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JakilaTheHun (99.93)

Tennessee Commerce Bank: Microcap Bank with High Potential

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25

October 25, 2010 – Comments (17) | RELATED TICKERS: TNCC

It’s been nearly a year since I started diving into small commercial banks, yet this is still the most attractive sector to invest in. My initial strategy was to buy a “basket of banks” in order to gain the upside from the winners and be protected somewhat from the losers; with the philosophy that the gains from the winners would greatly exceed the losses from the losers.

Thus far, that strategy has worked out well. I have scored some big gains Western Alliance (WAL), Huntington Bancshares (HBAN), and Webster Financial (WBS). I have also logged my share of losses with banks like Hampton Roads (HMPR) and Seacoast Bank of Florida (SBCF).

Overall, what I’ve learned from my bank investments over the past year is that this is a sector you have to watch like an eagle in order to make high returns in the current environment, because there is too much economic and regulatory uncertainty not to.

While nearly all the banks I have invested in will survive, the bigger issue is dilution --- you have to make sure these banks are not destroying all shareholder value with dilutive offerings. Some banks are forced to dilute (e.g. HMPR); others seem to do so for no good reason; except perhaps the desire of management to grow, even at the expense of shareholder value.

Luckily, I was able to spot the warning signs of trouble with HMPR, SBCF, and a few others before losing very much.

With all that said, I believe the environment is changing still. We are heading towards more certainty and that’s a good thing. While I do have a few reservations, I believe Tennessee Commerce Bancorp (TNCC) is one of the most attractive “high reward” potential bank stocks on the market right now.

Background

It’s not OK to steal merchandise from a store; nor is it OK to steal a patented technology from a company. Thankfully, though, it is perfectly OK to steal investment ideas. In fact, if you aren’t occasionally “stealing” an idea from someone else, you’re probably not maximizing your returns. On that note, I will unabashedly admit that I stole the idea to buy into Tennessee Commerce from Tom Brown of Second Curve Capital, who has initiated a fairly substantial stake in the bank.

Tennessee Commerce Bancorp is the holding company for Tennessee Commerce Bank (surprise, surprise!). The bank was founded in 2000 and is a “Business Bank” serving small and mid-size companies. It is headquartered in Franklin, TN; just outside of Nashville. The Franklin branch is the bank's only brick-and-mortar location; this is part of their low-cost strategy. TNCC’s management targets a loan ratio of 60% consumer loans and 40% real estate loans. The company also issues Visa (V) credit cards

According to the bank, their primary competitive advantage is efficiency. TNCC targets the non-retails segment of the commercial market, which typically has lower transaction and processing costs. TNCC’s average assets per employee are $15 million, which is impressive compared to the peer group average of $5.1 million.

Tennessee Commerce recently conducted a dilutive offering. While my outlook on TNCC is generally very positive, I admit a bit of frustration on this issue. TNCC is using the dilutive offering for growth purposes, but given the stock’s deeply discounted price, it seems highly unlikely that this move will create value for shareholders. All the same, even after the offering, I find TNCC very attractive.

Below is regulatory capital and some vital stats:

Note that the first column is actual results. The second column is modified based on my own projections after the dilutive offering. The third column gives some projections for the bank if they were to repay their TARP obligations today. From this, we can see that TNCC has healthy capital ratios and should not have to raise any further capital. Nonperforming assets are on the low end and net interest margins are very strong.

Attributes, Balance Sheet, and Earnings

Perhaps the first thing that really stuck out to me in regards to Tennessee Commerce Bank was their deposit growth over the past several years. It is been otherworldly! TNCC has increased deposits nearly six-fold in the past six years!

Even during the heart of the recession, they managed to increase deposits by 31.2% in FY ’08 and 16.2% in FY ’09. Deposit growth, however, has leveled off over the past two quarters, so this is something to keep an eye on.

If you want me to sum up why TNCC is so attractive in one chart, then take a look below:

[View chart by clicking this link.]

Notice this chart is an extension of the prior chart; except this time, I added stock price, total interest income, and shares outstanding to the deposit growth. In 2006, TNCC traded at $30 per share! Now it trades at around $4.25. Yet, total deposits were $560 million in ’06 and are $1.24 billion now. Until the recent dilutive offering, the number of shares had not increased dramatically between the two periods. Also take a look at “Total Interest Income” and you can see that it doubled from ’06 to ’09; in spite of a bad loan market in ’09.

If it weren’t for the dilution, this would be look like a bit of a no-brainer. The dilutive offering throws a wrench into the equation, though, and limits the upside to some degree; but not as much as it might seem. Given earnings potential, growth, and assets, TNCC still looks very attractive (and even a bit safer) post-dilution.

Below is the balance sheet for TNCC as of the end of Q2 ’10 (pre-offering).

I took figures from the offering and create a “post-dilution” projection balance sheet, as well:

While the dilutive offering does limit TNCC’s upside some, it does at least have the benefit of making it safer. This is important for bankwatchers, given how quickly things can go downhill for some banks. From the figures above, we can calculate TNCC’s Net Tangible Assets to be around $9.18 per share; the stock currently sells at about a 50% discount to this.

But it gets better once we take a look at earnings. First off, unlike most banks I have been analyzing, TNCC actually earns enough now that the stock would be attractive even if we didn’t look at “normalized earnings”. The chart below is historical earnings; note that these figures are based on historical number of shares outstanding, so the dilution changes things a bit (click to enlarge):

Note that before the dilutive offering, they were earning about $1.01 on an annualized basis, if we use the first two quarters of ’10 as our guide. Even if you factor in the dilution, that puts them around 40 - 50 cents per share if things were to hold up. Once again, the stock sells at about $4.

Of course, we are faced with a new post-dilution reality, so the next chart examines “normalized earnings” given the post-dilution outstanding number of shares:

 

[Motley Fool's formatting issues create a problem with the "normalized earnings" chart, but you can see the original if you click on this link.]

I created 8 different scenarios, with the primary difference being the amount of the provision for bad loans. The last two scenarios are a bit different, as well, as I assumed they had paid back TARP and hence, no longer needed to make the preferred dividend payments. Scenarios 4 and 5, as well as 7 and 8, should give reasonably good estimates of normalized earnings. From this, I would peg ‘normalized earnings’ in the $1.00 - $1.25 per share range on an annual basis.

Once again, we have a book value around $9.18 and we are looking at earnings over $1.00 per share. Yet, the stock price is at $4.25. Are investors conservative, much? Or just ignoring this bank because it flies under their radar?

There’s also the kicker that the bank (a) has a very good business model that creates more efficiencies and (b) it has grown rapidly over the past few years. Based on all of this, it may not be a stretch to say that TNCC should be selling closer to the $20 - $25 range.

Risks

There are, of course, risks with TNCC. The most notable of which I have alluded to numerous times in this article --- dilution! I cannot see a reason why TNCC would need to conduct another dilutive offering; but then again, I’m not totally convinced that they needed the last one. Too many banks have started doing dilutive offerings in order to continue their “growth”, but this growth is not beneficial for shareholders when it is bought with an expensive currency. And undervalued shares are an expensive currency; and the more undervalued, the more “expensive.”

Another risk with TNCC is the small market cap of $25 million. While I have found the stock to be much more liquid than other banks in this range, it’s still far enough ‘below the radar’ that liquidity could potentially be an issue. With that said, TNCC probably should have a $125 million market cap, so there is the potential here for the ‘liquidity risk premium’ to shrink as investors re-discover this bank.

Finally, there’s the obvious risk that the quality of TNCC’s loan portfolio deteriorates. One benefit here, however, is that by virtue of being a “business bank”, TNCC’s exposure to the housing market is minimal. Commercial real estate would be the bigger worry for TNCC. It's worth noting that fellow Tennessee bank, Green Bankshares (GRNB) had one of the worst quarters imaginable due to the deterioation of their loan portfolio. Macroeconomic risks are also present risks for virtually every bank.

Make no mistake about it --- if you're buying into banks, you're taking on a lot of risk no matter how you slice things right now. But this is also why the sector has some of the highest reward potential.

Conclusions

In spite of some frustration over the recent dilution, TNCC is still a fantastic buy. This is a well-run bank that is growing quickly, has positive earnings, with healthy capital ratios, that seems to be selling at a major discount to book value and is available at a very low multiple of normalized earnings --- or even current earnings in a down environment.

I’d give TNCC a valuation of about $20. Upside potential over the next five years could be in the $30 range. Downside risks include further dilution, which could keep the stock in neutral for a long time.

TNCC is now one of the largest positions for my personal portfolio and a client portfolio I manage.

Disclosure: Author is long TNCC, WAL, HBAN, WBS

17 Comments – Post Your Own

#1) On October 25, 2010 at 4:53 PM, Option1307 (29.65) wrote:

You definitely write some of the best blogs around, keep up the good work. +1.

It's worth noting that fellow Tennessee bank, Green Bankshares (GRNB) had one of the worst quarters imaginable due to the deterioation of their loan portfolio.

Hopefully you sold out of your position proir to this week!

I remember one of your first small cap bank ideas was SAVB last year, after a wild ride it is once again in the $8 range. I never got around to puuling the trigger when you originally mentioned it and I honestly haven't looked into it much lately. Do you have any thoughts on it currently?

Again, rock solid blog.

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#2) On October 25, 2010 at 5:34 PM, JakilaTheHun (99.93) wrote:

I actually plan on writing a general blog about bank stocks and the GRNB rollercoaster.

The short story is that I sold out a little more than half my position at $14 for about a 225% - 250% gain.  The rest I sold out of the other day for a 3% loss.  So basically, I'm came out ahead about 120%, but the 3rd Quarter earnings caught me by surprise. 

This is bad, of course, but I've always expected a few of these incidents and my exposure was fairly low after selling out of the majority of my initial stake at $14.   To be up 120% on a bank where things haven't worked out is sort of strange. 

Bank investing is risky, plain and simple. 

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#3) On October 26, 2010 at 12:30 PM, MegaEurope (< 20) wrote:

Thanks Jakila, this is a great pitch.  Any other micro banks on your radar?  How about CFFC or PFBI?

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#4) On October 26, 2010 at 3:22 PM, JakilaTheHun (99.93) wrote:

MegaEurope,

Haven't looked at CFFC or PFBI.  The volume on CFFC looks low enough so that I probably wouldn't be able to buy in.  

There are a ton of others on my radar, actually, but I don't know whether I'll get around to writing about them.  I tend to be rather relunctant to disclose these microcap banks except through  formal pitches and articles, due to the low volume.  

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#5) On October 26, 2010 at 4:11 PM, PaxtorReborn (29.48) wrote:

As usual, great pitch !

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#6) On October 26, 2010 at 8:35 PM, IgnoreTheCrowd (< 20) wrote:

Thanks for the great pitch as always Jakila! +1

What is your opinion on CRBC at the current valuation?

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#7) On October 28, 2010 at 8:25 PM, spundun (23.92) wrote:

Dear JTH, do you have any thoughts on recent dilution of TNP? I've been holding TNP stocks for over a year now (since around the time when you made a pitch for it). Feeling a bit uncomfortable with the direction it's going lately.

 

Thanks

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#8) On October 29, 2010 at 7:48 AM, JakilaTheHun (99.93) wrote:

spundun,

I don't hold TNP and only loosely follow it.   I use TMF as a way to learn more than anything and don't think I understand that sector all that well (at least not yet.)  I wish I had a better answer. 

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#9) On October 29, 2010 at 10:27 AM, PaxtorReborn (29.48) wrote:

Jakila,

Does the quarterly loss change your outlook on this one at all?

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#10) On October 29, 2010 at 10:57 AM, JakilaTheHun (99.93) wrote:

Paxtor,

Nope. 

In my head, I had about 50-50 odds for a significant loss this quarter.  GRNB reported an ugly quarter, as well, so it makes sense that TNCC would have some danger here. 

Long-term, TNCC is still cheap. And cheaper than it was a few days ago.  

This quarter is a really unpredictable one for banks, so I'd say you have to have a strong stomach for this to sit and wait. 

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#11) On October 29, 2010 at 11:07 AM, PaxtorReborn (29.48) wrote:

Jakila,

Yeah, that's what I thought.  I've been considering joining you on this one and now may be a better time to do so

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#12) On October 29, 2010 at 12:02 PM, JakilaTheHun (99.93) wrote:

One thing I would say about buying banks:

If you're worried about losing a lot of money, it's better to offset moderate to high risk banks, by buying a lower-risk bank with it. 

Some lower-risk profile banks I like right now:

Hudson City (HCBK) - less risky asset base than most banks; with high Tier 1 capital

Sonabank (SONA) - very high capital ratios

Pacific Continental (PCBK) - strong capital ratios; a little more risky than the above two banks, but one of the strongest NW banks. 

I own shares of all three of these. 

 

One way or another, though; by buying into banks, you're betting on some form of recovery, however moderate.  Even the good banks will suffer if things don't improve. 

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#13) On October 29, 2010 at 10:25 PM, PaxtorReborn (29.48) wrote:

I'm actually considering a paired trade of sorts.  Long on quality US banks (and some small positions in high risk banks) paired with select shorts on the Canadian FIRE equities.  I've got my eye on a couple of leveraged mortgage lenders, sky-high REITs and others.

My general thesis is that the US financial sector has bottomed and the Canadian sector is sky high in an asset bubble.

 

 

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#14) On October 29, 2010 at 11:02 PM, Momentum21 (96.14) wrote:

Great work here Jakila...I joined in here today when my $3.95 limit order hit...just because I like to play along sometimes for fun. 

It was Major moves in slow motion on TNCC today. The only smaller cap I own is CFW...so it is somewhat jarring to watch. 

On another note...one theme I have been hearing more of is M&A activity in 2011. It is apparent that the big banks are going to have to buy growth as we move forward. Do you consider that in your DD or no?

Probably not as big in the Micro Cap stuff but maybe banks like KEY or UMPQ (two I don't own but have been looking at)...

 

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#15) On November 01, 2010 at 3:28 PM, GenericInvestor (87.16) wrote:

down 10% today.

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#16) On January 12, 2011 at 9:31 AM, GenericInvestor (87.16) wrote:

Well, I ended up buying this 3.90 and 3.84. Around 5k worth, wish I had bought more! Thanks for the tip.

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#17) On January 21, 2011 at 11:56 AM, Momentum21 (96.14) wrote:

I sold out today after tuning into the call. I turned it into a trade understanding that the true potential here is for a much longer window. 

Listening to the call makes you realize how much hinges on a very small number of loans for them.  

My fear in the short term is that the big money pushing it up decides to take profits before I do... : )

No complaints for 35%+...I consider myself lucky to catch the entry point and that's about it. GL and thanks for the idea even though I feel guilty not seeing it through. 

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