The Bancorp's New Model With Substantial Upside, Price Target: $16
Jan. 16, 2015 12:49 PM ET | About: The Bancorp, Inc. (TBBK), Includes: BOFI, CASH
Disclosure: The author is long TBBK, CASH. (More...)
Many catalysts for price appreciation, including possible sale of the bank.
The street attaches no value to to rare, high-growth prepaid debit card business.
Steady-state profit model indicates 60% stock price appreciation using industry comparables.
Book value of $9.25 is a floor, as we believe loan portfolio writedowns are conservative, with possible gains on sale.
Increasing the Fed funds rate will boost profits significantly.
Betsy Cohen and Frank Mastrangelo turned a boring bank into a stellar growth institution. In 2006 The Bancorp (NASDAQ:TBBK) bought a software platform that enabled the company to become the 4th largest Stored Value Card issuer in the country. In our opinion, this asset has been assigned zero value by the marketplace. Stored Value Cards, TBBK's veiled business, are one of the most dynamic and fastest growing products in the financial industry.
TBBK, as the largest small bank issuer of stored value cards nationwide, has agreements with more than 400 non-bank financial service providers. Through these relationships, TBBK gains access to large customer groups at an extremely low acquisition cost - the unspent balance on the stored value cards from these groups stays on the bank's books as deposits. With the Fed getting ready to raise interest rates later this year, these deposits will begin to generate large profits.
TBBK has grown its deposit franchise to $4.2 Billion in deposits at the end of Q2 2014. From these deposits the bank can generate a spread in specialty lending including small fleet leasing, security backed lines of credit ("SBLOC"), CMBS origination, SBA loans and Franchise loans. The historic charge-off for these types of loans has been almost zero.
The Bank also invests surplus liquidity in five year treasuries and short duration, risk-averse, municipal securities. The bank has managed to grow its assets annually at about 14% CAGR. TBBK has locked in a return that can generate tremendous earnings. The key is that the stored value deposits, which grew approximately 50% year over year, only cost the bank 11 basis points, or about 1/10th of one percent. For every point up in Fed Funds, the bank should realize 15 cents in additional EPS. The bank also receives a substantial fee for processing the transactions. In this low interest rate environment the bank has grown this non-interest income by 38% CAGR over the last 7 years.
Stored Value cards are replacing traditional bank accounts for individuals. Similar to the change that Visa (NYSE:V) has benefited from; customers are converting from cash to credit cards. Due to heavy regulation, most banks have been unable to profit from checking accounts on low-income customers. So, they are encouraging these customers to leave the institution and set up a stored value account. This benefits TBBK as more customers leave the traditional banks and sign up instead for a simple "bank about in your pocket" - a stored value card.
So, TBBK has a unique and rare high-growth driver that is unrecognized by the market. Using comparables, the stored value business alone is worth two times more than the current market cap. See the current slide presentation for financial numbers.
Insiders seem to know that TBBK is a smart investment. The recently retired CEO (She is in her 70's) has bought $1,000,000 worth of stock in the open market in the last several months. The current CEO knows that this business is worth much more then where it is trading and we also expect him to make stock purchases.
TBBK has been the target of recent acquisition rumors. Analysts at Sterne Agee have speculated that Bank Of the Internet (NASDAQ:BOFI) is interested. BOFI has a highly liability-sensitive balance sheet and would offset some of this risk by acquiring asset-sensitive TBBK. We met with one account that speculated a high teens acquisition price after meeting with BOFI.
At this point in the cycle an investor is buying a bank with excellent credit metrics (non performing well assets under 1% with high reserves and very healthy capital ratios), an experienced management team with a history of selling banks at large valuations (Betsy Cohen sold Jeff Bank at 3x book) and a hugely undervalued asset that if bought by another institution could be worth a multiple of the price of the underlying.
But even if TBBK isn't acquired, there are a number of catalysts that should trigger near-term price appreciation. First, the commercial loan portfolio will likely be sold later this month. The net proceeds should be, at a minimum, the marked-down book value of $900 million. This already factors in a cumulative loss-to-date on the portfolio of 15%. It is possible that the bank will be able to sell the portfolio at a premium to its current carrying value. We believe that management took a very aggressive approach to marking down the portfolio so that current values are most probably conservative. If the portfolio is sold at book, the current tangible book value of $9.25/share will be validated. If it's sold at a higher price, book value will immediately pop.
In any case, the sale will create a floor for the share price at 1x TBV. The sale should also alleviate some current "soft costs" related to running the portfolio that are not yet separated into discontinued operations. These costs are related to the processing system of loans and head-count of the commercial group and should provide some relief to non-interest expense which we have not yet modeled.
Most of the proceeds from the sale of the commercial loan portfolio, excluding what has already been sold on a note receivable, will be fully reinvested at historical 4% yield within the next 18 months. This should create a recovery in NIM to 2.7% from current levels of 2.3% from continuing operations. On an interim basis, we project NIM at 2.2% in 2015 while proceeds are reinvested quickly at the lower rates. The remaining loan portfolio has had insignificant losses and there should be minimal credit risk going forward. For example, non-performing loans are only 0.55% of remaining portfolio vs. historical levels of about 2% and net charge-offs should be in the 15bps range as a percent of average loans. This lower risk portfolio of assets should yield a higher multiple.
Growth in the Prepaid business is large - open loop prepaid cards were projected to grow globally at a 22% CAGR from 2010 to 2017 and a 16% CAGR in the U.S. In comparison, TBBK's growth in prepaid GDV (Gross Dollar Volume) has been a 74% CAGR from 2009 to 2013. Additionally, the BSA order only affects TBBK's general purpose cards. These are a sub-segment that only represent 35% of the total prepaid business and are still allowed to grow at national average growth rates. The remaining 65% of the prepaid business will be allowed to continue to grow at historical higher growth rates. Once the BSA is lifted, TBBK will be capable of acquiring new customers and the remaining 35% of the business should see a recovery in growth rates as well. TBBK is also the bank used in emerging payment systems such as Paypal (NASDAQ:EBAY) and Google (NASDAQ:GOOG) Wallet as well as Simple.
European prepaid business will breakeven by the end of the year and has potential to add significant growth to prepaid fees. The current drag on operations was disclosed to be about $5 million/year and yearly EPS could improve by at least 9 cents once this business becomes profitable. In addition, the European business is not impacted by the BSA order and there are no growth constraints. This is all upside to both our modeled normalized forecasts and street analysts' estimates.
In a rising interest rate environment, TBBK should outshine its peers as its interest-earning assets will generate yields that are significantly higher than its low costs on prepaid deposits, which will stay sticky at low rates. For example, for every 50 bp increase in yields across the board for both interest-generating assets and interest-bearing deposits, our modeled normalized EPS of $1.20 increases by 10 cents. Using steady-state EPS and a 1.5% Fed Funds rate, TBBK should yield EPS of $1.45 or about 25 cents increase. This change would not happen instantly but over time in a couple of years as loans are gradually re-priced. In the short-run, the EPS should see a 10 cents lift immediately. While today's environment seems to rule out any rate increases, we believe they will come and TBBK contains a very nice asymmetric upside to that environment - an option investors are not paying for today.
The company recently announced a CEO change that is viewed as positive and appears to be a logical step in transforming TBBK into a financial-tech company. Betsy Cohen has retired and will be replaced by the current President and COO, Frank Mastrangelo. Frank has been the point-person on the prepaid card business in the U.S. and Europe. If TBBK changes its focus towards the prepaid cards industry it should have a re-rate in multiples that are closer to financial-tech companies, in the range of 20-25x NTM P/E.
Downside is Limited - 15% Worst-Case
We believe that management has taken a "kitchen-sink" approach for 2014 and the current tangible book value of $9.25/share reflects drastic mark-downs to the commercial portfolio being sold, which are further discussed below in "Commercial Loan Portfolio - The Worst is Over".
Also, during the Q2 announcement, management tried to charge off the entire $9 million of consulting costs related to the BSA order; however, this was later revised to be spread over the last three quarters in 2014 and $5 million has been expensed to date as such conservative accounting was not approved by the auditor, but it does speak to management intentions. In situations like this with banks, where loan portfolios have not been performing for a prolonged period, they become show-me stories and management has credibility issues until negative development stops or until the problems loans are sold. In TBBK's case, the announcement of the sale of commercial loans indicates that all major marks should have been taken. Management is essentially opening kimono to anyone willing to sign a CA and if there were any other major problems with the portfolio, they would come up during the sale process and would risk completing a sale. If that were to happen, the market would assume the worst.
Even with all the mark-downs, the company remains well-capitalized and management has indicated that they absolutely do not need more capital. Adding more margin of safety, large portions of the SBA loans on the balance have government guarantees and would trade at a 10-12% premium to par value if they needed to be sold.
Below is a summary of the multiples of its closest regional banks peers and competitors in the prepaid cards industry. We have also included multiples of "financial-tech" companies such as VISA and MasterCard (NYSE:MA). Once the BSA order is lifted and the commercial loan portfolio is sold, we believe that TBBK should trade somewhere between the regional banks and financial-tech companies in the long run at 12.5-14.5x our steady-state EPS of $1.20 at the end of 2015. This would imply a target range of $15-$17/share, which is 60% IRR to current share price if realized within one year and 25% IRR if realized within two years.
TBBK provides a breakdown of its interest-generating assets and deposits in their quarterly presentation (slides 12 and 14):
In our forecasts we have kept these yields and costs flat as they have been fairly steady over the past quarters. The only exception is to the proceeds from the Community Bank portfolio, which we forecast at 1.75% in 2015 and re-invested at 4% in our normalized year.
Primary Interest-Generating Assets (click link below for tables)
Commercial Loan Portfolio - The Worst is Over
Before announcing the discontinuation and sale of its commercial portfolio in the latest quarter, TBBK had several significant charge-offs and provisions related to the Commercial and Construction loans. In 2013 there were $29.5 million of provisions and $24.4 million of net charge-offs of which $14.6 million of NCOs were related to Commercial loans and $9.3 million to Construction loans. In the first half of 2014, problems with these portfolios continued and TBBK charged off a further ~$23 million and expensed $33 million of provisions on the income statement.
Before the Q3 announcement, management disclosed that the commercial loan problems were isolated to legacy loans from 2009 and a significant proportion had already been charged off. In 2009, there were $1.5 billion in loans of which ~$1.2 billion were related to the commercial portfolio. From 2010 to Q2 2014, $90 million of the commercial loans were charged off and in the Q3 release, a further $82 million mark down was mentioned. That would imply that 15% of the initial 2009 commercial loans has been charged off.
The discontinued loans are currently valued at $1.1 billion on the book and the remaining continuing portfolio is about $870 million. Management is currently reviewing options for selling the commercial loans and has indicated on calls that there is significant interest from other parties. However, they are looking to maximize proceeds and they will be deciding between (1) selling the loans in bulk to one or two sellers or (2) breaking them apart by geography. The banks that will be buying these loans will get a benefit from growing their portfolios in a very short period of time, incurring little to no origination costs, and instant valuation bump to those trading above book. However, our model takes a conservative approach and assumes there will be $900 million of net proceeds that management will be able to re-invest.
Once the loans are sold, management has guided to a 1.75%-2% immediate reinvestment rate. They expect to quickly invest the proceeds primarily in mortgage-backed securities within weeks of selling the loans. In the long-run, they will be capable of reinvesting these proceeds into their loan portfolio at historical yields of about 4%. We expect the proceeds to be fully reinvested at 4% by mid-2016 and at the very latest by end of 2016. For 2015, we have taken the lower end of management's guidance and assumed a temporary re-investment of $900 million of proceeds at 1.75%.
Prepaid Cards Business
TBBK's prepaid cards business is the main growth story of the company and gives a free option on a rising interest rate environment. The industry has grown significantly in the last few years, especially in North America, and TBBK has quickly become the leading bank issuer. TBBK generates fees based on the dollar amount loaded on each prepaid card and the number of prepaid cards sold or reloaded. Its affiliates are the ones who run and market the various prepaid programs, while deposits are held with TBBK. Fees are reported as a percent of GDV (Gross Dollar Volume), which is the total dollars spent on all cards in a given period and the metric used by its peers in the prepaid industry.
Growth in prepaid cards GDV and fee income has been significant in the past few years. GDV has grown at about 74% CAGR from 2009 to $32 billion in 2013 and as of Q3, TBBK has already generated $31 billion of GDV in 2014 YTD. In the last few quarters, YoY growth in GDV has been about 30%.
Prepaid card fees currently contribute about 60% of total non-interest income and 25% of total net revenue (net interest income + non-interest expense) in the past few years. Fees have grown at a 60% CAGR from 2010 to 2013; however, they are expected to be 12% YoY going forward due to the BSA order and market slowdown. Margins are 13bps and management expects these to remain flat in the next year.
The main advantage of the prepaid cards business is the low cost of deposits. These deposits only have an average cost of 2bps and can be invested in securities or loans at much higher yields in addition to TBBK earning non-interest income fees. Prepaid card deposits have grown from $781 million in 2010 to ~$1.7 billion in 2014 and represent approximately 40% of TBBK's total deposits. These low-cost deposits have kept the average costs down to ~25bps of total deposits. Other deposits, such as institutional banking and healthcare, have higher costs at 40-50bps. While the benefit of low-cost deposits cannot be fully seen today when competitors are able to attract funds at rock bottom rates, a more normalized interest rate environment will show the value of this deposit-gathering franchise.
Aside from its significant growth and profit contribution, the prepaid business also has the advantage of being well diversified. TBBK's largest customer in prepaid cards only contributes 6% of prepaid non-interest income, while the top 10 contribute ~40% and top 20 contribute ~70%. On a prepaid program basis, TBBK is even more diversified with the largest program contributing 4.5-5%. In the past, TBBK has not been afraid of ending relationships with un-profitable customers and management states that they have never had a large customer leave on their own. If this were to happen though, most contracts have a notice clause of 6-9 months. The recent departure of their customer UniRush was confirmed to have been a decision by TBBK and was press-released before the BSA order was in place. To date, there has been no material impact from the BSA order on any of TBBK's largest customers. Switching costs remain high for program issuers which solidify TBBK's market leadership in this space.
Background on the Prepaid Industry and Trends
According to a MasterCard industry report, global prepaid market size is expected to reach $822 billion by 2017 of which the U.S. will represent 51% ($421 billion). Open loop prepaid cards are projected to grow globally at a 22% CAGR from 2010 to 2017, 16% CAGR in the U.S., 27% CAGR in Europe and 38% CAGR in Canada.
TBBK is the market leader in the U.S. and was the largest issuer both by purchase volume and active cards in circulation in 2012 (Nilson Report). They had a purchase volume market share of 20.71% and a purchase volume of $20 billion and 44.6 million cards.
MetaBank (NASDAQ:CASH) is its closest competitor in this space; they had #1 market share in 2011 and dropped to second place in 2012 with a purchase volume of $15.8 billion and 26.3 million cards. MetaBank had a consent order issued by OTS (Office of Thrift Supervision) in July 2011 that was terminated on Aug 7, 2014. Despite the cease and desist order, MetaBank was still able to grow stored value deposits by ~30% during that period.
Through the Dodd-Frank Act, the Federal Reserve established rules regarding interchange fees charged for electronic debit transactions by payment card issuers. The rule limited interchange fees to a maximum of 21 cents plus 0.05% of the transaction value plus a 1% fraud-prevention adjustment, if eligible. However, this rule exempts any debit card issuer that, together with its affiliates, has assets of less than $10 billion. As a result, companies such as TBBK and CASH have been able to enjoy large market shares in the prepaid cards industry as they both have assets less than $10 billion, while larger players have stayed away. We assume that any change to this rule will make TBBK's prepaid card franchise an attractive acquisition as many larger banks would try to pursue a buy vs. build strategy.
More information on the exemption, along with a list of exempt institutions, can be found here:
TBBK purchased certain software rights and personnel of a prepaid program manager in Europe on Nov. 29, 2012 for $1.8 million to establish a European prepaid card presence. In 2013 they continued infrastructure spend and continued to bridge licenses across the EU. Operations consist of three operational service subsidiaries and one subsidiary that offers prepaid card and electronic money issuing services.
Although European operations contributed less than 2% of total prepaid card revenue in 2013, they are expected to have a breakeven rate in Q4 2014. In the second quarter earnings call, it was disclosed that the European business had a drag of $1-1.5 million/quarter of operating expenses. This implies that once the business is breakeven there should be a lift of $5 million/year pre-tax and a ~9 cents contribution to yearly EPS. Furthermore, on the latest earnings call management mentioned that they expect to have a number of clients fully boarded and integrated by end of Q4 2014. This side of the business could be a potential driver for profitability and GDV going forward. However, this is all upside to the current base story and none of the analysts have modeled in contribution from Europe yet - and in fact many have the drag of the losses unknowingly baked into their models.
The company's stock has been depressed due to a series of recent negative events. However, there are many catalysts in the next year and a half that should reverse the overhang on the company and lift the trading multiple in line with its peers. In addition, a steady-state scenario of the company has yet to be analyzed by the street and once investors realize the full potential of the business, the share price should trade at $15-17/share by the end of 2015, at a ~60% premium to current levels. On the downside, we believe that TBBK's current tangible book value of $9.25/share factors in a "kitchen sink" approach to write-downs and is an appropriate measure of the "floor" of the future share price at a 1x P/TBV multiple.