Isabella Bank (ISBA) – Tender Offer And Potential M&A Target – Upside TBD

Current Price: $25.75

Offer Price: $23.00 – $27.00

Upside: $123 (for odd lots at upper limit)

Expiration Date: 13th of October 2021

Proxy

This idea was shared by Dan.

 

Michigan community bank Isabella Bank Corp. has announced a tender offer for 10% of outstanding shares (with odd lot provision) at a price range of $23.00 – $27.00. At the upper limit, there is a potential $123 profit for odd-lot shareholders vs $272 loss at the lower limit. Despite this negatively skewed risk/reward of the tender, ISBA is a cheap bank with accelerating profitability due to improved financing structure and could become a potential acquisition target in the near term. Trading volume is quite low but has increased since the tender announcement.

The interesting aspects:

• ISBA is a stable, slow-growing community bank, which has recently started shifting away from higher-cost funding. The actions have been successful and the company has recently reported two record quarters in terms of profitability. Results of the two last years were impacted by two different one-off events and this year should be a breakthrough with ROE expected to increase from the historical 6-7% range to 9%-10%.
• Currently, ISBA trades at 1.2x TBV and 9.5x normalized TTM PE. Despite the expected material profitability improvement, ISBA shares are up only 7% above pre-COVID levels, rather in line with the regional bank ETF – KRE at +15% above pre-COVID levels.
• Multiple regional peers (Michigan) have recently been acquired at significantly higher valuations (1.7x-1.8x TBV). Given its size and valuation, ISBA could also easily become a target. According to the latest data (Mercer Capital Bank Watch, August) Midwest banks are getting acquired at 1.56x TBV and 17x PE on average – see below for more details.
• Directors own 9%, are frequently buying shares, and will not be tendering in this offer. Also, worth mentioning that this is the first-ever tender offer done by the bank. For this purpose the company issued $30m 3.25% coupon debt. I believe, this speaks well of directors’ confidence in the current value of the shares.

Recently acquired Michigan banks:

• August’21 – FNBH Bancorp. 1.8x TBV and 17.5x TTM PE. 10%-11% ROE.
• June’21 – Farmers State Bank. 2.3x TBV. 14%-15% ROE.
• April’21 – Mackinac Financial (acquired by another Michigan bank Nicolet Bancshares). 1.7x TBV and 18.3x PE. 8% ROE.
• April’21 – Sterling Bancorp. 1.7x TBV and 13.8x TTM PE. 8% ROE.
• October’20 – Edgewater Bancorp. 1.7x TBV. 7% ROE.

 

Risks

Apparently, there are other cheap banks in Michigan with even better profitability, e.g. IBCP (1.2x TBV, 15%+ ROE) and MBWM (1.2x TBV, 10%-12% ROE), so maybe I am overexcited with ISBA due to the recent tender.

 

ISBA

The bank operates 29 Isabella Bank locations in the center of Michigan (presentation):

Loan portfolio:

• Commercial Real Estate – 43%.
• Residential RE – 26%.
• Commercial – 17%.
• Agricultural – RE – 6%.
• Consumer – 6%.
• Agricultural – 2%.

Commercial real estate and agricultural loans’ credit risk is capped to $15k. LTV is 80% or less. Residential and consumer loans are secured by real estate or other asset types.

While it’s probably not the safest portfolio ever due to significant exposure to the commercial sector, the bank held up quite well during COVID. At the peak of the pandemic, 24% of the gross loans asked for deferrals, however, during the Q3 call the CEO repeatedly mentioned the rate does not reflect the actual credit risk, but rather that the borrowers “took advantage” of the national deferral program. It seems that there was some truth to his words as after the first 90 deferral days, only 8% asked for another extension and after that, almost all of them returned to normal contractual payments. In Dec’20 only 0.5% of gross loans were deferred. The actual nonperforming loans (to gross loans) remained stable around 0.3%-0.4% and were not impacted by COVID.

Historical performance and valuations:

Quarterly earnings:

Q4 2019 results were impacted by $3.6m intangibles impairment in ISBA’s previous JV – Corporate Settlement Solutions (CSS). The impairment was reflected in the noninterest income section. Q4 2020 results were impacted by a one-off $7.6m noninterest expense related to $100m Federal Home Loan Bank debt elimination. The move has resulted in a $2.8m annual interest savings, which can already be seen in Q1’21 and Q2’21 results. Management explains that lower expenses are also attributable to moving away from higher-cost funding. Additionally, in Q4 2020 the company sold its CCS JV, which has negatively impacted quarterly noninterest income by $0.4m.

Overall, ISBA has clearly received a small growth boost during the pandemic, which coupled with reduced financing costs has resulted in visible profitability improvement during the last few quarters. The interest income line is currently pressured by the low rate environment, but any positive change in the rates will result in additional profitability for ISBA.