest rates than its primary Maine peer community banks Bar Harbor Bankshares ( BHB ) and Camden National Corporation ( CAC ). The has largely been born out as Katahdin’s net interest margin and net interest income overall has grown with rising benchmark rates although it’s worth nothing that Bar Harbor has benefited significantly recently from repositioning of its asset portfolio.
Katahdin’s net loans have been essentially unchanged over the last two years while net interest income has increased by 6.9% over the same two year period. However, this statistic alone conceals the magnitude of the improvement in net interest income due to the short term benefits associated with PPP loans in 2020 and 2021. Indeed, while net interest income rose 4.3% for 2022 versus 2021, the growth in net interest income offset a $2.15 million decline in PPP loan related fees and interest. In the event net interest income is adjusted to only reflect the change in interest income excluding the change in PPP related load fees and income, net interest income increased by roughly 12.3%. Katahdin will likely see some erosion in net interest income growth going forward as benchmark interest rate increases moderate and the cost of and competition for deposits intensifies; nonetheless we remain positive on Katahdin’s overall asset and liability portfolio with a couple reservations as noted in a moment.
Improving Asset Quality
The most notable improvement in the company’s operations over the last several years has been the improvement in asset quality.
Katahdin Trust Asset Quality (Katahdin Trust Annual Report (2022))
Non-performing assets did rise slightly in the first quarter of 2023 – to 0.30% from 0.28% of total loans – but remain well below historical experience and, for that matter, well below the prior year period levels.
Solid Capital Ratios
In combination with the improvement in asset quality Katahdin has also experienced a material improvement in regulatory capital ratios. A slight decrease in the last year notwithstanding the bank’s capital ratios have improved every year since 2018 and, even adjusting regulatory capital ratios to include unrealized losses on investment securities, Katahdin would remain well capitalized with a sizable capital buffer.
Katahdin Trust Capital Ratios (Katahdin Trust Annual Report (2022))
A Few Quibbles
We do have a few quibbles with Katahdin which temper to a degree our enthusiasm for the company notably with regard to the company’s investment securities portfolio and the nature of certain liabilities.
In terms of assets we were disappointed that the company elected to allocate excess cash and deposits towards investment securities in the last year instead of focusing in reducing wholesale deposits.
The investment securities portfolio is also rather longer term than we would prefer in the current environment with roughly two thirds of the company’s investment securities expected to mature (or reprice) in more than 10 years. This relatively long duration portfolio makes the investment portfolio more sensitive to changes in benchmark interest rates than would be the case with a shorter duration. The average yield of approximately 2.5% is not as low as is the case with some community banks in our research universe but also not especially high given the extended duration of the portfolio and relatively fixed rate nature.
In addition, we believe that the company should target a higher (though still relatively conservative) dividend payout ratio closer to 30% which would indicate an annual dividend closer to $0.80 to $0.90 per share and a dividend yield closer to 3.9% to 4.4% at the current quotation. In comparison, the company’s Maine community banking peers, even at their currently depressed valuations, yield over 5.0%.
Finally, expense control has eroded somewhat recently as the company’s efficiency ratio has risen from its low in 2020. Katahdin’s efficiency ratio historically hovered above 70.0% but was reduced below this threshold in 2019 due to a consistent focus on cost efficiency by management. The efficiency ratio dipped to 63.8% in 2020 in the midst of the PPP program but rose to 66.7% in 2021 and 69.1% in 2022. The decrease to the low achieved in 2020 was in part due to the unusual nature of fee and interest associated with PPP loans which temporarily inflated revenues while the increase in the last year was in part due to inflationary pressures across the industry. Nonetheless the company’s efficiency ratio remains well above those of its publicly traded Maine community banking peers and the upward trend, especially from efficiency ratios achieved prior the pandemic based on concerted efforts by the company’s management, bears ongoing attention.
Conclusion
The recent decline in market valuations across the banking industry has created compelling opportunities for value-oriented investors willing to accept short term volatility in the face of stability concerns across the banking industry and the potential impact on forward earnings from recessionary pressures should loss reserves increase in the face of rising loan delinquencies.
In addition, despite the company’s statements to the contrary, our view remains that Katahdin represents an appealing acquisition candidate for other Maine based financial institutions. The reduced valuations across the banking sector make an acquisition in the near term less likely, especially for potential acquirers interested in paying in shares rather than cash. Camden National, which we still view as the most probably acquirer, is particularly unlikely to do so in the foreseeable future given its particularly notable erosion in share valuation multiples over the last several months. However, this may represent a particularly attractive time for potential acquisitions by some of the area’s closely held and/or privately held institutions, such as Bangor Savings Bank or Machias Savings Bank, which would focus on a cash acquisition and which we have also previously identified as potential acquirers.
In any event, in a normalized environment, the potential to leverage cost savings and drive efficiencies throughout the company in a combination, especially given Katahdin’s vastly improved asset quality and loan loss reserves relative to historical experience, would be significant. A purchase would be immediately accretive to any acquirer at valuations significantly in excess of the current market price. Katahdin has periodically stated its intent to remain independent – a common protestation for community banks including those that eventually become acquisitions – and we don’t expect an acquisition to be likely in the near future. However, as previously noted, such an eventual outcome would simply be, so to speak, icing on an otherwise appealing cake.
Regardless, whether Katahdin remains independent or eventually becomes an acquisition target, Katahdin remains one of our preferred community bank opportunities.
A Note About Liquidity
Katahdin Trust is a rather thinly traded security with a market capitalization of approximately $66 million which entails specific risks and the potential for higher day-to-day volatility in the share price dependent on the bid/ask spread. The risks inherent in lower liquidity securities should be considered prior to taking a position in Katahdin Trust and we would recommend the use of limit orders to mitigate bid/ask spread considerations.
For further details see:
Katahdin Bankshares: Steady Progress