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  1. Home
  2. / Investing
  3. / Financial Services

In Pennsylvania, 3 Small Banks With Big Potential

Consolidation may begin to accelerate in the second half.
By TIM MELVIN Aug 03, 2015 | 12:00 PM EDT
Stocks quotes in this article: ESSA, PBIP, PBCP

This week I want to continue to look at some of the states that should see an uptick in small bank M&A activity. A Barron's article earlier this year identified five states that the editors thought should see increased activity due to the number of banks, valuation and economic activity.

Today I want to take a look at Pennsylvania, my father's home state and still home to a whole bunch of Melvins in the Philadelphia area. Of course it is also home to the Pittsburgh Steelers -- no place can be perfect.

My portfolio is heavy with Pennsylvania-based banks, and I expect to see consolidation activity there begin to accelerate in the second half of 2015 and well into 2016. It is a big state, with a very diverse economy, and there are a ton of opportunities in the banking sector.

The state's banks face the same challenges as everyone else does across the industry right now. The new edition of the Pennsylvania Association of Community Bankers has an article discussing the challenges facing the industry and lists the big three as low net interest rate margins, costs including technology, and regulatory changes. It is the same across the United States and it leaves smaller banks with two choices: find a way to grow in a very difficult environment, or put your bank up for sale.

ESSA Bancorp (ESSA) has been one of my favorite Pennsylvania-based banks for some time. The Poconos area bank has decided that the way to face the obstacles is to grow by acquisition. Earlier this year, it bought a bank that allowed it to expand into the Scranton and Wilkes-Barre markets, and this week it announced it was buying Eagle National Bank in the Western Philadelphia market.

I am a big fan of CEO Gary Olson, and would not want to bet against the bank achieving the scale needed to not only remain independent but to continue to grow in the years ahead. The stock is still cheap at 93% of book value, and management have been opportunistically buying back stocks. At today's price, the yield is 2.8%, so you enjoy decent dividend while the price works higher over time.

Prudential Bancorp (PBIP) is another long-time Pennsylvania bank holding. The bank is located in Philadelphia and focuses primarily on South Philly and Center City as well as Delaware County. Prudential did its first step conversion in 2012, and completed a second step in 2013. The bank isn't eligible for takeover until 2016 because of the change in control provisions of thrift conversion regulations, but once the restrictions are removed it should be a very favorable target.

In the meantime, this is a well-run little bank that is shareholder friendly, too. It is actively buying back stock and recently paid a special dividend on top of the regular quarterly payout. The shareholder list is full of bank stock specialists and activists who will expect a decent return on their investment over time. I like the bank at the current level of 1.1x book value. I would like it even more if the stock would pull back below book in a market downturn.

Polonia Bancorp (PBCP) also operates in the Philadelphia market, and I do not think that this bank has very much more time as an independent bank. Earlier this year, activist shareholder Lawrence Seidman said that in his opinion, "based upon publicly available information, a sale of the Issuer, subject to applicable regulatory restrictions, would be the best way to maximize shareholder value."

Between them, the three best-known bank stock activists -- Mr. Siedman, Joseph Stilwell and PL Capital -- own more than 20% of Polonia, while bank stock specialists who would be inclined to support an activist-inspired proxy fight own close to an additional 20%, so I suspect we will see a sale of this bank sooner rather than later.

With the shares trading at 95% of book value and takeover premiums hovering around 135% of book, there is still pretty good upside potential in the shares. Polonia's conversion to a stockholder-owned institution was done in November of 2012, so they will eligible for change of control in November of this year.

The trade of the decade in small bank stocks is very much alive and well, and breaking it down by state can help us further refine and identify those stocks likely to benefit from the consolidation activity.

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At the time of publication, Tim Melvin was long ESSA, PBIP, PBCP, although positions may change at any time.

TAGS: Investing | U.S. Equity | Financial Services

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