NSTS Bancorp: Post 3-Year Thrift Conversion, Possible Sale

I apologize in advance, this one might only have a limited audience, it is a small and illiquid community bank in my backyard, maybe there are others in a similar position near you.  

NSTS Bancorp (NSTS) (~$60MM market capitalization) is the holding company for a three branch community bank, North Shore Trust & Savings, located in Waukegan, IL with $282MM of assets.  Like many other thrifts, NSTS has a fairly simple business model, they take in deposits from the local community and primarily (~90% of the loan book) make 1-4 family residential mortgages in the area.  The bank is significantly overcapitalized (Tier 1 capital ratio is 23.11%) due to their demutualization in January 2022 and three years later, still struggles to turn a profit.  The assets are pretty clean, the entire securities portfolio is accounted for as available for sale (held on the balance sheet at fair value) and the loan book has minimal credit issues, but the tangible book value would take a $1.30/share haircut if the loans were held at fair value.  Normally, this wouldn't be of particular interest, but a few things make this a likely sale candidate in the relatively near future:

• Thrift conversions need to wait out a three year cooling off period as a public company before they can be acquired.  NSTS passed that mark this past January.  Given the increased deal activity where we see credit unions acquire thrift style banks, it would make sense for a similar transaction to happen here with NSTS.  The hit rate of conversions being acquired in years 3-5 is pretty high.
• In this year's proxy statement, the following proposal was made by a shareholder, usually in these situations the company will defend themselves and recommend that shareholders vote no, but NSTS was surprisingly indifferent and almost went as far as agreeing with the shareholder despite some accusatory statements towards the board and management.  The annual meeting was yesterday, I'm eagerly awaiting the results to be posted on Edgar.

PROPOSAL III – CONSIDERATION OF NON-BINDING STOCKHOLDER PROPOSAL RECOMMENDING THE SALE OR MERGER OF THE COMPANY

 

“RESOLVED, that the Stockholders of NSTS Bancorp, Inc. recommend that the Board of Directors engage in an investment banking firm experienced in community bank mergers and acquisitions to guide the Company in promptly taking the reasonable and customary steps to merge or sell NSTS Bancorp, Inc on the best terms available so as to maximize stockholder value.

 

     Supporting Statement

 

NSTS does not have the size and scale to compete effectively in the 21st century financial world. In fact, a CEO of another Illinois thrift recently stated to me in conversation about the future of micro-cap community banks: "We are all dinosaurs!" Since the IPO in November 2021, NSTS has traded at a significant discount to tangible book value per share. The shareholder proponent believes that NSTS is worth close to or above TBVPS in a sale or merger, and that such sale or merger process to be undertaken is consistent with the Board of Directors Fiduciary duty to all shareholders.

The board of directors can recommend the highest and best offer by "running" the M+A process with their investment banker, and the shareholders will have the final vote on the best offer available.

 

Since the IPO, this BOD and management have purchased very few shares in the open market. Their economic interests are not well aligned with the shareholders as they will earn board and management fees, salaries, accumulate "freebie" shares, and vest in the ESOP plan over time. They get paid to wait. Meanwhile, the stockholders earn an inadequate return on their equity of less than the risk free rate on T bills, CDs, or money market funds of around 5% at this time of writing. For these and other reasons not included here, this shareholder asks that you vote FOR this proposal.”

 

Board of Directors Statement

 

The Board, together with Company management, regularly reviews and assesses the Company’s performance, future growth prospects, business plans, competitive position, and overall strategic direction. In connection with strategic planning and consideration of strategic alternatives, the Board has from time to time engaged investment banking firms and financial advisors. As a result, the Board currently receives, and will continue to receive, investment banking advice and information on such factors. As part of this ongoing review process, the Board evaluates and considers a variety of potential strategic alternatives available, including pursuing potential strategic transactions with third parties, with the goal of maximizing stockholder value consistent with the requirements of Delaware law and its fiduciary duties.

 

However, the Board is not recommending a vote for or against Proposal III. Rather, the Board will consider the voting results on Proposal III in its ongoing discussions and considerations, together with any additional stockholder input received in connection with the Annual Meeting and through stockholder engagement. Stockholders should note that this proposal is advisory in nature only and support of this proposal would not, by itself, result in the merger or sale of the Company as contemplated by the proposal, and would not require any action by the Company.

• Share repurchases have stopped for no particular reason, indicating they might be going ahead with a sale process.  Typically these thrift conversions will buyback shares because they're overcapitalized and usually trade at a discount to book (NSTS trades for ~80% of book).  NSTS was a pretty consistent buyer of their own shares for most of 2024, but stopped in December and haven't restarted.

This is a little bit more "reading the tea leaves" than I like, especially compared to the broken biotech basket, but the signs certainly point to the pressure being ratcheted up on NSTS to sell the bank.  What could it fetch in a sale?  I think at least TBV would be the floor, or ~$15/share, maybe more if it is bought by a credit union, it trades for $11.88 as of today.

Disclosure: I own shares of NSTS

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.

Valuation/Conclusion
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

Experimenting with Mutual-Bank Conversions

I've been having trouble lately finding new cheap investment ideas without a lot of hair on them.  So I've spent some time re-reading classic investment books and seeing what I can glean from a 2nd or 3rd reading.  A common investment theme of Peter Lynch, David Einhorn, and Seth Klarman has been investing in mutual bank conversions, something I've looked at in the past, but generally passed on for no particular reason.  But at this point in the business cycle, I'm attracted to the built in value and clean balance sheets of mutual banks that convert to stock corporations.  This isn't a new strategy, but I think for the individual investor, its an easy formula to follow for above average returns with relatively low risk.

Why Mutual Conversions?
Mutual banks are those that are "owned" by their depositors and have no shareholders, they're designed to be low risk institutions that cater to their members by taking deposits and making loans in the community.  They tend to be conservative in their lending and accounting as there is no stock or ownership group to please, and reporting profits could be a sign of risky lending.

When a mutual bank determines it wants to convert to a stock corporation, the depositors have to come up with cash in order to buy shares in a company they already "own".  Unlike a typical IPO, there's no exiting investor group selling their shares to an unsuspecting public, its the bank's directors and the IPO buyers on the same side of the table.

By construction, the post-IPO thrift conversion is undervalued.  By adding the new IPO share proceeds to the existing equity capital held by the bank, the new investors effectively get the company for free as ownership of the post-IPO bank includes both the offering proceeds (minus expenses) and the exisiting capital itself.  What you end up with is a low-risk balance sheet with excess capital available to increasing assets at a significant discount to tangible book value.  In many cases, mediocre banks begin to show profit improvements after the IPO as the animal spirits of the thrift's management takes over.  Newly converted mutual banks tend to outperform due to these reasons, however they are restricted from repurchasing their stock for 1 year post IPO and from being acquired for 3 years post IPO.  After this three year lock up period, many converted thrifts are purchased at premiums to their tangible book value. 

Sunnyside Bancorp
On July 15th, Sunnyside Bancorp (OTC: SNNY) completed their mutual conversion IPO by selling 793,500 shares (adjusted maximum) for $10 a piece.  Sunnyside Bancorp is the holding company for Sunnyside Federal Savings and Loan Association of Irvington, a one branch thrift located in Irvington, NY, a bedroom community about 25 miles north of New York City in Westchester County.  Irvington is a small affluent village on the Hudson River.  It's been named as the "Best Place to Live in Westchester" which is the second wealthiest county in New York, with a median household income of $80,725 and a median home value of $547,000.

Balance Sheet & ROE Potential
Besides being located in an attractive community, Sunnyside's balance sheet shows a conservatively run thrift that's ripe for additional capital to improve profitability.  Sunnyside is primarily funded through customer deposits and has no senior debt.  A vast majority of their loans, 86.4%, are owner occupied residential mortgages which ranked high on Peter Lynch's criteria when investing in small thrift banks.  The view on the safety of residential mortgages has probably changed drastically from the early 1990s (when Peter Lynch was investing in mutual conversions), but Sunnydale's portfolio is rather clean, they have no subprime or Alt-A loans and borrowers almost always need a 20% downpayment.  Historically, Sunnydale hasn't written their mortgages to "conforming" standards since they've held all their mortgages on balance sheet, but going forward they will be putting more emphasis on selling mortgages to the GSEs in order to increase non-interest income, a general theme of their strategy going forward to increase profitability.

Unlike many large banks, Sunnyside's balance sheet is basically free of problem assets, as of the S-1, they had zero delinquent loans.  It looks like that's changed slightly as of the latest quarterly as 1 loan has slipped into delinquent status, but overall Sunnyside's balance sheet is almost a blank canvas.

Although the balance sheet is clean, Sunnyside posted a net loss in 2012, but with the excess capital, what could Sunnyside's income statement look like post-IPO?  Below I attempted to make a pro-forma income statement using Sunnyside's current net interest margin (which hopefully will increase as Sunnyside makes slightly riskier loans), increasing the thrifts non-interest income to represent the new strategy to sell loans to the GSEs and then increasing expenses as appropriate for the increased size and newly public status.

While a 5% ROE is still too low, it should be a fairly conservative proforma estimate.  I would expect Sunnyside to improve on these results as it engages in slightly riskier lending and the stock ownership/options of management increases their incentives to generate a profit where that wasn't a key motivation as a mutual bank.

And despite a potentially low ROE, Sunnyside's value should still be close to tangible book value as an acquirer (after the 3 period is up) can come in and buy the company, strip out the costs, and utilize any excess capital to their advantage, the equity capital is worth more than the bank as an ongoing entity.

SBA Lending
Slight tangent: In December 2012, Sunnyside was approved as an SBA lender and plans to hire an SBA loan officer here shortly.  SBA 7(a) loans are typically for small businesses that cannot get credit at reasonable terms elsewhere, so these are risky loans made to less than credit worthy borrowers.  To encourage small business lending, the SBA will guarantee up to 85% of the loan balance if the loan meets certain criteria which can often lead to a lengthy paper intensive underwriting process.

On the positive side, the guaranteed portion of SBA loans are in high demand (and sell at huge premiums) because they have no default risk due to the U.S. government guarantee, and their interest rates are typically higher than comparable treasuries as they are floating off of prime.  Many banks will sell their SBA loans to regional investment banks who specialize in pooling these loans into securities.  The original lender will keep the unguaranteed portion of the loan, and will continue to service the loan and collect a servicing fee.  By selling the guaranteed portion, a bank like Sunnyside can effectively increase their profit margins on each loan because they maintain the servicer fee on the entire balance, while only keeping the unguaranteed portion on their books (and the credit risk), plus they pocket much of the premium at the initial sale of the guaranteed portion.

Sunnyside currently has little in non-interest income, so the move into SBA lending will likely be a nice source of additional profits for the small thrift.

Management Experience and Incentives
In 2008, Sunnyside brought in Timothy Sullivan as President and CEO, his previous experience is mostly as a commercial lending guy which explains the gradual move toward commercial lending that Sunnyside plans to make.  Being such a small thrift, it's hard to get much information on Mr. Sullivan, but given Sunnyside's lack of delinquent loans and relatively strong balance sheet, it would appear that he's taking a moderate approach to the move into riskier commercial lending.  Directors and senior officers are buying $440,000 of the offering, not a small amount for a bank with only 15 full time employees.  Additionally, there will be an ESOP which will dilute shares, but is a net benefit as it will align their incentives with the outside shareholders and in this case, the performance of each employee can really make a difference.

Risks
Sunnyside is a very small bank and pre-IPO it wasn't particularly overcapitalized like many pre-conversion thrifts.  Post conversion, they're going to need to increase their asset base by 75-100% to generate an acceptable ROE, given tepid loan demand and fierce competition for good loans, Sunnyside might not be able to lend that money out at favorable risk adjusted rates.

Strategy Going Forward
My plan going forward is to dedicate a portion of my portfolio to purchasing new mutual conversions soon after the IPO date if I can buy the newly converted thrift for less than 2/3rds of tangible book value.  I will then look to sell once the thrift reaches tangible book value and recycle that cash back into new mutual conversions.  I'll leave myself a little room to change course if the 3 year acquisition period is around the corner, but my general goal is to be methodical with this strategy long term.

Disclosure: I own shares of SNNY