2023-06-02 16:58:49 ET
Summary
- Despite being up 256% in the past year, M&F's stock has not caught up to its fundamentals.
- Buoyed by grants and ECIP participation, M&F has increased earnings by 125% YoY.
- Funds are rotating out of regional banking, with the failure of FRC and SVB, but not all banks are harmed by rising rates.
Banks can be incredibly complicated and have a greater degree of balance sheet complexity than many other businesses. With the present miasma surrounding banking, even the best among the regional banks are seeing declines in stock price. Only down 23% from recent highs, I believe M&F Bancorp ( MFBP ) is still positioned to grow substantially in the years to come. The business of M&F has become much stronger with capital investment from the Emergency Capital Investment Program, ECIP, and is benefiting from higher rates unlike some other banks that have made headlines. With the seemingly unexpected bank failures going on, the first thing we want to look at is the risk profile of the bank to understand if this business is subject to the slings and arrows of rising rates.
Are There Risks Hidden On The Balance Sheet?
At this point, it has been well publicized that the paroxysm of fear that led to the failure of Silicon Valley Bank (SIVBQ) was initiated due to a sudden awareness of the difference in accounting practices between securities that are 'Available For Sale' or 'Held To Maturity'. Here's a quick refresher:
- Available For Sale securities are marked to market and will be reported on the balance sheet with the price they would fetch if sold on the date in which the figures are reported.
- Held To Maturity securities are not marked to market and are held on the balance sheet at cost.
Before moving on, let's just run through one quick example:
Imagine you buy $100 worth of 10-year treasury bonds at a 3% coupon. At the point at which you purchase the bond, the value of the bond is the same as if it was held to maturity or available for sale. So, let's imagine that the rate on the 10-year treasury bill increases to 6% the next day. Now, my 3% coupon bond looks comparatively much worse than it did yesterday. The true value of my bond, if I needed to sell it, would be marked down to a price of $79.17 to account for the discount rate over the life of the bond going from 3% to 6%.
However, I don't have to take that hit if I decide not to sell the bond. I can keep the bond on my books at $100. There are a lot of incentives to avoid taking the write-down and to keep these securities at full value on the bank's balance sheet. In a rising rate environment, we should look at the amount of held to maturity securities and see if there are unmarked losses that we need to pay attention to. So what are we dealing with at M&F Bancorp?
Fortunately, the bank reports fair value very clearly for us right in the balance sheet. Additionally, this line item is only 6.4% of total assets and the bank is only levered 4-to-1 (incredibly low for banking). For contrast, SVB was levered 13 to 1 and had 42% of their assets in held to maturity securities. So let's take a deep breath and note that there will not be some massive SVB-like loss from held to maturity securities. I won't go through the balance sheet line by line, but with valuing any bank, understanding the balance sheet is critical.
Before we get into the truly exciting aspects of M&F Bancorp and the impact of the ECIP on this bank, let's look at the second key risk:
Is This Bank Losing Deposits?
Yes. Almost every commercial bank in America is losing deposits right now. We are working off the great American sugar rush of 2020/2021 and cash is increasingly in short supply.
Since banking can be so overwhelmingly complex, the right way to invest is to nullify one fear at a time, so you can actually feel okay about what you are doing. Trends in commercial deposits are not making anyone feel as if the banks are in for an auspicious decade. Bank deposits are down as much as 20% in Q1 on average - reversing the excess cash of the past few years.
While M&F is not immune, they are doing much better than the pack. M&F Bancorp reported Q1 deposits down only 2% QoQ .
This is no guarantee that deposits will not take flight in future quarters, leaving the bank underfunded.
So What? What Makes M&F Bancorp Compelling?
Over the past 12 months, M&F's stock price has increased more than 200% and earnings are up 125% - this doesn't just happen.
On June 22nd of 2022, M&F Bancorp announced that they had received $80 million in funding from the Emergency Capital Investment Program ("ECIP"). This capital came in the form of preferred equity with a 2-year deferral on interest payments and with an interest rate of 0.5% to 2%. This low-cost source of funding is nearly equity. The bank has a market capitalization of $47 million and is holding $85 million in cash right now.
This liquidity gives the bank flexibility as we work through this banking crisis. Liquidity can protect the bank from fleeting deposits and earn a decent yield in the interim. The cash can still be deployed in higher-yielding assets and loans if the bank finds attractive options, which would in turn buoy earnings. As rates rise, the cash and low-cost funding sources become more valuable .
In their most recent quarterly report , M&F reported $1.7 million in after-tax earnings. If you annualize that figure, the bank will be doing $6.8 million in earnings per year. Better yet, as loans come to maturity in their loan book and cash is deployed, income will grow dramatically. Their earnings assets are currently producing a yield of 4.7% with an effective federal funds rate of 5.08%. New loans are likely to be originated substantially above 5.08%.
Valuation
Many analysts will determine the value of a bank not by the stream of earnings it produces but by the balance sheet that they hold. After all, a bank is basically a portfolio of loans levered by deposits.
Common equity at M&F Bancorp was $21.25 million in Q1. However, we must also consider the value of ECIP preferred equity to common. At an absolute maximum, the preferred shares will yield 2% per annum or $1.6 million. If we discount this at a 5% rate, we get a present value of 32 million. So of the $80 million, $32 million is liability-like and $48 million can be attributed to common equity. If you buy into this approach, we would arrive at a tangible book value of $69.25 million, representing a 47.5% upside from today's price.
Still, I think this is a gross undervaluation. The ECIP program was designed to help minority-owned banks provide capital to underserved communities. It is not collateralized and has no teeth if the bank does not pay the dividend ( see 4.1(i) ). The fair market value of the instrument could be as low as 10% of face value, but as a base case, I think you could conservatively value the instrument at 25% of face value. That would lead you to say that $60 million of preferred goes to common, giving MFBP an implied tangible book value of $81.25 million (representing a 73% upside from today's price).
Additional Risks and Considerations
Any investment involves risk, but when we are looking at a business with a market cap as low as MFBP's, we have to be extra careful. We've already reviewed some of the intrinsic risks of banks and how MFBP fares, but we need to dig deeper to understand what we are looking at.
- Liquidity - Trading in and out of position in micro-caps can be challenging. Trading volume on average has been slightly over 2,000 shares traded per day, but volume can go much lower. For example, as of writing this (June 1, 2023), volume was only 374. You may struggle to build a position in this stock, and you may not be able to exit the position quickly.
- Credit Risk - Being a small lender, the pool of outstanding loans is relatively small, meaning the credit risk may not be well diversified. Looking at the loan book , nearly 21% of outstanding loans are C&I loans, which are generally high risk. Additionally, 38.1% of loans have been collateralized by owner-occupied non-farm non-residential properties. While collateralized, if these properties are offices, then there may be some risk in the collateral being valued lower than the outstanding loan.
Banking is a highly complex and regulated business. As investors, we can only understand so much about the loans made by banks and changes in the regulatory environment. Getting comfortable with all of the prevailing risks and the complicated nature in banking is a tall task. The investment decision for a micro-cap like MFBP requires a careful scrutinization of all of the imaginable risks.
For further details see:
M&F Bancorp: A Hidden Gem In The Banking Sector