United Bancorporation of Alabama is the holding company for United Bank, a local community bank focused on southern Alabama and the Florida panhandle.
The bank is underfollowed, largely due to its small market capitalization, but has significant potential value due to a low cost deposit base, loan growth, and earning potential.
The bank’s large loan portfolio of agricultural and farmland loans is resistant to agricultural tariffs due to a regional focus on cotton and peanut production.
The shares currently trade at book value and less than eight times our projection for year ahead earnings per share.
We believe long-term investors will be well rewarded over time as the value of the bank is recognized by the market.
United Bancorporation of Alabama (OTCPK:UBAB) is in many ways a typical small local community bank underappreciated by the market. However, the company has a number of uncommon attributes – not the least of which are a high proportion of noninterest bearing deposits and a loan portfolio geared towards rising interest rates – which make the bank unique among its peers. The significant charge associated with corporate tax reform, which temporarily depressed the company’s reported annual earnings per share, also masks the company’s strong future earnings potential.
In fact, our valuation of the company suggests that the shares, even continuing to trade at a discount to the broader community bank universe, have an intrinsic value between $18.50 and $22.50 – between 19% and 45% over the current market price. In addition, we believe that the company’s ongoing profitability will continue to boost that valuation threshold and provide a foundation for additional gains over the longer term.
We believe the market will eventually recognize these attributes and adjust the valuation. However, even if the market continues to assign a discounted valuation to United Bancorporation, investors will still be well rewarded over time based solely on the company’s earnings yield approaching 14% and associated ongoing accumulation of tangible book value.
We therefore believe the degree of underappreciation for United Bancorporation represents an extreme and the current valuation presents a significant mispricing opportunity for long term investors.
In short, United Bancorporation of Alabama is a true southern belle.
United Bancorporation of Alabama is a small community bank holding company based in Atmore, Alabama. The company is the parent of United Bank, founded in 1904, which has 18 branch offices in three southern Alabama counties (Baldwin, Escambia, and Monroe) and one Florida County (Santa Rosa) in the Florida panhandle. The company’s market areas are primarily rural and while they border on more urban locations such as Mobile, Alabama, and Pensacola, Florida, the company has no branch locations physical presence in these markets.
United Bancorporation has 18 branch locations scattered in the rural areas adjacent to Mobile, Alabama, and Pensacola, Florida, although the bank has no locations directly in these larger urban markets. The banks’ geographic region is primarily characterized by smaller communities with a heavy emphasis on agriculture which is reflected in the company’s loan portfolio.
Source: Google Maps
In general, the counties in which the bank’s branches are located are not known for high population growth rates which typically attract investor attention although parts of the region are experiencing decent population growth. In particular, the Pensacola metropolitan area ranked in the top fifth of urban areas for population growth from 2015 to 2016, largely based on growth in local business, while Mobile has experienced an incremental decline on population. We characterize the bank’s market region is stable from a population standpoint with attractive long term growth potential in the Pensacola region which is surrounded by the bank’s branches.
United Bancorporation’s deposit base is rather unusual for a local community bank in that approximately 42% of the bank’s total deposits reside in noninterest bearing accounts. The proportion of community bank assets in noninterest bearing accounts typically falls, in our experience, closer to a range of 10%-25% depending on the specific market dynamics in a geographic region.
The high proportion of stable noninterest bearing deposit accounts provides the bank with unique opportunities to take advantage of rising interest rates while also locking in a base level of profitability. In a rising rate environment, the bank would be able to grow net interest income faster than broad market competitors as increases in rates on earning assets are not offset by rising rates on the corresponding deposit liabilities. In a declining rate environment, or more specifically a flattening yield curve environment, the large proportion of noninterest bearing deposits allows the bank the opportunity to effectively "lock in" net interest income with longer dated loans and securities or accommodate falling long-term rates due to a flattening yield curve without seeing compression due to rising relative short-term rates.
Indeed, a high proportion of noninterest bearing accounts, all else being equal, may also provide the bank with extra level of protection against potential deposit flight as the bank can offer higher interest rates on its deposit products versus competitors with a less advantageous deposit mix and still maintain a low overall cost of deposits.
The availability of stable and significant low cost deposit financing is, in our view, one of the key attractive features of the bank.
Investment and Loan Portfolio
Unfortunately, the bank has not always been able to effectively deploy those low cost deposits and, as a result, maintains a rather high proportion of assets in low yield cash and equivalents and investment securities relative to its loan portfolio. This challenge remains although recent strength in loan demand has allowed the company to shift the balance in the last few years. Investment securities represented 32% of core interest earning assets (investment securities and loans) at the end of 2017 versus 38% at the end of the prior year. The accelerated growth in the loan portfolio has provided additional opportunities for the bank to more effectively deploy deposits and increase net interest income, boosting overall results, and opportunity for more improvement going forward adds to the bank’s earning potential. The investment security portfolio itself is not especially unique, primarily comprised of securities issued by the federal, state, and local governments and government sponsored entities, although there is a concentration in longer dated securities which is discussed in more detail later in the article.
United Bancorporation’s loan portfolio reflects the rural nature of its primary markets with relatively large concentrations in agricultural and farmland loans versus more urban community banks. The breakdown of the bank’s loan portfolio is reflected in the following chart:
Source: United Bancorporation
Commercial, commercial real estate, and residential real estate loans comprise the bulk of the portfolio, but 19% of the loan portfolio is allocated to agricultural and farmland loans. We discuss the potential risks associated with this allocation later in this article, but in broad terms find few reasons to be significantly concerned about this unusual concentration.
The loan portfolio has experienced a broad deterioration in quality over the last year marked by rising non-performing and past due loans and more loans classified as impaired based on expectations of performance in accordance with all loan conditions. The value of loans classified as substandard, which also is discussed in more detail below, increased from $6.9 million in the prior year to $12.9 million in the current year although the cumulative value of loans classified as special mention and substandard actually declined slightly from the prior year despite growth in the loan portfolio. In addition, the value of loans classified by the bank as impaired increased to $14.0 million from $8.7 million in the prior year. Non-performing and past due loans also increased from the prior year to a cumulative $7 million from $5 million.
The increase in impaired loans was driven by commercial real estate and farmland loans although it’s worth noting that nearly half of the loans classified as impaired continued to perform as of the end of the year.
In fact, although there was a notable increase in farmland loans classified as impaired in the last year, it was actually commercial real estate and residential real estate loans which drive the increase in past due and non-performing loans. Indeed, despite a third of impaired loans falling in the agricultural and farmland categories, past due and non-performing loans in these categories remained very modest – only 10% of the $5.5 million in agricultural and farmland loans classified as impaired – and non-accrual and past due agricultural and farmland loans combined actually declined from the prior year.
The deterioration in broad credit metrics is certainly cause for attention but, in our analysis, is not at this stage a cause for excess concern. The company is in a strong position to absorb any significant deterioration in the loan portfolio, which we review later, and although we’d of course prefer to see ongoing resilience in the loan portfolio, we believe a large measure of safety exists against any significant downturn.
Indeed, it was historically a concentration in construction and land loans, not agricultural and farmland loans, which was one of the historical sins of the company. In the years leading up to the last recession, the company was heavily exposed to construction and land loans such that these loans represented as much as 10% of the company’s loan portfolio. The construction and land loans went sour quickly during the financial crisis and as recently as 2013 the company had $9.7 million in other real estate owned (OREO) properties, virtually all of which were foreclosed construction and land development properties. The OREO represented, at the time, nearly a third of the bank’s shareholder equity, greatly depressing results due to a high proportion of non-performing assets and the associated expenses and loan losses.
The company has spent the last few years working through this backlog and, as of the end of the most recent year, held only $1.4 million in OREO. The OREO remains considerable relative to the size of the bank, but the reductions have allowed the company to significantly reduce nonperforming assets and redeploy proceeds from sales into earning assets, materially boosting operating results. In addition, while expenses associated with disposal of OREO property were elevated in the most recent year, amounting to $638,000, or nearly $0.18 per share (after tax), these expenses should decline substantially going forward due to the ongoing reduction in OREO. In fact, of the $638,000, a full $398,000 was associated with provisions for losses on OREO and $122,000 was associated with losses on actual sales as the company reduced OREO by $2.8 million in the last year which are unlikely to recur and certainly not to that order of magnitude. The remaining $1.4 million in OREO represents less than 4% of shareholder equity versus 33% only five years ago.
Of course, it remains to be seen whether the company has truly learned from past experience notwithstanding the unique nature of the financial crisis, but current indicators suggest a willingness to better diversify the loan portfolio. Construction and land loans presently represent only 6% of the company’s loan portfolio, down from 10% before the recession, with a greater concentration on commercial and agricultural loans.
Investment and Loan Repricing
The previously mentioned concentration in longer dated securities from a maturity or repricing standpoint would typically be a concern and it is a concern in this case, but less so than in the case of other financial institutions. The reason is the company’s unusually large percentage of deposits from non-interest bearing accounts, accounting for some $228 million out of total deposits of $537 million. The percentage of total deposits represented by non-interest bearing accounts is 42%, far higher than most community banks, and provides a rationale to support longer dated securities and accept the potential loss of interest rate margin from rising rates in order to secure a base level of net interest income. The high proportion of non-interest bearing accounts therefore mitigates to some degree concerns about the company’s longer dated investment securities since it provides a base where these investments will be profitable, even in a rising rate environment, regardless of short term changes in interest rates or a flattening of the yield curve. In addition, the longer dated investment securities represent only a fraction of non-interest bearing deposits – around 38% – providing the company with additional net interest margin opportunities beyond the slow repricing of the investment securities portfolio.
Source: United Bancorporation and Proprietary Calculations
On the loan portfolio side, United Bancorporation, like most small banks, does not provide extensive disclosures in its financial statements about asset repricing beyond investment securities. It’s therefore necessary to go to the financial information from the Federal Financial Institutions Examination Council (FFIEC) to better evaluate the company’s exposure to interest rate risk when it comes to the loan portfolio.
In this case, the loan portfolio composition proves to be rather favorable in terms of loan maturities and repricing in the event rates rise in the future. In contrast to the company’s investment securities portfolio, nearly half of the company’s loan portfolio matures or reprices within the next three years. In addition, more than three quarters reprices within the next five years. The extended tail of maturities and repricings – those loans that extend beyond five years – represent a mere 23.6% of the entire loan portfolio, largely concentrated in longer term residential mortgages.
Source: Federal Financial Institutions Examination Council
The consolidated investment and loan portfolio is also rather favorable on a maturity and repricing basis, as reflected in the following chart:
Source: Proprietary Calculations
In this case, although only 40% of the consolidated portfolio matures or reprices within the next three years (with more than half – 22.8% – within the next twelve months), the company’s potential interest rate gap relative to deposits appears to be quite modest. In time, the company’s net interest margin may not grow as fast as it otherwise would if interest margins widen between interest bearing deposits and newer loans due to the static interest rate margin between noninterest bearing deposits and longer dated loans and securities, but we consider this reduction a small price to pay for the added stability associated with the large proportion of noninterest deposits.
We should note that loan portfolio totals based on the FFIEC data differ slightly from those reported in the bank’s financial statements due to the differences in classification. The differences are not material to the analysis.
We therefore believe the company is well positioned for a rising interest rate environment and, indeed, the company is more sensitive to falling interest rates due to the large noninterest bearing deposit base than it ultimately is to rising interest rates. In addition, to the degree that longer dated loans and securities are replaced with higher yielding loans and securities over time, the differential against the noninterest bearing deposits provides a potential for ongoing net interest margin improvement and, possibly, a partial bulwark against falling interest rates in later cycles.
United Bancorporation has two key debt commitments in addition to its traditional deposit base. The first, a $10 million capital trust security which was issued in 2006, carries interest at three month LIBOR plus 1.68%. The second, a $5 million term loan used, in combination with other funds, to redeem preferred stock in 2016, carries interest at a variable rate of prime less 0.25%. The debentures backing the capital trust became callable, in whole or in part, in September of 2011, although the securities remain outstanding.
In April 2012, the company entered into an interest rate cap swap agreement on the capital trust debentures such that the company would receive swap payments in the event the three-month LIBOR exceeded a cap of 2.5%. Unfortunately, the swap agreement expired in April 2017, such that the company is no longer hedged against ongoing interest rates increases. The three month LIBOR is presently approaching 2.5% and will likely exceed that threshold in the near future such that, in combination with the prime rate based term loan, interest expense associated with these liabilities will continue to increase.
In our view, while the rates on these variable securities remain relatively low, the company will be well positioned going forward to use available cash and future retained earnings to repay some or all of this debt, thereby boosting earnings and eliminating the (comparably) high cost variable debt component. In fact, in the event interest rates accelerate quickly, the company could use some of its significant cash and equivalent holdings – equal to roughly 9% of total assets – to redeem high interest rate debt and immediately boost net interest income. The positive earnings impact of such a move would be immediate and add a few cents per share to earnings above those projected later in this article.
The board of directors and executive officers of the company hold 175,819 shares of the company’s common stock per the company’s most recent proxy statement. The breakdown of shareholdings by individual is not provided, but this group in the aggregate holds 7.23% of the company’s outstanding shares. We don’t consider this factor in itself a rationale for investment, but the meaningful level of insider ownership of shares provides an additional measure of confidence. In addition, it’s worth noting that the level of insider ownership is not so significant that it would substantially impede an acquisition of the company.
Agriculture and Farmland
The concentration of the loan portfolio in agricultural and farmland loans, in addition to the fact that the strength of at least a proportion of the bank’s loans in other categories are likely indirectly tied to the health of the local agricultural industry, warrants attention. The developing trade dispute between China and the United States serves to reinforce the necessity of evaluating risks in this segment since China is a significant importer of agricultural products from the United States and, confirming speculation that agricultural products would be included in any goods on which China may impose retaliatory tariffs, agricultural products did in fact feature in the country’s most recent response. In particular, soybeans have been a commonly speculated target for tariffs along with corn, cotton, and other products. A significant potential risk would be present in the event that the agricultural products supporting the company’s agricultural and farmland loans could be subject to retaliatory tariffs and their producers placed under greater financial strain.
Soybeans are, in fact, a major agricultural product in one of the company’s key counties in Alabama although production is comparatively insignificant relative to the production of the leading soybean states. However, the agricultural revenues in the company’s key counties of Baldwin, Escambia, and Monroe are primarily derived from cotton and peanuts, products which have some or little effective exposure to potential tariff risk. Indeed, according to the United States Department of Agriculture, the primary agricultural products in the company’s geographic area, aside from soybeans in Baldwin County, Alabama, are cotton, peanuts, and hay.
Cotton is another potential tariff target although less subject to tariff exposure than soybeans. Cotton from the southern United States is, on average, considered to be a higher quality than most other global sources and recent production challenges in India, another leading producer, have dented global supply. In fact, 2017 was a banner year for U.S. cotton exports and, given that cotton tends to be a fungible commodity, much like oil, tariffs that reduce exports to China (shifting Chinese demand to India, for example) will likely tend to increase exports to other countries that would otherwise source their cotton from India. Of course, this is not to say that Chinese tariffs will have no impact on cotton prices and exports, but these impacts should be relatively muted compared to other agricultural products. In addition, cotton is somewhat immune to the longer term threat to products such as soybeans where the question is whether tariffs will ultimately increase Chinese domestic production of soybeans which is not feasible in the case of cotton.
United Bancorporation has not provided a detailed disclosure of the specific agricultural products supporting the agricultural and farmland loans in the loan portfolio, but our assessment is that, more likely than not, the composition ultimately reflects an allocation reasonably proportional to the value of the agricultural goods produced in the geographic region. It’s possible, though unlikely, that the company has a concentration of loans to soybean producers in Baldwin County, but even under this circumstance, such a concentration should not be so large as to impair the average quality of overall loans. The large production of cotton and peanuts in the company’s key regions therefore strongly suggests that the majority of agricultural and farmland loans are supported by products without significant exposure to tariff risks. We therefore view the risk to this segment of the loan portfolio to be relatively limited in the event trade disputes escalate and significantly impact overall agricultural exports.
Nonetheless, regardless of potential tariff considerations, the strength of the cotton and peanut commodities markets is a key factor when considering the risks associated with the bank’s loan portfolio due to the significant production of these commodities in the bank’s service area. Indeed, delinquency rates at commercial banks for agricultural and farmland loans have been on a modest uptrend over the last two years as average farm incomes have fallen although delinquencies remain well below the peak levels experienced in the last recession.
Source: Federal Reserve Bank of Kansas City
Cotton and peanut prices are volatile over time and occasionally experience significant changes in price as is the case with many commodities, especially those impacted by weather. In the gulf coastal region, hurricanes can also impact agricultural production, an ever present risk to which the bank is uniquely subject that is often only partially offset crop insurance and other sources of funds. However, from an historical perspective, there is little reason to believe that a significant adjustment in cotton or peanut values is on the horizon, certainly one of such magnitude that it would materially affect the company’s loan portfolio.
Source: Index Mundi
The current commodity prices for cotton and peanuts are presently within the historical price band with cotton trading at the upper end of the range over the last ten years and peanuts at the lower end of the range over the same time frame. A broader 25-year perspective, reflected in the second chart below, suggests that cotton is trading somewhat above the longer term historical range, especially relative to the early 2000s, while peanut prices are in line with the historical average.
Source: Index Mundi
Source: Index Mundi
Cotton, from an historical perspective, may be at risk of a moderation in prices while peanuts may have the potential for an improvement, but under either scenario, it’s unlikely that prices would deteriorate significantly barring a sudden increase in global production. It’s also notable that even when cotton prices declined in the 2014/2015 time frame, United Bancorporation did not experience any signification performance issues with respect to agricultural and farmland loans although the decline was relatively short in duration. A more persistent decline in commodity prices for either cotton or peanuts would have the potential to materially impact the bank’s performance, but our view remains that the risks associated with a price shock in either key commodity are relatively small and can be managed by the bank.
The above factors, aside from the potential for commodity price volatility, all contribute to the company’s earnings potential. Our first step in assessing the company’s earnings potential was to adjust the most recent year’s results to eliminate the impact of income tax adjustments in the fourth quarter related to the revaluation of deferring income tax assets and liabilities in relation to the new tax law. The impact of the fourth quarter income tax adjustments was quite large for the company – around $1 million – resulting in an effective tax rate of 45.2% for the year versus our adjusted estimate (roughly in line with prior experience) of 29.8%. The adjustment results in earnings of $1.84 per share versus the $1.44 per share reported by the company assuming no changes in the corporate tax rate.
The second step was to estimate the company’s earnings for 2017 as if the new corporate tax rates had been in effect for the year with a couple adjustments to eliminate certain income and expense changes associated with loan loss reserves and mortgage fees. The company has significant tax exempt income which impacts the calculation, in addition to the state income tax effects associated with less deductible federal income tax, so we approached this estimate by developing a revised income tax table reconciling actual income tax expense with the statutory rate expense. The result was a projection of $2.04 per share in earnings for 2017.
Source: Proprietary Calculations
We also developed a range of forward earnings estimates for the company based on a number of different scenarios to evaluate the company’s sensitivity to various noninterest income sources. In particular, we looked closely at the sensitivity of earnings to changes in the provision for loan losses and changes in gains from investment securities and mortgage loan fees which can be more sensitive to interest rates and therefore more volatile from period to period than other income sources, especially net interest income. We also eliminated special items, such as the $277,000 grant the company received in the prior year, which will likely not recur in the future. The result was a forward projection for earnings, depending on assumptions regarding growth in net interest income, etc., ranged from $1.85 to $2.25 with a most probable midpoint estimate range of $2.10 – $2.20. The lower end of the range reflects significantly higher provisions for loan losses in combination with significantly lower mortgage related fee income, a worst case base operating scenario.
The company also has significant opportunities to further expand net interest income if the company can continue to grow the loan portfolio faster than the securities portfolio. Indeed, for many of the last several years, the company was challenged to grow the loan portfolio at a significant clip, resulting in securities, which tend to provide lower yields, representing a proportionally larger share of total interest earning assets. The recent growth in loans, especially relative to investment securities, boosted net interest income in recent years and has the potential to continue doing so in future periods. The ability to deploy additional low cost deposits into higher yielding loans – as well as the company’s cash and cash equivalents which also represent a higher than average 9% of total assets – provides additional opportunities to grow interest income much faster than any increase in interest expense.
Testing the Loan Book
In evaluating community banks, we often also perform a more subjective test of potential loan losses relative to earnings and existing loan loss reserves. The test is not financially rigorous in that we’re not looking to evaluate the company’s ability to withstand a significant economic shock on par with the housing crisis, for example, but to evaluate how quickly the company would be able to cover potentially large losses on identified problem loans and return to profitability.
The approach to this analysis is to define relatively liberal loan loss estimates for all loans currently classified by the company, particularly non-performing and past due loans, and compare this value to the company’s earnings and loan loss reserves. In some cases, banks with relatively marginal profitability and loan loss reserves would have to commit earnings to cover loan losses for an extended period of time while others are able to commit earnings for a year or two and return to profitability rather quickly.
In essence, we’re evaluating how quickly the bank could cover a high level of losses and return to profitability after covering the loss reserve expenses.
In the case of United Bancorporation, our analysis takes all loans classified as either special mention or substandard (which includes all non-performing and past due loans) and assigns improbably high loss ratios for these loans in the aggregate. In the case of special mention loans, which are classified as loans with potential weaknesses for which a minimal loss potential exists in the event of further financial deterioration of the borrower and liquidation, we assign an aggregate loss ratio of 33%. In the case of substandard loans, where a clear financial strain on the part of the borrower exists and a loss of some degree would be expected on liquidation, we assign a loss ratio of 66%.
We then calculate the projected aggregate losses the bank would incur upon liquidation of all special mention and substandard loans, and compare this amount with the bank’s current accumulated allowance for loan losses plus one year of pre-tax income. The resulting ratio reflects how quickly the bank would be able to return to profitability after such an event.
United Bancorporation would recover exceptionally quickly from such a shock – the bank would be unprofitable for one year and then return to near full profitability the following year.
Source: Proprietary Calculations
Clearly, the assumptions in this assessment are highly improbable. The likelihood of experiencing 33% aggregate losses on special mention loans and 66% aggregate losses on substandard loans, many of which are secured by real estate and other collateral, is exceptionally unlikely in most cases. Moreover, the total of loans classified as special mention and substandard (at $23 million) far exceeds the loans the bank considers impaired (at $14 million, 61% of special mention and substandard loans) as well as the loans which are currently non-performing and past due (at $7 million, 30% of special mention and substandard loans).
This assessment is highly subjective and some may criticize the simplicity of the application. However, we consider it informative from a high level perspective since it provides a basis for evaluating a bank’s ratios of special mention and substandard loans, many of which will ultimately continue to perform, to the company’s allowance and earnings instead of simply looking at the non-performing and past due portions of the loan portfolio. In addition, it provides an additional level of confidence that a bank can withstand an economic shock or significant worsening in loan performance (or a significant undervaluation of the risk in the loan portfolio when determining the allowance for loan losses) when the ratio is relatively high.
We approached our valuation of United Bancorporation in several ways to develop a range of potential values for the shares. The initial approach focused on the company’s historical price-to-earnings ratio at year end versus the respective year earnings, which has been rather consistent over the last several years, as reflected in the following table:
Source: Company and Market Data
The company’s year end price-to-earnings ratio has frequently been in the range of a rather modest 10-11, and the resulting projection for potential year end share price based on this experience and our forward earnings estimate is $20.50 – $22.55, a significant 32% to 45% premium over the current market price. A more modest price-to-earnings ratio of 9 would still yield a point estimate of $18.45, a 19% premium to the current market price.
We also evaluated the company’s valuation on a current and forward basis against similar peers in various markets, notably companies such as Auburn National Bancorp (AUBN), Katahdin Bankshares (OTCQX:KTHN), and Southwest Georgia Financial Corporation (SGB), as reflected in the following table:
Source: Proprietary Calculations
These valuations, along with others in comparison with smaller community banks and, all support the conclusion of a valuation for the shares at or possibly slightly above the range defined by the historical price to earnings ratio. The current valuation relative to tangible book value of just under 1.0 is also unusual for a small community bank as valuations recently have tended to range from 1.2 to 1.7, with some outliers, depending on the specific characteristics of the bank.
In addition to the potential valuation adjustment based on current year results, we also believe there is significant long term potential for investors interested in stable long term returns. The projected earnings yield on the current valuation exceeds 13%, but even after the valuation adjustment based on the rather modest historical valuation range, the earnings yield – and resulting growth in book value in combination with dividends – on an ongoing basis will likely be in the range of 9% to 11% per year. A stable valuation slightly above tangible book value and modest price-to-earnings ratio going forward provides the potential for a consistent and compelling growth in value relative to the associated risk over the long term.
Of course, it rather begs the very reasonable question why the company’s current valuation is so low if our earnings estimates and valuation models – as well as the company’s collection of positive attributes – are accurate. In our view, this largely comes down to the fact that the company is simply too small to attract significant market attention. A company with a market capitalization of less than $40 million is on the lower end of the range, even for local community banks, and is not going to attract any significant analysis from larger market participants – if the company receives any attention at all. The lack of analyst attention contributes to valuations which don’t necessarily reflect underlying fundamentals. Indeed, the fact that the company’s shares traded only slightly above the historic multiple of reported year-end earnings at the end of the prior year (and have since fallen back) despite the significant unusual expense associated with the fourth quarter income tax adjustment and the potential for earnings benefits going forward strongly suggests that there is a lack of attention to the adjustments necessary to develop and understand the implications of a "clean" earnings per share figure for the company. After adjustment, the company ended the year trading near its historic low valuation based on earnings despite the potential for the coming year.
In the case of micro capitalization funds, with which we have prior experience, there are a number of factors that would dissuade an investment even assuming the potential returns we project are accurate. The first would be the relative lack of liquidity which makes it difficult to build a suitably large position to make a material difference in the performance of even a $50 million fund. In addition, even if a fund could build a sufficiently large position, the unique ownership limitations and requirements associated with financial institutions tend to make them less compelling than less regulated companies to which state banking department regulations are inapplicable. Finally, given the above factors, micro capitalization funds tend to focus on long term growth opportunities and, while the bank’s ongoing profitability should support healthy returns over the long term, it’s unlikely the company is going to grow into a major regional bank in the next decade. In other words, the valuation may be compelling from an absolute standpoint, but the long term potential may be less attractive to a micro capitalization fund than other businesses with long periods of potential double digit revenue growth.
Or…we could be wrong on our earnings estimates or the risks inherent in the company’s loan portfolio. In particular, the agricultural risks may be greater than we appreciate or the rise in substandard loans may reflect a growing trend that will accelerate in the future. However, we believe that our calculations and projections demonstrate that the current valuation incorporates a significant margin of safety and limits the potential long-term impact of errors in our estimates and projections.
The next logical question is what will be the impetus for the market correcting this undervaluation. We believe there are a few potential factors although some may only be recognized over a period of years. First, the company has a history of being valued at a relatively stable multiple of earnings. The unusual expenses associated with tax reform in the most recent year obscured the underlying earnings power of an underfollowed company and the share value may adjust as the company reports earnings going forward and this earnings power is reflected in headline results. Second, the company is positioned to add significant shareholder’s equity over the coming years at a pace as high as $5 million per year, and the increasing size of the bank will attract more market attention. Third, significant undervaluation in the banking sector, especially when insiders do not hold sufficient shares to effectively block a merger, typically does not persist over extended period of time, although there may always be a liquidity discount.
A more unlikely scenario would be the expansion of the company into the Pensacola and/or Mobile markets, which could drive scale, or the outright acquisition of the company by a competitor.
Regardless, we need not rely on the market recognizing the full estimated valuation – or even a fraction of it – for United Bancorporation to represent a compelling long term investment. In the event the share price remains unchanged – and assuming our earnings estimates are within the range of actual results going forward – the earnings yield on the company’s shares at the current valuation falls somewhere between 12% and 14% per year. The shares already trading at tangible book value, even a price which tracks the incremental annual increase in tangible book value would result in superior potential returns over an extended period of time. In essence, we believe there is robust compound gains potential in the company’s shares over time even if the market continues to assign the company its present low valuation metrics.
We therefore consider United Bancorporation to be significantly undervalued from an absolute and relative perspective regardless of the specific valuation approach taken for the company. In addition, the modest current valuation, in our view, provides a significant margin of safety in the long term despite the potential for short term volatility associated with the thinly traded nature of the company.
Community banks are always potential acquisition targets, especially when undervalued relative to competitors in the same or adjacent markets.
We consider United Bancorporation an interesting acquisition target. The company’s current geographic footprint does not cover a region notable for its population growth potential, but the company nonetheless has several positive attributes for a potential acquirer, including the high proportion of noninterest bearing deposits, opportunity to deploy deposits into higher yielding loans (versus investment securities), and proximity to larger metropolitan areas. The company would be an interesting bolt-on acquisition for another bank looking to increase its presence in the Mobile and Pensacola regions, or for a more local bank to expansion its geographic footprint beyond these urban markets. In addition, even a rather large premium to the current market price would result in rather modest valuation ratios from a price-to-earnings and price-to-tangible book perspective. On this basis, an acquisition valuation may range towards the upper end of comparable peers, closer to $25 to $30 per share, which would still only represent an acquisition price-to-earnings ratio of a modest 11-14, on par with or even below market valuations of comparable community banks absent an acquisition.
However, while recognizing the potential for an acquisition of the company, we don’t consider such an acquisition imminent or necessary for the company to be a compelling investment opportunity. In other words, an acquisition would be icing on what, in our view, is already a very appetizing cake.
United Bancorporation of Alabama is a little followed financial institution which has a number of positive attributes, including:
a leading market position in its core geographic markets; a low cost deposit base with a significant proportion of noninterest bearing deposits; the opportunity to more productively deploy existing deposits and cash; a diversified and growing loan portfolio with limited repricing risk; a manageable level of past due and non-accrual loans; a clean balance sheet with few intangible assets; the ability to quickly grow shareholder’s equity; a low valuation in both absolute and relative terms.
The current undervaluation combined with the potential opportunities for the bank to further improve earnings significantly outweighs risks associated with potentially problematic loans and other factors. In our view, the company’s shares presently trade well below our intrinsic value estimate of $18.50-$22.50 per share based on current earnings power complemented by the recent reduction in corporate tax rates. In addition, the company should be able to continue building shareholder’s equity at the rate of around $2.00 per year, plus or minus $0.25 depending on assumptions with respect to loan loss reserves and the profitability of mortgage operations, suggesting ongoing contributions of about 10% per year. As a result, the overall risk/reward balance, especially over an extended investment time horizon, appears very compelling.
We have accumulated a meaningful position in the company’s shares and may continue to add to our position on an opportunistic basis as blocks of shares come available at reasonable prices.
Author’s Note: United Bancorporation of Alabama has a market capitalization of around $38 million as of the writing of the article and tends to be rather thinly traded as is the case with many small local community banks. We advise actively using limit orders to acquire the shares to control price as well as recognizing that liquidating positions in such companies may be difficult under certain circumstances. The liquidity risks are inherent to investments in such companies.
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Disclosure: I am/we are long UBAB, SGB, KTHN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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