Friday, February 7, 2014

Mutual Conversion: Coastway Bancorp

Coastway Bancorp (NASDAQ: CWAY) is the holding company for Coastway Community Bank, a Rhode Island based mutual savings bank that completed its stock conversion on January 14, 2014.  The investment thesis is simple and straight forward for Coastway Bancorp (its the same as most any mutual-to-stock conversion): (1) As a mutual conversion, investors essentially get the built up capital "for free" creating an overcapitalized cheap bank, (2) It's balance sheet is fairly clean with limited legacy bad loans, (3) It's trading at an attractive valuation of just under 75% of proforma TBV.

Coastway is located and does primarily all of its business through nine banking offices located in Rhode Island, not the most attractive economic environment as its been plagued with higher than average unemployment rates for years.  Coastway was a credit union for much of its life before converting to a mutual savings bank in 2009, thus its only recently begun making strides to generate profits.  But this is generally an easier problem to fix (compared to say a lot of problem loans) by converting to a stock corporation as management is now incentivized to start generating a profit and can do so by increasing assets and taking a detailed look at expenses.

Balance Sheet
Coastway's balance sheet is pretty clean with $380 million in assets, only a little more than 2% of which are non-performing.  With fresh conversion capital at its disposal it should be able to grow the balance sheet to get a closer to point where the regulatory costs become more bearable and spread across a wider base.  While many pundits point to this magic number being $1 billion, I think there's still space below that for a bank to succeed and many of the regulatory burdens may end up being less than what the industry originally feared.

Loan Portfolio
One thing to like about Coastway is their loan portfolio is more commercial bank like than many savings institutions, less emphasis on one-to-four family residential mortgages and more emphasis on commercial loans.  While commercial loans are riskier, it's hard to make money being a traditional thrift in today's low interest rate environment.  Expect this trend towards commercial lending to continue at Coastway as they deploy their fresh capital. 
I also have a soft spot for SBA loans as I think it's a great way for banks to increase their non-interest income (really the driver for bringing down the efficiency ratio and increasing ROA) by originating and servicing the loans, and then selling the guaranteed portions of the loans (at a hefty profit!) into the secondary market, freeing up more lending capacity to rinse and repeat.  Coastway despite being either 7th or 8th in deposit share their markets, has been one of the top 3 SBA lenders in Rhode Island for the past six years, hopefully this trend continues.

Real Estate
Coastway owns a majority of their bank branches and office space, the book value of which is $24.4 million, a potential hidden asset if these buildings are worth more than their cost minus depreciation (although I haven't looked, would be a minor positive).  In fact, they're moving from their current headquarters in Cranston, RI and moving to a new building that's under construction in Warwick, RI.  While I typically wouldn't like the sound of a new headquarters being build post IPO, in this instance I hope it makes sense, and signals plans for further growth which is key in a mutual conversion.  Coastway has also recently opened up two new branches, combine this with the new headquarters and you also have a lot of one time costs that are masking profitability.

Interest Rate Risk
Although interest rates have recently pulled back, the longer term trend should be higher as the Federal Reserve reduces its stimulus and forces the markets to fend for themselves.  Higher interest rates in general will be a positive for banks as their assets will likely reprice quicker than their deposits/liabilities which are generally sticky (banks will try for as long as possible to keep their deposit rates near zero) and their net interest margins should improve.

Coastway is positively leveraged towards higher interest rates, above are the results of a model included in the prospectus that attempts to capture the change in equity value for a given change in interest rates.

Income Statement
Coastway, like other mutual conversions, as a limited history with profitability.  The efficiency ratio is way too high and the ROA and ROE are both extremely low.
Some one time costs around the mutual conversion and expanding their branch network have brought up the efficiency ratio recently, but even in the low 80s (where it's been historically) is too high.  But it is a common problem with small mutual conversions, and is actually a fairly easy problem to fix now that they're a public bank with fresh capital to invest.  There's likely some low hanging fruit around expense reduction and some positive operating leverage as the asset base should be able to increase without expenses following suit too much.  Coastway is also ripe for an activist investor, it's in that sweet spot of small, but still liquid enough for a fund of decent size to accumulate a position and push management.

As of today (2/7/14), Coastway has a market capitalization of $50.3 million, versus a book value of $68.6 million after the conversion, or a P/B of  0.73x.  As Coastway expands and improves profitability, the discount to book should close producing an attractive return.  While the mutual conversion prevents Coastway from being acquired for three years, Coastway will have the opportunity to close the discount to book themselves as they're retaining roughly 40% of the net proceeds from the conversion at the holding company, likely to either fund a dividend or repurchase shares.

Overall, there's nothing to jump up and down about over Coastway, it's a pretty typical small community bank that's trading at attractive valuation due to the recent conversion.  I have added Coastway Bancorp to my slowly developing mutual bank conversion bucket (along with just Sunnyside Bancorp at the moment), as it's a fairly proven lower risk investment theme.

Disclosure: I own shares of CWAY


  1. I love this strategy, buying cash at a discount. It appers both Sunnyside and CWAY have not traded well since IPO. Do thrifts usually take three years to play out? Do you expect Sunnysides one year mark to have an impact? Thanks.

    1. I try to be a pretty patient investor so I'm not worried about the short term trading in either, especially Coastway as its been less than a month since it came public. I'm slightly concerned that Sunnyside might be too small and it will be hard for it to generate meaningful ROE. But in general these mutual to stock conversions have a pretty good track record (for a good logical reason), and that's the motivation behind having a basket of smallish positions.

      As for the three years to play out, it doesn't always seem that way, many seem to appreciate above book value quickly, but many also get acquired in those 3rd and 4th years after the conversion, and usually at a nice premium, but I would guess my average holding period will be around 2.5-3 years.

  2. Thanks for this idea. Sounds interesting. What makes you so confident that profitability can increase? Can you talk a bit more about the conversion dynamics? I guess the idea is that the company has fresh capital to spend building assets and a new found focus on costs. Profits looks really weak tho so I'm wondering how much and how fast it can grow.

    1. I think profitability will rise for two main reasons, (1) there's more of a focus on profitability that wasn't there before, its really secondary as a credit union or mutual savings bank, and (2) with the new capital the bank will be able to increase their balance sheet and gain scale without presumably adding too much additional costs.

      The main driver of the conversion is depositors are in effect buying the retained earnings of the bank that they already "own", and all of the equity raised in the conversion goes into the bank, creating a cheap overcapitalized institution. Most mutual banks are conservatively run, so they tend to have clean balance sheets too, the capital raise isn't done out of a need to plug a balance sheet hole.

      Increasing the ROE won't happen overnight, its a 1-3 year process, if it were to happen quick I would be concerned about the quality of the loans being underwritten. Investing in mutual conversions isn't sexy, but its a fairly time tested approach. Thanks for the comment.

  3. Dont most of the thrift conversion returns happen pre conversion? I.e. dont you need to be invested pre conversion? There are studies that show the long-term performance of thrifts after conversion is negative. Thanks.

    1. I'd be curious to read the studies you mention, please post a link if you can. Yes, it's more advantageous to be a depositor before the conversion takes place and get in on the initial pop, but I personally don't have the time or desire to open up accounts at various banks that may or may not convert within a reasonable time frame. I think the economics are still attractive post conversion.

  4. Here is one study. Good returnd at IPO and for six months than returns go negative. I know Lynch and Kalarman discuss this strategy and the benefits. But Im with you and dont wont to setup accounts at thirfts pre conversion. If returns post IPO still are good and reserach supports this please let me know. thanks.

    1. Thank you. I gave it a quick read tonight (probably need to read it a second time), it brings up some interesting points and clearly has an academic/quant lean to it. I doubt many investors were buying all 200+ conversions during the sample period. I'd be curious to see recent results, the current environment after the financial crisis is much different than the 1990s for financial institutions, and many conversions haven't seen the initial pop to the Total Value (Pre-Value + IPO proceeds - Expenses) figure, or a lot of investor overreaction. Coastway for instance is only trading 2.8% higher than the IPO price and at significant discount to tangible book value. It was an interesting read, thanks again for the link and comment.