Van Wert Federal Files to Convert

Preliminary takeaways from the initial review of the VCF Bancorp Prospectus

Greetings and thanks for reading Conversion Confidential! Today, we’re looking at another recent prospectus. Back in March, Van Wert Federal filed an S-1 to undertake a standard conversion and become VWF Bancorp. VWF must sell a minimum of 1.87 million shares and may sell as many as 2.91 million shares at the adjusted maximum. The subscription occurs at the usual $10/share price and the offering period will end on June 15th, 2022.

One uncommon aspect I noticed almost immediately is VCF intends to list on the OTCQB market operated by OTC Markets Group, as opposed to listing on a national exchange. I suspect this a result of the extremely small nature of the bank and an effort to save on filing and other admin/compliance costs. OTC Markets has also been making a concerted effort on their part to obtain more community bank listings.

The High Level Stats (Prior to Conversion Proceeds)

Total Assets: $137.0 million

Market Cap: N/A

Dividend Yield: 0%

Loans/Deposits 3yr Growth Rates: 7.5% / 8.1%

2021 ROA: 0.20% (0.34% in 2020)

3Q22 (FY ends 6/30) NPL Ratio: 0.28%

5yr Avg. NCO Rate: 0.00%

TCE Ratio: 17.3%

PF TBV/Share: $16.13 - $20.21

3Q22 LTD Ratio: 70%

Deposits/Branch: $112.2 million

The Market

Van Wert Federal’s origination story dates all the way back to 1889 when it was chartered as a federal mutual savings bank. As you might suspect, the bank is headquartered in Van Wert, Ohio and considers the county by the same name to be its core market.

Van Wert, located about 35 miles east of Fort Wayne, Indiana is a small, rural community with a mix of manufacturing and agriculture industry. The 2022 estimated population of the county is only 28,000 and it suffers from a lower population growth rate (0.1% p.a. through 2027) than both the state (0.3%) and nation (0.6%). The median household income for Van Wert County is $63,200 compared to $65,100 in Ohio and $72,500 nationwide. Unemployment was low at 2.6% in December 2021 compared to 3.4% statewide and 3.7% nationwide.

In short, this isn’t a robust home market to operate out of and I wouldn’t expect VWF to have a lot of organic, in-market growth opportunities going forward.

Capital

With a TCE ratio of over 17% prior to the conversion, it would typically be safe to say that the bank has no need for additional capital. But wait just a second, VWF intends to withdraw from their defined benefit pension plan late this year and the estimated withdrawal cost is $3.1 million pre-tax. For a bank with only $24 million in equity, that’s a substantial hit! I don’t believe it would be fair to conclude this is the driving force behind the conversion (after all VWF’s TCE ratio would still be over 15% pre-conversion), but perhaps it was a consideration. As a small aside, VWF witnessed a recent decline in equity due to AOCI impacts, a topic I discussed in last week’s issue of Conversion Confidential.

At the minimum and maximum range of the offering, capital levels will increase to approximately 24.6% to 28.9%! This even takes into account the after-tax deduction related to the pension plan. With a traditional loan book, VWF finds itself well in excess of any regulatory capital requirements.

Loan Portfolio / Asset Quality

The loan portfolio is largely what you’d expect to see out of a sleepy thrift. A large proportion of the book is residential mortgages, followed by commercial real estate, while agricultural and construction loans vie for the third spot. Nearly 70% of the loan book is fixed rate. In typical post-conversion thrift fashion, VWF intends to methodically increase their CRE and C&I loan emphasis. On that front, I wasn’t incredibly impressed that their largest loan in the CRE space is a participation interest for warehouse facilities in Alabama. I prefer a thrift (and all banks) maintains lending operations in their local area. CRE loans are also underwritten to 1.15x DSCRs which is slightly lower than many banks who opt for 1.2-1.25x.

The asset quality strikes me as satisfactory and given the lending focus, it should be a pretty conservative portfolio. I would like to note that the loan loss reserve looks low to me. Of course, if credit quality truly is strong, then you don’t need much in the way of reserves. Van Wert hasn’t been charging anything off the past several years and NPLs remain a low proportion of total loans. However, I want to say the low end of what I typically see at other banks is still at least 0.50% of total loans and most banks are probably over 1.00%. What this means for VWF is that if any problem loans begin to surface they may need to provision a fair amount from the income statement to reinforce the loan loss reserve. And given their low earning power, VCF would likely show material losses in the corresponding year(s).

I do think it’s a bit interesting that NPLs are slowly ticking up. The absolute level as of March 2022 at 0.28% remains quite low, but it’s worth watching given the scenario I outlined above. Another indicator worth watching is the balance of past due loans which recently jumped up. To illustrate, on June 30th, 2020, VWF had a total of $96,000 in total past due loans. It’s possible this figure was artificially low since banks hardly had to recognize any problem assets during Covid. In June 2021 however, past due loans increased to $276,000 and by December 2021, it is now $1.46 million! That’s well above the reserve for loan losses so it wouldn’t take many of these past due loans to stop accruing before the reserve was fully accounted for. It will be interesting to see how the current 30-59 day past due loans evolve into 60-90+ past due loans in the ensuing quarters. There are also $484,000 worth of Covid-19 loans still on deferral status relating to eight residential mortgage loans.

Deposits

I think Van Wert has a respectable little deposit base all things considered. The county only as eight banks operating in the market according to the FDIC. VWF has a 15.7% deposit share which ranks 4th as of June 30th, 2021. Perhaps this means another bank would be interested in scooping them up down the line. The market leader, Citizens National Bank of Bluffton owns a 21.4% share. Several years back, Wells Fargo had a dominating share of 82%. My guess is that they sold their branches to local banks due to the lacking market dynamism as they no longer appear on the register beginning in 2019.

At year-end 2021, 67% of VWF’s deposits were “core”. VWF has steadily increased this from 56% a couple years back. And while deposits have grown modestly, I wouldn’t expect to bake much into your expectations going forward. Non-interest bearing deposits represent only 2% of the total which isn’t unexpected given the market and loan book.

Management / Corporate Governance

Mark Schumm, age 50, currently presides over Van Wert Federal as President and CEO. However, a search for a new CEO is currently underway and Schumm will transition into the Chief Operating Officer and Chief Risk Officer upon the appointment of a new candidate. This seems somewhat unique, but not having spoken with the bank I can only presume they feel an executive with public company experience is a better fit to lead after the conversion to stock ownership.

There isn’t a ton to see regarding the board of directors. As regular readers will be used to by now, the directors serve on staggered three year terms. The board is only five members which is a positive, but at least two of the directors seem like a stretch for providing proper oversight to a bank. For example, Jon Bagley serves as Secretary on the Board of Directors of Vancrest Management Corporation, a health care company but appears to have no relevant banking experience. He is also the brother-in-law of Chairman Gary Clay, which I think is what explains his appointment.

Director fees and management compensation are relatively low, as they should be given the small scale and lack of profitability at the bank. That’s not an excuse to not drive better operating results by the way. CEO Schumm brought in $218,000 in 2021 and director fees are under $30,000 for everyone but Clay who was brought back as a salaried employee (Chairman?) in October 2021. I’m not sure why that was necessary. Insiders also benefit from a bank program where they can borrow at a reduced interest rate of 1.00% below those offered to the public on primary residence loans only.

I must say, insiders are subscribing to this offering in strength which is nice to see! The prospectus calls for a total of 482,000 shares which will represent 25.8% of shares outstanding at the minimum offering range, ~16.5% at the adjusted maximum. Three separate directors are putting down $1 million (100,000 shares) to participate. I take that as a good indicator, but also note the articles of incorporation and bylaws contain supermajority voting provisions that require holders of at least 80% of VWF’s outstanding shares to approve certain actions. Insiders, by holding just over 20% (which they will when considering the ESOP) will be able to ensure the supermajority needed to approve corporate action cannot be attained. The way I read this is it will be difficult for activists to come in and drive change or shareholder friendly actions so you’re at the mercy of management.

Earnings Power

Earnings at Van Wert Federal are close to non-existent, but in the past two full years they have at least been profitable. That changed in 1H22 which I expect was driven by increased costs in anticipation of the conversion. As the high level stats point out, ROAs are low and ROEs even lower given the high capital.

As hideous as I find the 84% to 100%+ range for the efficiency ratio of the past several years I will say their non-interest expense to average assets surprised me by being in the low 2% range. They may not derive enough income to support their expenses, but I’ve seen far worse ratios relative to assets. I suspect that is a function of at least being wise when it comes to branch optimization. VWF operates out of a single branch and has no immediate plans for expansion.

Valuation

The conversion will take place at a proforma valuation range of 0.50x to 0.62x price to tangible book value. I think that will prove to be a good deal if you can purchase shares in the offering. I’ll hold off on my full valuation for now until we progress a bit further down the road and know the exact amount of capital to be raised, pro-forma shares outstanding, etc., but I don’t think I’ll have much interest in this thrift once it’s publicly traded.

In short, it is too small, too unprofitable, and operates in a weak market. Beyond that, it’s possible some loans are deteriorating in their portfolio. I’ll watch the price and results after the conversion is complete because I suppose if the price declined then it would at least give you something to consider! After all, they are well capitalized and somebody might come calling for those deposits eventually.

Risks

• Asset quality - I noted the recent jump in 30-60 day past due loans as well as a modest increase in NPLs. Is this a one-time phenomena at the bank or is there a larger concern moving forward?

• Local Market - This is somewhat related to asset quality, but the underlying market isn’t very enticing. It’s rural, hardly growing, and the two biggest industries are at least somewhat cyclical.

• Management - Who will VWF find to run this bank? Will they be the right person for the job and/or shareholder friendly?

That’s all for this week folks. Thanks for reading and if you like what you’re seeing then please don’t hesitate to share with your friends!

Disclaimer: No position. This is not investment advice nor a recommendation to buy or sell any 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.