PSB Group (PSBG): Deep Value/Arbitrage Opportunity
U P D A T E
I found this article in Crain’s Detroit Business. It supports my argument that PSBG is sufficiently capitalized and that management will again try to go private.
Madison Heights-based PSB Group Inc. (OTCBB: PSBG) has canceled a shareholders’ meeting scheduled for Nov. 5 to approve a board decision to take the bank-holding company private and has delayed for at least 180 days any decision by the board to proceed with the plan.
The cancellation is a result of a review of the loan portfolio for its Peoples State Bank, which required a loan-loss provision of more than $2.5 million to be set aside for the third quarter that ended Sept. 30.
Mike Tierney, who became president and CEO of the bank in July 2006 and president and CEO of the bank-holding company in January, said the loan-loss provision didn’t leave enough capital to proceed with the buyback.
“We’re a well-capitalized institution and we want to remain well-capitalized. We didn’t think it was prudent to go through with the buyback,” he said.
“We’ve got a new management team here and we’ve been digging through the loan portfolio and there were things we weren’t comfortable with. We wanted to go through the portfolio, recognize the risks, call a spade a spade and take our losses,” said Tierney, who said most of the troubled loans were to developers of residential real estate.
On May 23, the board voted to pay a premium to back the shares of all stockholders with fewer than 1,380 shares, which would leave the bank with fewer than 300 stockholders.
That’s the threshold for no longer having to comply with Sarbanes-Oxley requirements that kick in for small-cap companies next March.
PSB also planned to cease filings with the U.S. Securities and Exchange Commission. The company said it would then save between $300,000 and $400,000 a year by avoiding the cost of Sarbanes-Oxley compliance.
T H E S I S
On May 24, 2007 PSB Group announced its intention to terminate the registration of its common stock under federal securities laws. The CEO stated, “Our costs associated with routine SEC filing and reporting are estimated at approximately $147,500 or approximately 0.8% of our overhead expense for our 2007 reporting cycle… We believe that the costs incurred over the 2007 reporting cycle are a conservative estimate for the recurring annual cost savings that should result from the going private transaction.”
As reported in PSBG’s preliminary proxy statement, each share owned by a holder of fewer than 1,380 shares was to be converted into the right to receive $21. (Holders of more than 1,380 shares would remain owners of the company.) This proposed transaction was intended to reduce the total number of shareholders from 518 to below 300—the SEC’s threshold for reporting.
The maximum amount receivable to an arbitrageur was $28,959 (1,379 X $21). Shares could be purchased at $19—for a total cash outlay of $26,200—leaving a potential gain of $2,758. No timetable was provided, but going private deals typically close within six months of announcement. This looked like an easy 20%+ annualized return.
However, it was indeterminable whether PSBG would get requisite approval from shareholders. The company’s directors and officers planned unanimously to vote in favor of the transaction, but they represented only 5% of PSBG’s outstanding shares. Thus the affirmative vote of at least 47.36% of the remaining shares would be required for consummation. Compared to a typical going private transaction, where controlling shareholders negotiate the deal, probability of failure was high.
Another problem was the deal price. PSBG had retained Donnelly Penman & Partners to estimate the fair value of its shares. DP&P’s valuation involved (1) comparable company analysis, (2) core deposit premium analysis, (3) trading indication analysis, (4) discounted cash flow analysis and (5) management projections. The resultant figure of these elaborate methods was $21 per share, which valued PSBG at $64.5 million. It’s a mystery to me how a bank earning 8.5% on its equity and paying most of this out in dividends could possibly be worth much more than book value—$14.41 per share, or $44.3 million, at the time of the report. Because arbitrageurs paid $19 for something potentially worth $14.41, they were guaranteed to suffer large losses if the deal fell through. A good arbitrageur never pays more than intrinsic value.
On October 4, 2007 PSBG announced that its mortgage loans had performed worse than expected, and that it had increased loss reserves by $2.5 million. The going private transaction was postponed for at least 180 days. In total neglect of underlying value, arbitrageurs dumped PSBG shares. The entire company sold temporarily for under $29 million, while its book value was over $42 million.
Buying PSBG at $10 is like buying a bond at 69 cents on the dollar, receiving a 7.2% annual coupon and getting the possibility to be called at 45% above par. (In my bond analogy, par is equal to book value and the coupon is the dividend rate.) The main risk is that loan losses are still understated. I should note that the bank is managed very conservatively relative to others; its Tier 1 leverage ratio (cash and cash equivalents / net loan value) is something like 15%. (The minimum regulatory ratio is 4%.) Moreover, four officers of PSBG bought shares at $13 after the crash.
Investors will do fine even if no going private transaction occurs (the dividend is sustainable, and probability of permanent capital loss is minimal). However there is a very high chance that the Board will again announce its intention to go private. On page 11 of the preliminary proxy statement, the company states:
In general terms, Section 404 of the Sarbanes-Oxley Act will require that management include in each annual report an assessment of the effectiveness of its internal control structure and procedures for financial reporting. Further, for PSB’s annual report to be filed in 2009, it will require that PSB’s registered public accounting firm attest to, and report on, this assessment. These requirements are expected to result in significant increased expenses, both in terms of the investment of management time to implement the requirements and increased annual charges from PSB’s registered public accounting firm. The merger proposal is being made at this time, primarily to avoid the costs to be incurred in complying with Section 404 of the Sarbanes-Oxley Act and, secondarily to eliminate those costs that we currently incur as a result of having our securities registered under the Securities Exchange Act. The sooner the proposal can be implemented, the sooner PSB will cease to incur the expenses and burdens associated with having our securities registered under the Securities Exchange Act and the sooner holders who are to receive cash in the merger will receive and be able to reinvest or otherwise make use of such cash payments.
Investors can use Donnelly Penman & Partners’ valuation models to reach an estimate of the new offer price. In any event it’s likely to be well above the current quote.
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[...] PSB Group (PSBG): UPDATE I found this article in Crain’s Detroit Business. It has made me more confident that PSBG is well-capitalized and that management will again try to go private. You can read my original thesis here. [...]
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[...] PSBG (Generally Undervalued) -35% Annualized -80% [...]
Derek:
As usual, this is an interesting idea. I apologize in advance for the rambling of this posting and the sloppiness of my reasoning.
I think there is a lot of risk in the S.E. Michigan market. S.E Michigan is VERY dependent on the auto industry. Many public parts suppliers are in bankruptcy. An unbelievable amount of privately owned machine shops & tool & die have simply gone out of business and been liquidated the past ten years. Membership in the UAW is down by 50% in the past 10 years. Michigan’s job base has been hurt tremendously this past decade. This puts a strain on all other businesses obviously.
Almost all of the banks loans are in this geographic area.
According to the 2006 annual report It looks like about 85% of their loans outstanding are some type of mortgage on real estate.
How do you figure that mortgages are 17% of their loan portfolio? Do you mean single family mortgages? Commercial mortgages seem to be the single largest part of the portfolio, about 49%.
Despite the risk of being in S.E Michigan, the bank is selling at good discount to book value. I notice that they own land & buildings in some of the more desirable areas of Metro Detroit (Madison Heights, Southfield, & Farmington Hills!). I wonder if they own the Grosse Pointe location?
Depreciation on their physical assets (buildings, equipment) appears to be about .46/share. I would suspect that in 2008, capital expenditures & maintenance should be less than depreciation (they are done building in Grosse Pointe). All of their Universal Mortgage loan origination offices are leased, so they could probably shut them down relatively easily. Do you think there could there be about .25/share in excess depreciation?
They have about 4.4MM ($1.46/share) of goodwill on the balance sheet, surprisingly, it is not amortized, but reviewed on a yearly basis for impairment (Note 1 pg. 12, 2006 AR). Would it not be more conservative to amortize this over 15 or 20 years? if they increase loan reserves, I wonder if they might also take a charge for impairment of goodwill? I wonder if this goodwill is related to the “Universal Mortgage Loan Origination”?
Tangible book value is about $12.30 a share. I can assure you that the loan loss reserves need to be increased. They are setting aside about 1% for loan losses. To be more conservative they might need to increase it to $2-3/share. HOWEVER, If Ford or GM enters bankruptcy, you will need to increase loan loss reserves even more. Remember, a lot of business in MI was/is parts supplier to the big 3. The part supply industry has not had it this bad since the Great Depression.
Barring a recovery to the Michigan economy OR better management, I don’t see how this bank would trade above “real” book value. If I am right about need loan loss reserves, REAL book value is about $9-$10/share. Management should be able to earn 10-12% ROI on that. So about $1.10-$1.25/share earnings, add back .25/share depreciation, that would be about $1.3-1.4 cash earnings IF THE LOCAL ECONOMY STABILIZES OR GETS BETTER.
Michigan is facing a “double whammy”. The housing bubble is starting to unwind/explode. AND Detroit is facing it’s worst time (business related) since the great depression.
I think that until things get better in the Michigan economy, management won’t be able to get the number of shareholders below 300.
I guess that at $8/share that gives plenty of margin of safety! Thanks for posting this very thought provoking idea.
Yes, I did mean that 17% of the loan portfolio consisted of RESIDENTIAL mortgages. Thanks for catching that huge error on my part. I tend to analyze a company less if I’m thinking about it from a risk arbitrage perspective – that’s a bad habit.
Goodwill is no longer amortized on a book basis. I think this is a better method because amortization charges are of no economic substance, and a corresponding reduction of earnings, therefore, makes no sense.
PSBG’s 10-K states: “Goodwill totaling approximately $358,000 was recorded during the year ended December 31, 2005 bringing the total to $4,458,000.” Since we cannot identify the source of goodwill, we cannot determine whether it is likely to be impaired. This is a good question to ask management.
Ultimately, the decision to invest will depend on how one perceives loss development and whether the current share price provides a margin of safety against adverse developments.
Derek:
It has been a long time since I’ve analyzed any banks, so I’m very rusty.
Please correct me on anything that I am mistaken/incorrect on.
If I am reading the latest quarterly report correctly, non-performing loans INCREASED by 15.8MM (about 4% of the loan portfolio). Of these 15.8MM of non-performing loans, the bank thinks that they will have to write off (lose) 2.5MM. Therefore, they will eventually recover about .84 on every dollar of non-performing loans.
If I am reading this correctly, the bank’s loans are well collaterized.
Additionally, if this is correct, they have some of the best recovery on non-performing loans in the banking industry. OR is it possible that management has overestimated recovery on these?
Thanks,
Robert
It is probably impossible to know how losses and recoveries will develop. We don’t know which properties underlie the loans or how much they can be sold for. Management definitely has better recovery estimates. Whether they are reporting conservatively is the main question.
Four senior officers have recently purchased shares in the open market. Management also has a stock-based compensation plan under which the weighted average strike price of their options is around $21. There is a huge incentive for management to act in the best interests of shareholders, and this entails setting reserves properly. As far as I have checked the SEC Form 4′s, there has been zero insider selling. Management seems oriented toward the long term.
I hate to reduce analysis to qualitative measures such as this, but it is a helpful clue, given incomplete information. Of course the investor should leave himself or herself with a large margin of safety.
Derek:
Have you been following this bank at all? I am attempting to take a position in it. The stock is now trading for about $1/share.
There are many small banks that are being left for dead by investors. If these banks are not liquidated, there is an opportunity to make a substantial return.
Let me know your thoughts on this.
Sincerely,
Robert
Robert,
I commend you for judging the extent of the loan problems far more accurately than me. No, I haven’t done any research on the company since selling out in early 2008.