2023-03-22 06:08:15 ET
Summary
- OP Bancorp is a well-managed small community bank with a focus on the Korean-American community, with a solid track record of growing tangible book value at a CAGR of 12%.
- Insiders are heavily involved in the company, owning 24% of the total shares outstanding, and the bank has been returning cash to shareholders in the form of dividends since 2019.
- OPBK has a relatively low concentration of large depositors and a decent amount of their loans are on a variable rate schedule, indicating potential resilience to market fluctuations.
Introduction and general risk disclosure
Mr. Market is currently presenting us with the opportunity to acquire shares of good businesses at attractive prices. Particularly in the banking sector, stock prices have been volatile and in a downward trend since the turmoil began two weeks ago. As Benjamin Graham famously stated, "The intelligent investor is a realist who sells to optimists and buys from pessimists."
Although the full extent of the emerging banking crisis is not yet clear, it is important to acknowledge the potential risks. In theory, a countrywide or global bank run cannot be saved due to the nature of fractional reserve banking. However, there are ways in which institutions, both private and public, can mitigate these fears and restore confidence in the system. While this article is not focused on macroeconomic and banking policy, it is important to recognize the possibility, albeit remote in my opinion, of a black swan event affecting regional, national, and global banks, and ultimately, the economy.
Investment Thesis
Banks' valuations are typically based on two factors: profitability and book value.
A) Profitability
Regarding Open Bank, their profitability has been outstanding until the last quarter. One way to measure this is through return on assets (ROA), which shows how effectively a bank can generate profits on its total asset balance. In the US banking sector, ROA has averaged 1.3 in the decade pre-GFC and 1.0 in the decade following the GFC (and pre-Covid). However, OP Bancorp (OPBK) has been able to outperform its peers and the sector as a whole on this metric for the past five years. Let's take a closer look to understand why.
Chart: US Banks Average ROA
Chart: US Banks Average ROA (St Luis FED)
Chart: Banks ROA
Banks operate by using liabilities, such as equity, deposits, and other borrowings, to purchase assets. These assets can include government or agency bonds, cash and short-term bills, and loans. Generally, the more value-add and risk a bank is willing to take on the asset side, the higher the yield it can charge. For example, a 10-year loan to a small or medium-sized enterprise will likely have a higher yield than a 3-month US Treasury. Although the risk of the loan has many dimensions, such as duration, liquidity, and credit risk, the US Treasury asset has very little embedded risk, but it also pays a lower interest rate. Now let's take a closer look at OPBK's balance sheet.
The same can be said for the liability side. Equity is an expensive but perpetual form of funding, while third-party bank loans, Fed financing, and bonds can vary in duration and interest rate expense. These three funding options can provide banks with funds without being dependent on the grace of their depositors. However, the most significant form of funding is typically through deposits. Clients can deposit funds with the bank through interest-bearing or non-interest-bearing deposits, among other forms. The cheapest way for banks to fund themselves is through non-interest-bearing deposits, but even interest-bearing deposits are a viable option, as the rates banks pay on these deposits can be one-third compared to the current FED fund rates.
Table: Example of JPM Deposit Rates as off 17 March 2023
Example of JPM Deposit Rates as off 17 March 2023 (JPM Chase)
Let's now focus on OPBK and examine how they achieve such high profitability. In the table for 2022, we can see data on their:
- weighted average balances, the total dollar amount of interest income from interest-earning assets and the resultant average yields,
- average balances, the total dollar amount of interest expense on interest-bearing liabilities and the resultant average rates,
- net interest income,
- the interest rate spread, and
- the net interest margin
Chart: Interest Rate and Balances Details
Interest Rate and Balances Details (OPBK 10-K)
OPBK has a very high ratio of deposits to loans, which can be risky if depositors decide to withdraw their money due to the duration and liquidity mismatch between short-term deposits and long-term loans. However, this is also the most profitable way to generate interest rate margins. The bank's average cost of funding was 0.66%, up from 0.22% in 2021, while Fed Funds averaged 1.66% during 2022. Despite US rates increasing by over 400bp, the bank only had an overall increase in funding costs of 44bp.
While this may seem like a free lunch, recent events have shown that it is not always the case. Unwinding a profitable loans book that yields almost 5% is a difficult task. If depositors demand their money back, the bank must find the liquidity to meet those demands. OPBK has a loan to deposit ratio of 90%, with more than 50% of its deposits funding loans with a maturity of over 5 years and a fixed interest rate. This situation means that the bank is taking on liquidity, duration, curve, and credit risk. While it may sound risky, managing these risks is the job of a bank, and they are usually rewarded handsomely for doing so.
In conclusion, OPBK earns above-average ROA due to their high loan to deposit ratio, which enables them to take advantage of cheap funding from deposits and invest in loans with a high interest rate margin.
B) Book Value
Chart: Book Value OPBK
Since the Global Financial Crisis, tangible book value has become the anchor for bank valuations due to regulations requiring banks to be well capitalized. As a result, the banking business has become more stable, with average ROE since 2009 of around 10%, in line with long-term S&P returns. Price-to-tangible book values are usually around 1.00, although growth and ROE can affect this valuation metric. It's worth noting that tangible book value doesn't include losses from HTM (held to maturity) securities, which can be sizable for some banks. For example, the mark-to-market value of BAC's HTM portfolio would wipe out about 30% of their tangible book value. However, with OPBK, the bank has 0 HTM securities, and AFS (available for sale) assets only make up about 10% of the balance sheet, with mark-to-market techniques used on an ongoing basis. The current price-to-book value of OPBK is below 0.80, leading to the question of whether Mr. Market is offering an opportunity to purchase a good business at a good price.
OPBK has successfully grown its book value per share at a CAGR of 12% over the past decade by retaining and reinvesting most of its earnings into the business. However, being a small regional bank, there is a possibility that depositors may withdraw their balances during a banking crisis, which could cause the bank's market cap to decline. However, OPBK has other liquidity sources, such as advances from the FHLB (Federal Home Loan Bank), which are collateralized by residential and commercial real estate loans. As of December 31, 2022 and 2021, the bank had a maximum borrowing capacity from the FHLB of $582.8 million and $417.6 million, respectively, but had not borrowed from FHLB as of those dates ( https://seekingalpha.com/filings/pdf/16495416 ).
One consideration when looking at discounts on book value is interest rate sensitivity risk. This metric measures how much the price of a fixed-income asset will fluctuate as a result of changes in the interest rate environment. Banks report this metric in various ways, but it typically includes two components: NII (net interest income) sensitivity and EVE (economic value of equity) sensitivity. OPBK's EVE analysis shows a negative impact in both interest rate environment shifts, which is concerning. I reached out to OPBK's investor relations team for more details on this issue.
Table: NII and EVE Analysis
NII and EVE Analysis (OPBK 10K)
Risk and Challenges:
One of the most obvious risks for OPBK is the possibility of depositors withdrawing funds to move them into Systemically Important Banks. This could result in a reduced balance sheet (if they are in a position to liquidate assets) and/or replacing their funding with other forms that will certainly be more expensive (remember their average cost of deposits was only 65bp in 2022).
Although they have a relatively small proportion of deposits above the 250k FIDC threshold (16% of total deposits), and the concentration is relatively low: the 10 largest retail depositor relationships accounted for approximately 8.9% of deposits, and the biggest wholesale depositor accounts for 7.5% of total deposits. Still, a loss of any combination of these depositors, or a significant decline in the deposit balances due to ordinary course fluctuations related to these customers' businesses, would adversely affect their liquidity and require them to raise deposit rates to attract new deposits, purchase federal funds or borrow funds on a short-term basis to replace such deposits. On a positive note, 55% of borrowers also have a deposit with the bank. It is plausible to assume that borrowers will have a higher psychological fidelity to the bank that provides them with funding. It is possible that these depositors are more sticky and less inclined to withdraw funds.
The EVE analysis mentioned in the section above is material. If there is an upward shift in the interest rate curve, it could generate an equity present value reduction of 42% (according to their 10K), and the tangible book value would shrink considerably. The reason for this can be found in the AFS that would be marked much lower, plus loans that have longer-dated maturities with fixed interest rates would have a much lower net present value. On the positive side, the bank has no HTM securities, and their AFS portfolio is relatively small (10% of balance sheet). Additionally, they have a decent amount of their loans on a variable rate schedule.
Currently, a lot is happening in this industry. Regulators are trying to find appropriate ways to avoid contagion. OPBK being a $145 million market cap banking stock is certainly not systemic, and in case of a bank run, might not receive the same attention from regulators.
Conclusions:
During the past decade, OPBK has managed to achieve a 12% CAGR growth in tangible book value. In addition, the bank has been returning cash to shareholders in the form of dividends since 2019. Despite being a small community bank with a focus on the Korean-American community, the market is currently pricing in a stressful situation for all banks, without differentiating much based on the quality of the balance sheet. Insiders heavily own the company, holding 24% of the total shares outstanding. Furthermore, we have seen several new insider purchases in the past months, especially since the banking crisis started ( Insider Filings ). While the high deposit ratio (91% of total liabilities) is a weakness in the balance sheet, I remain optimistic about the bank's ability to retain clients and continue its operations. We will have to wait and see once the next 10-Q is released to better understand how many clients have shifted funds away from regional banks and which banks were able to retain their customers.
For further details see:
OP Bancorp: Good Bank At Good Price - Closer Look At Investment Opportunities