jebmo’s posthaven

Background

This current market has been challenging for value investors. Great values are hard to come by, and value names have had poor relative performance as of late. It is for this reason that I was particularly excited when I stumbled across shares of Greene County Bancorp, Inc. (NASDAQ:GCBC), which is one of the most compelling risk/rewards I’ve invested in this year.

GCBC is a little thrift with a branch presence scattered in and around… you guessed it… Greene County, New York. GCBC’s flagship branch is located in Catskill, NY - a slow-to-no growth community with a population slightly below 50K. The remainder of GCBC’s branches are located in smaller communities in the surrounding area.

At the current market price, $24.75 at the time of this writing, common shares of GCBC have a significant margin of safety, and in this article, I’ll explore some of the reasons that support this thesis.

A brief aside on thrift conversions…

Before discussing the fundamentals of the business, I’d like to touch on a critical and unique aspect to GCBC that must be understood to accurately calculate the impressive margin of safety implied in the current share price. In 1998, shares of GCBC went public via a thrift conversion. Under the conversion, GCBC’s mutual holding company retained a majority interest in the shares outstanding (54.2%) with public shareholders owning a minority interest (45.8%). As has been noted by value investors for decades, the true economic interest of common shares should disregard the MHC interest, as the MHC interest is more akin to treasury stock e.g. the MHC waives any right to dividends. Most financial data providers are incorrect when reporting the market cap of thrift conversions, basing their calculations on the total shares including the MHC interest, which miscalculates the current market value of the common equity significantly.

The basis of this analysis will assume the correct share count of ~3.9 million, yielding an adjusted market capitalization of ~$96 million at the current share price vs. the reported market cap of ~$210 million.

To validate this conclusion, one only needs to look at a 10-Q – let’s take 9/30/2016 to demonstrate the issue:

For the quarter, GCBC paid ~$369K in dividends to shareholders. GCBC declared $0.095 per share. Therefore, with a little math, we conclude that ~3.9 million shareholders were paid. The reported number of shares outstanding includes the MHC interest (~8.5 million total shares). 3.9 ÷ 8.5 = 45.8%, reconciling with the reported MHC interest described above. So we can conclude that standard valuation screeners will overstate the share count, current market cap, and dividend yield of GCBC by a substantial margin

It’s easy to see why GCBC could so easily be off the radar, as most institutional investors would struggle to invest in such a small, thinly traded issue, and many retail investors erroneously see a valuation more than double its actual value at first glance.

The Deposit Franchise: Clear Path to FY 2018 Double-Digit Growth

GCBC’s performance over the last few years has been excellent, especially given the demographics of its markets are relatively unexciting. GCBC’s branch network is small. When I say “small”, I definitely mean it, every GCBC branch is listed below:

As of FY 2016, all but three branches had at least double digit deposit growth, and the flagship branches in Catskill performed particularly well over the period in adding over $100 million in deposits. Although 2017 branch-level data has not yet been released by the FDIC, based on the company’s reported financials, they’ve successfully carried their momentum into 2017 with FY 2017 y/y deposit growth of ~16%. Overall, this is a compelling deposit growth story that suggests deposit share capture in GCBC’s markets.

The more interesting question is whether above-industry growth is likely to continue in the future. The most impressive attribute of GCBC’s recent deposit growth is that it has come without the benefit of additional branch distribution. I’m somewhat skeptical GCBC will be able to maintain this organic growth rate across its existing branch network in the medium term. Nearly all of GCBC’s deposit growth is in Greene County, and as a market, this county has enjoyed strong overall deposit growth over the last few years. But there isn’t a clear demographic narrative to suggest that this banking market will be able to support this growth in the future. GCBC owns over a 60% deposit share in Greene County, so there is limited room to capture additional market share.

However, largely offsetting these negatives, GCBC announced a little tidbit last quarter: they are opening a new branch. The Bank of Greene County is entering the bustling community of Copake, NY. For a bank of GCBC’s size, a new branch actually can have a material impact on FY 2018 expectations. The new branch location was left vacant by KeyBank, and KeyBank’s branch network in the area can give us some clues as to the potential growth opportunity for the new GCBC branch opening. As of 2016, KeyBank had about $75mil in deposits at the location in question and a few nearby ATMs. After researching all of the nearby KeyBank branch locations, the next KeyBank full service branch is about 30 minutes away – there is clearly a nice opportunity here for GCBC to pick-up the stranded customer accounts. $75mil represents 9% growth above FY 2017 ending deposits. Between the new branch opening and a track record of execution across its existing branch network, GCBC is well positioned to hit double digit deposit growth in FY 2018.

On the loan growth side, historically, the ratio of loans to deposits has been quite low but trending in a positive direction. With GCBC’s rapid deposit growth over the last few years, I would have expected deposit growth to outpace loan growth, but Loans/Deposits have actually increased from 66% in FY 2013 to 74% in FY 2017, providing some lift to net interest margin over the same period. Assuming this relationship holds, like deposits, loans are well positioned to see double digit growth in FY 2018.

Worth noting, there doesn’t appear to be any evidence of price concessions on either the deposit or loan side. Pretty easy for any bank to rapidly grow deposits and loans by jacking up yields on deposit accounts or drastically reducing underwriting quality, but GCBC’s approach seems to be more methodical and protective of its long-term health.

GCBC’s Earnings Multiple: Highly Undervalued on a Trailing and Forward Basis

Putting the aforementioned pieces of the puzzle together, GCBC is very undervalued on both a trailing and forward earnings multiple basis. The earnings story in 2018 is favorable purely because of arithmetic. Because 2017 growth was strong, assuming no deposit or loan growth in 2018, I estimate earnings will grow by ~8% during the next fiscal year. This growth is purely attributable to the fact that 2017 growth has not yet fully manifested in earnings i.e. if ending loans stay flat y/y, average loans will still increase y/y. A flat growth scenario positions GCBC for ~$12 million in after-tax earnings against a market cap of $96 million, so we’re at about an 8x NTM P/E.

Of course, flat growth is rather too conservative in light of the deposit/loan growth story discussed above, so I’ve penciled out a proper base case. Before going further, I should highlight the operating efficiency of the business, which is very compelling. Over the last three years, GCBC has demonstrated significant operating leverage and has managed to improve an already stellar efficiency ratio. For FY 2015, 2016, and 2017, the bank’s efficiency ratio was 61.4%, 58.6%, and 54.2%. I haven’t seen any evidence to suggest that GCBC has a unique “special sauce” that allows them operate so profitably, but I’ll attribute the positive trend to a lean operating culture and the bank’s ability to drive significant organic deposit growth over the last few years. For purposes of sketching out a base case, a 50% efficiency ratio seems like a reasonable cap, as anything less than this suggests they are cutting to the bone from a cost standpoint.

For our base case, assuming a successful branch opening and even modest organic loan and deposit growth, I estimate FY 2018 earnings of ~$15 million or ~6x NTM P/E. Very cheap for a bank warranting a premium multiple. Both the “Flat” and “Base” 2018 outlook are detailed below:

Regulatory Capital: Healthy Balance Sheet with Significant Excess Capital

Not unusual for its peer group, GCBC currently and historically has maintained capital ratios well in excess of what is required under Basel III. This “excess” capital represents one of two potential positives: (1) the bank could easily support a significant buyback or one-time dividend, or (2) in the event of a downturn in the credit cycle, this excess capital would ensure its own safety and allow GCBC to opportunistically pick up assets at distressed prices. Given the Agencies keep a watchful eye over bank capital plans, we’re highly likely to fall into the latter vs. the former going forward. The bank’s current capital position is outlined below:

Highlighting a few salient ratios, GCBC’s Tier 1 Capital Ratio and Total Capital Ratio stand at 14.5% and 15.8% as of its 6/30/2017 call report. That represents a 6.0% and 5.3% cushion above regulatory minimums, respectively. This is a significant. If I were to translate the most limiting capital ratio (Total Capital %) into a $ cushion, it’s about ~$29 million or about 30% of the current market cap. In other words, GCBC could return $29 million to shareholders as a one-time special dividend and still be well capitalized from a regulatory perspective.

That said, GCBC would likely not be willing or permitted to run its capital down to minimum levels, so a $20 million return to shareholders is a more realistic view of the ‘excess’ capital opportunity. Layering in this attribute to the earnings analysis above, we see that GCBC is even more deeply undervalued than previously indicated. Assuming a $20 million reduction in market cap, GCBC’s LTM, NTM (Flat), and NTM (Base) P/E stands at 6.8x, 6.3x, and 5.1x, respectively. A safe 20% earnings yield is a winner by my grade in any market. The correction for the share count and excess capital is illustrated below:

However, I don’t want to suggest that $20 million is likely to be returned to shareholders in the near-term. Although the company is financially capable of returning this capital, I fully expect this conservative capital position to be maintained indefinitely. It is for this reason that we can take comfort in our downside risk – regardless of how the credit cycle performs over the next few years – GCBC’s balance sheet can withstand some serious punishment.

Credit: No Evidence of Excessive Risk

Since we’re on the topic of downside risk, I should touch on the credit culture/profile of the bank. I say briefly only because there isn’t anything particularly eye popping about GCBC – which is a good thing. This credit cycle is certainly long in the tooth, and when credit does deteriorate, GCBC seems to be positioned very well to absorb losses. Over the last credit cycle, net charge-offs peaked at about 29bps. The company maintains Loan Loss Reserves in the ballpark of 1.7%-1.8%. Nonaccruals peaked at 117bps of total loans. Overall, I would characterize GCBC’s credit profile as clean and conservatively managed – again supporting the thesis that the bank would be fine if not opportunistic if the credit cycle heads south in a hurry.

Management: Betting on Themselves

A company as small as GCBC isn’t going to have great IR, so outside of the numbers, we don’t have much on which to judge the quality of management. Insider ownership/activity does provide some clues, and the report card is flawless. Total insider ownership is decent at about 22% of adjusted shares outstanding (adjusted to exclude the MHC interest). There are no reported instances of insider selling and many instances of insider buying in 2017. I will note that some of the reported transactions are humorously small. CEO Don Gibson purchased 22 shares on 8/8/2017, a transaction size of about 500 bucks – maybe there’s a rationale there that escapes me.

Fair Value of GCBC

Taking into account much of what is described above, I’ve put pen to paper on a fair value of GCBC and margin of safety prevalent in today’s prices. I’ve cut the fair value of GCBC using two different methodologies appropriate for bank valuation.

Relative Valuation

First, I’ll briefly describe GCBC’s valuation relative to its peer set of thrifts/savings banks. Important that our comparison banks reflect a similar underwriting and loan mix as GCBC, so I’ve filtered the publicly traded list to correct for this. Additionally, my filtered peer set includes other thrifts with MHC ownership, so I’ve made the same market cap adjustment to reflect the true shares outstanding. All said and done, at the time of this writing, the peer group trades a median multiple of a little over 18x last year’s earnings. Applying this same multiple to GCBC, we land at a price of about $52 per share, suggesting that GCBC trades at over a 50% discount to fair value – quite significant – and I would argue for the reasons described above that GCBC should trade at a premium to its peer group.

Discounted Capital Valuation

I’ve put together what I would describe as the bank equivalent of a plain-vanilla DCF valuation. I say 'bank equivalent' because of the unique characteristics that impact bank economics: regulatory capital requirements (driven off of GAAP accounting), loan loss reserves, etc. Rather than laying out every assumption in the model, I’ll focus only on the core pieces:

• 10 year financial projection that assumes annual growth descends to a GDP growth rate by Y6
• 10 year total deposit CAGR of 6.3%
• Loan to Deposit ratio held fixed to reported FY 2017
• Investment, loan, and borrowing spreads are held constant to FY 2017
• Interest rate trajectory consistent with the latest Fed dot plot (June 2017)
• Mix of new originations consistent with reported FY 2017 balances
• Total Basel III RWA / Total Assets of ~57%, consistent with FY 2017
• Total Capital Ratio held fixed to FY 2017 – despite opportunity to return capital to shareholders
• Allowance for Loan Losses / Total Loans = 1.80% in all years
• Charge-Offs / Total Loans = 0.18% annually
• Efficiency Ratio no lower than 50% in all years

I would characterize these assumptions as conservative. Plenty of reasons to believe that management will be able to deliver better growth in the medium-term than the 6.3% base case assumption. And as with any bank in this environment, a higher interest rate trajectory would have a significant positive impact on projected returns.

My base case assumptions above suggest a significant margin of safety. Assuming a CAPM derived required return of 11.2%, my estimate of GCBC’s fair value is as follows:

Of course, as with all models, I will be wrong about some (or all) of the assumptions above, so I’ve re-run the valuation, sensitizing two variables that are particularly impactful: deposit growth and projected interest rates. For deposits, I run the growth rate all the way down to a GDP equivalent, basically laying out a scenario that assumes the company’s recent success was an anomaly never to be repeated. For interest rates, under the most bearish scenario, I shocked the current Fed projection by 100bps in all years, severely impacting the net interest margin of the business. Taking the most extreme assumption for both cases, we still reach a fair value in excess of the current share price (~$29 per share).

Key Risks to the Valuation

Having highlighted many of the key variables of consideration, it’s worth spending some time discussing certain unknowns (at least to this author) that could materially impact GCBC’s return in the future.

Fed policy obviously has a significant impact on the returns of all banks, and I don’t have an edge here, and frankly, very few do. Maybe rates go up more than expected? Maybe they don’t? I don’t really care, as there’s still a compelling investment rationale whether rates are high or low. However, if rates do plummet, the market will take GCBC lower along with the rest of the sector.

Second, banking distribution is fundamentally changing. It should be obvious to most bank investors that physical branches are less critical to distribution than they were 20 years ago, and digital banking is playing an increasingly prominent role. Again, I don’t really have an edge here either, and I could not possibly handicap the timing and nature of these changes. I do know that the large institutions can invest to stay ahead of these trends, but smaller banks cannot really afford to do so. That said, this is a long-term trend, and we’ll likely have made our money back in earnings before this negatively impacts GCBC.

Conclusion

GCBC is one of the better prospects I’ve uncovered this year, and I’m definitely buying at these levels. As the company continues to execute and expand, I expect this will start to grab the attention of the institutional investors that play in the micro-cap arena. When it does, we should see multiple normalization. Based on the two valuation methodologies discussed in this article, shares of GCBC would have to appreciate between 110% and 130% to reach fair value. We have room to run.

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Disclosure: I am/we are long GCBC.

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.