NSTS Bancorp

An Illinois mutual completes its standard conversion and begins trading

Greetings! It’s been a bit of a wild ride in the markets to start 2022. Down in thrift land however, I haven’t noticed much in the way of significant downward pricing pressure. This is not to say the thrifts can’t drop 50% like any other company, but I do consider them a bit more of a defensive strategy, if properly selected. A part of me also can’t help but wonder if I should have more of my portfolios allocated to the strategy than my current 10-12% weighting. Something to chew on…and so the search for thrifts with asymmetric return profiles continues!

This past week, Illinois-based North Short Trust & Savings completed a standard conversion, becoming NSTS Bancorp after offering 5.29 millions shares (the adjusted maximum) at $10 per share. NSTS shares officially began trading on Wednesday, January 19th and jumped as much as 26.5% before settling around 25%. Not bad for a single day’s work! Participants in the offering were rewarded as is routine in a conversion, but let’s jump in and see if there’s enough meat left on the bone for the investors not fortunate enough to have had funds deposited with North Shore.

The High Level Stats (Pro Forma Estimates for Conversion Proceeds)

Total Assets: $304.2 million

Market Cap: $67.8m

Dividend Yield: 0%

Loans/Deposits 3yr Growth Rates: -1.1% / 5.2%

9M21 ROA: 0.0% (-0.05% in 2020)

3Q21 NPA Ratio: 0.10% (0.70% including TDRs)

5yr Avg. NCO Rate: 0.01%

PF TCE Ratio: 29.7%

PF TBV/Share: $16.72

3Q21 LTD Ratio: 47.2%

A couple things jump out right away. Can you guess what they are? I’d say the big ones are negative loan growth, no ROA, and an extremely low LTD ratio. Let’s continue on to help put these in context.

The Transaction

Because the conversion didn’t occur until January (post year-end), it will be awhile before the proceeds of the offering are reflected in the consolidated financials. For the purpose of estimating the pro-forma figures, I’ve used a combination of the prospectus and 3Q21 10-Q to get us a firmer picture. Come 1Q22 earnings results, we should officially see the extra capital on NSTS’s books.

The Market

NSTS operates in Lake, Cook, and Kenosha counties. The former two are located in Illinois while the latter is in Wisconsin. Overall, the local market strikes me as pretty attractive. The largest employers in Lake County, their primary market, include the likes of Abbott Laboratories, AbbVie, and Baxter International. Kenosha County counts Amazon, Uline, and Snap-on amongst its largest employers. Lake County also has a median household income north of $93,000 (vs. a US average ~$68,000). As an extension of the Chicago metro area with strong employers, this isn’t exactly your average sleepy little thrift in the middle of nowhere. A healthy local market all else equal should do better on asset quality issues when the inevitable economic downturn comes. In addition, a thriving local economy should also be a source of stronger potential loan growth.

On the downside, the demographics do not trend quite as positively. The population of Lake County has been flat to slightly down the past decade and from 2021-2026, it is anticipated to lose 0.14% of the population per year. This appears in line with the general trend you hear of cold, Midwestern states losing their residents and tax base. Unfortunately for NSTS, it also appears to be a very competitive banking market, one in which NSTS has but a toehold.

Over the past five years, they have lost deposit market share. To their credit, NSTS has been in business for over a century. If nothing else, they get points for longevity.

Capital

Among the more important considerations for a bank, capital levels here are very strong. The 3Q21 10-Q reveals NSTS ran at a conservative 17% TCE ratio as of 9/30/21 and 19.3% at YE20. After the conversion, NSTS sports a TCE ratio near 30%. Given a focus on lower risk residential mortgages, it’s CET1 regulatory ratio is expected to be approaching 70%. Their biggest problem might be finding areas to invest the excess capital to bring leverage to a reasonable level, but otherwise, no real concerns here.

Deposits

I’ve already highlighted NSTS’s deposit market share above. Total deposits have grown at ~5% the past 3 years and core deposits represent 64% of total deposits, which is probably about par for a small thrift. Without much of a presence in the commercial lending space however, the ratio of of non-interest bearing deposits is only 6%. This obviously hurts overall profitability and is a contributing factor to the low net interest margin (NIM). Like many thrifts with, NSTS intends to move the loan book weighting more towards commercial real estate loans via their own originations as well as via purchases in local CRE participations. Will this help over time without risking loan quality?

Asset Quality

I’ll say this about NSTS, they don’t appear to take a lot of excessive risk. This is certainly better than the alternative and not uncommon in the world of residential mortgage focused thrifts. 90% of the loan portfolio is in 1-4 residential mortgages while multi-family and commercial real estate (CRE) loans essentially split the remainder. 15.6% of total loans are adjustable rate (ARMs) and have a 2% cap on an increase or decrease at any adjustment date and a 5% cap above or below the initial interest rate over the life of the loan. Perhaps something to be cognizant of if we find ourselves in sustained period of rising interest rates from the Federal Reserve.

1-4 residential loan-to-value (LTV) ratios generally do not exceed 97% in the case of ARM loans, and 95% in the case of fixed-rate loans. In CRE underwriting, the bank seems to require the industry standard 1.25x debt service coverage ratio (DSCR).

Going back to the financial crisis, it appears net charge-offs (NCOs) peaked a few years later at 0.57% in 2013. This doesn’t strike me as a high level at all given the turmoil that occurred at many other banks. Of course, it’s also possible the management team dragged out recognizing losses until they were no longer non-performing loans, but I’ll give them the benefit of the doubt.

In the below table, you can see problems loans have ticked up a bit in recent years, albeit from a very low base. It also appears the bank also charged off a bit more in 3Q21 as the NPA ratio at 0.10% at 3Q21 is back down from the 0.24% 2Q21 level.

Management / Corporate Governance

NSTS is ran by CEO Stephen Lear. He is extremely tenured having served as CEO since 1998, Chairman since 2012, and as a director since 2003. He started at the bank back in 1979 so his whole career has essentially been at NSTS. 2020 compensation of $282k doesn’t seem egregious on an absolute dollar basis, but doesn’t look great for a loss-making bank either. Lear’s age of 65 tells me he may be considering retirement plans, a plus for a thrift investor. Perhaps this is why the bank converted in the first place. There also has been some newer, younger blood injected into the executive ranks of NSTS however. COO Nathan Walker and CFO Carissa Schoolcraft are only 43 and 29 years old, respectively. Will they be as keen on selling the bank if the time comes?

Unfortunately, the board of directors doesn’t appear to be one that will hold management accountable. Two directors (Ivantic, Kneesel) are not independent because they are in-laws of the Chief Lending Officer (CLO), Amy Avakian. Can you really depend on them to mix things up in the boardroom with those personal ties? Thomas Ivantic is a retired pilot and Kneesel runs a residential appraisal firm (at least relevant to a thrift’s focus). While the rest of the board has some finance and legal experience, there isn’t anyone other than Lear with a banking background. Again, can they be relied on to keep shareholder interests at the forefront when they do not have direct industry experience? I suspect not, taking NSTS’s historical performance into account.

The board of directors is also classified over three year terms. This bank needs an activist in my opinion. Will they get it? Watch the ownership disclosures on EDGAR over time to find out.

Finally, I will give them credit where credit is due. Six of the ten directors/executive officers participated in the public offering to the maximum amount allowed. We know this is essentially a no-brainer decision, but its still good to see them put their own capital on the table alongside shareholders. In aggregate, insiders are expected to own ~5.8% of shares outstanding post-conversion.

Management Discussion Revelations

I will admit I haven’t had the opportunity to speak with anyone in management to hear their side of things yet. It looks like I’ll be able to have a call with CEO Stephen Lear in the coming week, so I’ll update the post with any worthwhile commentary assuming the call happens.

Earnings Power

NSTS’s earnings power problems begin at the top. Residential mortgage is a highly competitive, largely undifferentiated, and lower margin lending area. Recall this is 90% of the bank’s loan portfolio and you can see its effect with a 9M21 NIM below 2%. Of course, some of this is also a function of the overall low-rate environment. I wonder though if the three additional loan production offices NSTS intends to open will emphasize more residential lending. If so, I’m not sure I see this helping them much.

NSTS is also significantly “under-loaned” with a LTD ratio of 47%. Ideally, this figure should probably be closer to 75-90%. A low LTD can be a positive for a bank in that it leads to less risk-taking as excess funds are invested in safer investment securities (treasuries etc.), rather than loans. This is especially valuable if the bank has a profitable lending niche. Unfortunately, a low LTD in this instance is more likely an indication NSTS has a lack of customer demand and nowhere/nobody to lend to. Negative growth in the loan portfolio supports this notion. Too low a LTD ratio lowers the overall yield received on assets and impairs the bank’s profitability.

Combine a low level of profitability with a small, subscale cost structure and you end up with low returns, if not outright losses. I also went on the FDIC site to go back a bit further to see what else NSTS has done. In 2018, ROA peaked at 0.29% so this is probably the best you can reasonably expect from NSTS in the near term.

So What’s It Worth?

Given the miniscule profitability in good years and net losses in others, I’ll go ahead and throw any kind of earnings valuation out the window. Further, I’m not sure I would count on any positive net income to add to shareholder equity and thus increase intrinsic value either. In recent years, NSTS has been shrinking/destroying value.

I’ve triangulated a range of fair value estimates using core deposit premiums of 5-10% and TBV multiples of 0.9x-1.1x. The latter range is a bit lower than I’ve used for other banks such as NECB and FFBW, and more in line with how I viewed ERKH. NSTS is small, undifferentiated, and recently, unprofitable. Below is a table of prospective returns considering the recent $12.55 share price:

As for me personally, NSTS is a pass for now, even at an undemanding valuation of 0.75x TBV. With a lot of capital and at a lower valuation (if that occurs), I suppose that could change, especially if I get convinced of management’s capital allocation or a respected activist bank investor comes onboard. My main concerns are a combination of what I deem a lower quality franchise, concerns about management and the board, as well as potential losses eating away at whatever value is present. As the table depicts, the potential returns start dropping off rather quickly if the price targets aren’t hit right at the three year anniversary. Moreover, if NSTS isn’t going to be profitable in the coming years, these estimates may turn out to be optimistic.

Risks

• Profitability - We know the returns in profitable years aren’t all that compelling to begin with, but can NSTS even manage to breakeven most years?

• Management / Corporate Governance - Like many thrifts, the management team and board of directors look too comfy for my taste. In the case of NSTS however, we have a combination of weak operating performance and directors who don’t look like credible sources of true sovereignty or accountability.

• Credit losses - It’s a bank, so I can’t leave this one off. Even though NSTS has managed NCOs well in the past, reason dictates I always consider this.

Disclaimer: No position. This is not investment advice nor a recommendation to buy or sell the security. Everything written is for general educational/entertainment purposes and I have not considered your specific financial situation. Always do your own research before making any kind of an investment.