One Last Tour of California's Banks

 | Apr 05, 2013 | 5:00 PM EDT
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As we move into the weekend, I want to take a final tour of the California banking Industry. It is probably not as much fun as a tour of the California Wine Country but it may just be more profitable in the long run. There are some good reasons why California is seen as a beleaguered, troubled state by many these days. The state government is a mess and the real estate market was devastated by the credit crisis. In spite of this, California has several strong economic sectors and, much like Europe, it will muddle through and survive in the long run.

Many of the larger community bank stocks have traded up and are at a premium to tangible book value (TBV). Most of these premiums are small in the range of 1x to 1.25x TBV, but they are still too high to chase at the moment. A strong market pullback could change this, but for now resist the urge to chase banks stocks that are trading above book value. Most of the value right now is the smaller institutions.

One that seems worth investigation and investment is Pacific Mercantile Bank (PMBC). The bank just sold an additional $14 million worth of stock to its largest shareholder, Carpenter and Company. Carpenter runs a specialty fund that is registered as a bank holding company and makes private equity like investments. The funds were transferred to a new asset management division and will be used to buy nonperforming loans and foreclosed real estate from the parent company. This will help with the continued efforts to clean up the bank's portfolio and improve operating performance going forward.

The efforts have been working, as nonperforming assets have declined steadily over the past two years. The bank is positioning is itself to participate in the economic recovery of California with an continued focus on commercial lending and SBA lending. In fact, 68% of the bank's loan portfolio is in commercial real estate and C&L loans, so the Costa Mesa-based bank in the right spot to profit as business conditions improve. The company has seven branches in the Los Angeles area with over $1 billion in assets. Plus, the stock is cheap, trading at less than 90% of tangible book value, making it a fantastic way to participate in the eventual recovery and growth of the Golden State.

One of the intriguing banks in the region is United Security Bancshares (UBFO) of Fresno. Fresno is in the San Joaquin valley, which was one of the hardest hit regions in the country during the real estate collapse and prices are just now showing signs of stabilizing at much lower levels. Shares of the bank have shot upward this year as the bank turned a profit in the fourth quarter but are still cheap at 84% of tangible book value.

This is definitely a long-shot bank as it does have some problems. According the latest FDIC call report, nonperforming assets are falling, but at more than 5%, they are still quite high. The bank has been solidifying its loan loss reserves and working off its large supply of real estate acquitted through foreclosure and restructuring and this should continue as housing in the region stabilizes. Most of the real estate was acquired through the construction loan portfolio so it should be easily sold when development activity sees renewed activity. To preserve capital, the bank has halted cash dividends and has been paying a stock dividend since 2008.

The bank faces a potentially difficult turnaround, but the officers and directors seem confident that they can accomplish this. More importantly, they are backing their convictions with cash. In the last six months, insiders have purchased more than 175,000 shares of the bank. I wouldn't bet the farm on United Security, but it is worth owning a few shares as an asymmetric payoff potential bet on a California recovery.

Since the  credit crisis began, I have been watching and eventually buying the smaller banks as I believe that they will recover as they did in the aftermath of the savings and loan crisis. The valuations, especially of the smaller community banks, represent solid values with enormous potential returns. This is especially true of those banks in the hardest hit regions that survive, recover and eventually either thrive or get acquired.

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