The Bancorp - Nothing But Upside From Here: Target $16
May. 1, 2015 11:33 AM ET | About: The Bancorp, Inc. (TBBK)
Disclosure: The author is long TBBK, CASH. (More...)
Loan portfolio Sold at 102% of Par.
Deeply undervalued at 104% of Book Value.
High Growth Prepaid Card Business will generate increasing revenue and profit.
European Card Business will ramp in the near term.
The Bancorp (NASDAQ:TBBK) has been a very controversial story. We have always believed that the company would sell its discontinued loans for par or par plus. The bears (such as this SA writer) have argued that the loans would sell for a deep discount to where they were marked. After quite some time, we have finally received some news on the sale - but not from TBBK, from another bank. TBBK did not put out a press release because they have not filed their 10k as of yet. As such, we believe that the market may have missed this very significant news.
On Tuesday, Cape Bancorp (NASDAQ:CBNJ) announced the purchase of $102.0 million of Philadelphia metropolitan area based commercial loans and loan commitments from an unnamed financial institution. The loans were purchased at 102% of par, producing a $4 million gain. We are quite sure that the unnamed seller is TBBK. TBBK's stock price has already started to react as the news is probably leaking out, but it's still at book value. TBBK had been under selling pressure as many have speculated that the loans were bad and would be sold at a loss. But, as we have pointed out on a number of occasions, that is not the case.
TBBK is a combination of several banking services. It provides various commercial and retail, and related banking products and services to small and mid-size businesses. But TBBK"s real niche is its prepaid card business. With the soon to be announced additional sales of the loans, TBBK's issues are put behind it, so investors will focus on the prepaid card business in the US and Europe.
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 unprofitable 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, but these are now behind it. Further, 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 $9.20/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.