EP18: War, What Is It Good For?
Stock Ideas From Investment Professionals
Welcome back to Elevator Pitches. Thanks to a slew of investment letters that have been released since our last issue, we’re pleased to share four new stock ideas this week. Hope you enjoy.
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Time for the ideas.
Upslope Capital initiated a position in defense consultant CACI International (CACI). With tensions high between and among the United States, Russia, and China, this could be a timely purchase.
CACI International (CACI) – New Long
CACI provides specialized technology and consulting services, primarily to U.S. defense and intelligence agencies. The U.S. Army is CACI’s single largest customer. This position replaces BWXT in Upslope’s “defense basket” (articulated in Q1 on p. 4). CACI’s business is mostly split across Expertise (providing talent to government agencies – e.g. software engineers) and Technology (design and delivery of specific technology-oriented services and products, including for example, battlefield hardware). The company offers its services and products in support of both day-to-day agency operations and specific missions.
At a high-level, CACI reminds me of another Upslope long in an unrelated sector: Silgan Holdings (packaging/dispensing and food can business). Both are truly sleepy value stocks that trade for low double-digit earnings multiples, but have a strong history of steady value creation and free cash flow per share growth. Both the stocks and underlying businesses appear very well-positioned for the uncertain macro (or geopolitical, in CACI’s case) environment we’re likely to face in the years ahead. Other notable thesis points for CACI specifically:
(1) Long-term Geopolitical & Other Tailwinds – like other components of Upslope’s defense basket, CACI should benefit from an attractive defense spending environment for years to come. CACI should also benefit from IT modernization efforts in U.S. government agencies, as well as its strength in cyber/electronic warfare offerings.
(2) Strong Management – CACI’s CEO has been in-role since 2019 and previously served in various COO capacities for the company since 2012. His communication is unusually straightforward and clear, and his focus on “free cash flow per share” (despite underwhelming comp incentives) is notable. He is also a significant shareholder, owning $20mm+ of stock (and only one modest sale – in 2020 – during his history at the company).
(3) Attractive Financial Profile – CACI has a track record of solid organic growth (typically around mid-single-digit %) with limited cyclicality, supplemented with tuck-in acquisitions (for which there continues to be a long runway). ROIC is modest (HSD%) but stable. The balance sheet is nearly under-levered at ~2.5x net – providing flexibility for additional acquisitions or share buybacks.
(4) Healthy Earnings Backdrop – given strong geopolitical tailwinds, bipartisan support for defense, and a sizable gap between rising defense budgets and recent outlays (which typically come through on a lag and correlate with revenues for CACI/peers), the earnings outlook for CACI should be solid in the periods ahead. Such a healthy outlook is unusual in the current market/economy.
(5) Attractive Valuation – even if estimates do not come up, valuation on consensus figures today is modest, suggesting limited downside: 7%+ FCF yield, 11x EBITDA, 14x EPS. Notably, CACI peer ManTech was recently taken private by Carlyle Group at a premium valuation (5% FCF yield, 16x EBITDA, 26x EPS). The deal was announced in May 2022 and closed in September.
Key risks for CACI shareholders include: high portion (~30%) of fixed price contracts (mitigant: solid track record of managing costs and, more importantly, significant diversification by project), lumpy organic growth, labor availability/challenges, M&A execution risk (very acquisitive and larger deals could present heightened risk), and potential government budget headwinds (depending on November elections and potentially driven by elevated inflation/rates longer-term).
Tourlite Capital Management has a quick pitch for Verra Mobility (VRRM), a recent SPAC that focuses on traffic management software/hardware. For more color, also check out this excellent overview of Verra from Vestrule.
New Long: Verra Mobility (VRRM)
Verra Mobility is a leader in transportation technology. The business has three segments: commercial, government and parking. The commercial and government segments represent 85%+ of revenues. Verra is an attractive business with mid-to-high single digit revenue growth and sustainable competitive advantages.
Commercial services provide tolling services and violation management for commercial fleets (i.e., rental cars). Verra is integrated with tolling authorities and has a revenue split with rental car operators. The business should benefit from two key tailwinds including the continued shift from cash to cashless tolls and conversion of highways to toll roads. Currently ~65% of toll booths are cashless and that is expected to grow to over 80% over the next few years. Verra is highly integrated into the rental car system with long-term contracts and technology that would be expensive to replicate.
The Government segment offers solutions to cities and school districts including red-light, speed and bus lane camera enforcement. Most of these relationships are revenue shares and Verra maintains ownership of the hardware/cameras. Future growth will come from expanding offerings to states with limited current enforcement (i.e., only have red light cameras) and breaking into the 17 states with no photo enforcement.
Based on our projections for 2023, Verra trades at over a 7.5% free cash flow yield.
Finally, we finish with a very detailed pitch on M&F Bancorp (MFBP) and Citizens Bancshares (CZBS) from Cedar Creek Partners. If you’ve never heard of the Emergency Capital Investment Program (ECIP) and how it has greatly impacted smaller banks, read on.
The Best Investment Opportunity We Have Seen in a While
First, I have to thank @dirtcheapstocks on Twitter for bringing this opportunity to my attention. You can find a write up “dirt” released here that came out on October 6 causing a bump in the share prices.
Great investment opportunities have an abnormal risk/reward profile. Typically, high reward potential carries high risk. Occasionally there are opportunities where the profile is skewed - a high potential reward without commensurate risk. Charlie Munger has spoken of this related to his investment in the 1970’s in Belridge Oil. It was a California oil producer with massive low risk reserves (380 barrels per share) selling below book value and at less than three times earnings, with a 10% dividend yield. It was a 35 bagger for him in just a few years as the company was sold for $3,665 per share versus his $115 entry price. It was a once in a lifetime opportunity. Unfortunately, the best investment we have seen in a while is not at that level, but one that is still quite attractive.
The fund has taken large positions in two small community banks. Citizens Bancshares (CZBS) and M&F Bancorp (MFBP) along with smaller positions in similar banks. All these banks have a skewed risk reward profile. Thanks to funding through Emergency Capital Investment Program (ECIP) these two banks received capital equal to two to three times their book value (or market value).3 This funding is in the form of perpetual noncumulative Preferred stock. 4 Thus, the banks have more capital than most banks and are thus able to withstand negative events to a greater degree. Since the funding is in the form of low yielding Preferred stock, the common stockholders have nearly all the upside from the increased earnings potential of the additional capital.
The opportunity existed due to the market failing to recognize the value of the ECIP investment for common shareholders. These two banks were trading at six to seven times earnings in early summer, despite having announced months earlier expected receipt of the investments. The additional capital could be used to grow the bank organically. Assuming similar returns on equity as their existing capital, the bank’s earnings potential increased three to four times. Organic growth would take a number of years, but a bank with that kind of potential should not trade at a discount to industry multiples. The capital could also be used for a major cash acquisition, which could double or triple earnings almost immediately. If that were to happen the share prices could match or exceed the earnings growth. We say exceed since a larger community bank is more likely to be valued at a higher earnings multiple than a smaller bank. For maximum bang for the buck, the ECIP recipients should acquire other ECIP recipients since the preferred is only transferrable to a fellow recipient in the first five years (BankFirst (BFCC) appears to be aggressively adopting this model. Hopefully other ECIP banks are paying attention and will follow BankFirst’s lead. If not, BankFirst may soon be offering to buy them.)
M&F Bancorp (MFBP) is a North Carolina based bank that has run rate earnings as of the second quarter of $1.85 per share. As we write this the stock is $17.50. There are less than two million shares outstanding. M&F received $80 million of additional capital. Thus, even today, a buyer is paying under ten times earnings for a bank with the potential to see earnings potential triple if it acquires a bank earning $7 million after merger synergies, or roughly $6 million currently. That is not only very possible, but probable assuming the bank understands what it has in ECIP. There are even more tail winds for M&F that we mention below that will also help propel earnings upward. The fund started buying in June at under $9 per share.
Citizens Bancshares (CZBS) is an Atlanta, Georgia based bank with similar characteristics. Its shares have jumped a bit due to the write up on twitter I mentioned above. Citizens has roughly 2 million shares outstanding. Shares traded last at $23 per share. Citizens received $95.7 million of additional capital. Citizens does not report quarterly earnings, but the bank and the parent both file quarterly Call Reports. Both are available on otcmarkets.com. Earnings for the first half of 2022 were about $1.60 per share, but that is inflated due to a $1.8 million grant. Q2 EPS excluding the grant were roughly $0.55 per share. Thus, Citizens is also trading at around ten times its earnings run rate. Citizens has additional tailwinds beyond ECIP. The fund started buying in June at $12 per share.
In order to be successful a bank needs access to capital, low cost deposits, lending and investment opportunities, and usually some form of additional non-interest fee or trust income. ECIP solved the problem of lack of capital.
Amazingly enough, ECIP funds are not the only capital funds some of the CDFI’s have received. Citizens (CZBS) and M&F Bancorp (MFBP) both received preferred stock investments from money center banks in 2021. Citizens issued $22 million of Preferred Stock in 2021 with just a 1% dividend to major money center banks. M&F issued a total of $17.5 million in Cumulative Perpetual Preferred Stock to JP Morgan, Bank of America, Wells Fargo and Citibank, and also issued 39,600 common shares. The preferred has a low 1% rate; however, it does have a dividend share that gives the preferred a proportionate share in dividend increases. Bank of America has also purchased 5% common equity positions in ten MDI’s and CDFI’s (link). Most are privately held, but the list includes M&F Bancorp (MFBP).
Post George Floyd, a number of large corporations announced their intentions to advance racial equality by supporting MDI’s and CDFI’s by putting deposits at those banks. The problem became the bank’s ability to have large deposits from just one customer. JPMorgan created the JP Morgan Empower fund to address that issue. It is an institutional money market fund where 12.5% of the management fee revenue received is directed to specified CDFI’s and MDI’s. The minimum investment is $50 million. Both Citizens and M&F receive funds from this program. If you look at M&F’s income statement under noninterest income you will see a line titled “Commissions from sales of financial products.” This is funds from this program directed to M&F. In Q1 it was $122,000. In Q2 it rose to $231,000. If the trend continues, the Q3 number should be between $300,000 and $350,000. Due to rising interest rates, we would not be surprised if Q4 income approaches $500,000, which would mean a pre-tax run rate of $1 per share from this program alone versus nothing in 2021. Hopefully we are not being too optimistic.
As the banks get larger, they will be able to take on larger deposits on their own balance sheets which will allow them to earn multiples of what they currently receive from the JPMorgan program. It is a virtuous cycle – as the banks grow larger, they can take on larger deposits, which allows them to grow larger, etc.
The money center banks have also created a program to allow participation by select CDFI’s in loan syndications. There is also the recently formed National Black Bank Foundation, which recently organized a syndication team to structure a deal for the Atlanta Hawks practice facility and complex. Citizens and M&F both participated in the loan.
A number of money center banks have also agreed to provide ATM access free of charge to customers at M&F and Citizens. This will allow them to attract deposits outside of their local branch base, as well as lower fees for existing customers who travel. We can envision people intentionally choosing to bank with a CDFI or MDI, which would further grow deposits. In a branchless banking world, why not support a CDFI instead of a large money center bank?
Lastly, a number of government programs provide grant income. As we noted above, Citizens received $1.8 million through CDFI Rapid Resource Grant program as well as $5 million from Morgan Stanley in 2020. Even with ECIP funds, we expect the government programs, including the grant programs, to continue.
In summary, M&F Bancorp and Citizens Bancshares have obtained:
1. Significant funds via ECIP
2. Preferred stock investments by Money Center Banks
3. Substantial ESG investments (deposits, JP Morgan Empower fund)
4. Participation in Loan syndication with money center banks and National Black Bank Foundation
5. ATM access nationwide with no fees
6. Government and private grants
Valuation
How should we value the ECIP funding? What is it worth to the banks? We are more income statement focused; therefore, we look at what it could do to earnings and then apply a fair multiple to those earnings. One way is to apply historical return on equity to the ECIP funds less expected dividend rate of 0.5 -2.0%. This requires estimating current earnings run rate and future return on equity once ECIP fully put into use, which should exceed historical return on equity since certain overhead is already covered.
The result is the smaller the bank the better with the proviso that they are already decently profitable. Periodic grant income makes estimating profitability difficult for many of the banks, and Harbor in particular. Citizens (CZBS), M&F Bancorp (MFBP), United Bancorporation of Alabama (UBAB), BankFirst (BFCC) and Community Bank of the Bay (CBOBA) stand out the most. Assuming a 10-12x price to earnings ratio would result in a 2 -3x return for those five banks. When we first started buying M&F and Citizens their future P/E was under two times using this approach, which meant we were expecting a 5-6x return within three or four years. Since both have nearly doubled in price, future expected return is no 2-3x over four years. We would stress that the timeframe assumes organic growth. An acquisition can bring the increased earnings almost immediately. Thus, we have a base case of 2-3x in four years, with an upside scenario of 2-3x in one year.
Another valuation approach is the balance sheet. The balance sheet investor is typically looking at community banks that sell at a discount to tangible book value. Preferred stock doesn’t impact that; however, since this preferred is potentially redeemable by the bank, it could become common equity in a few years. The Treasury has implemented a number of rules and already provided guidance on a minimum repurchase price. Without permission, only another MDI or CDFI can buy a CDFI and rollover the preferred. What is interesting is that the Treasury has said it may sell the preferred down the road, and when it does the bank will have the opportunity to match an offer. The price will not be below 10% of face value. Yes, you read that right. Treasury already recognizes that the fair value of the preferred is a fraction of face value. A simple discounted cash flow comparing the preferred to the market price of bank preferred with a hypothetical 7.5% yield will result in a fair value of 10-25% of face value, thus the bank (i.e. common shareholder) is essentially being gifted 75-90% of the face value of the preferred. The balance sheet investor could add that amount to tangible book to get a ballpark estimate of fair value.
Using this metric, the five most attractive are Harbor (HRBR), Broadway Financial (BYFC), Citizens (CZBS), M&F Bancorp (MFBP), and Merchants & Marine (MNMB). We have not spent equivalent amounts of time on each of these banks. We have primarily focused on M&F and Citizens. There may be benefits in some of the others we are not aware of, as well as risks. Our rough estimate of their earnings may not be accurate.
With any investment there is risk. Buying banks in a rising interest rate environment is typically not ideal. While we do have the additional capital protection courtesy of the ECIP funds, there are still a number of risks, including:
1. rates paid on deposits approach or exceed rates paid on historical loans Bank
2. mark to market on securities portfolios results in significant decreases to tangible book value
3. increase in troubled loans, particularly since many borrowers have moderate incomes.
4. poor capital allocation
Another reason we like M&F Bancorp and Citizens is they have relatively small securities portfolios that have to be marked to market and large cash and deposits at other banks. Citizens had $360 million in cash and deposits versus its $832 million of assets. A ridiculous 43% of assets. That is a lot of capital that can be deployed at higher rates, whether 4% Treasury bills or 7% mortgages. M&F Bancorp had $135 million in cash versus $450 million in assets. While still an attractive amount, it is 1/3 less percentage wise than what Citizens had.
Footnotes:
3 The Emergency Capital Investment Program (ECIP) was part of the Consolidated Appropriations Act, 2021. The Act was a $2.3 trillion spending bill, which combined $900 billion of stimulus spending and a $1.4 trillion of omnibus spending bill for the 2021 fiscal spending year, signed into law by President Trump on December 27, 2020. It included stimulus checks for most Americans, extended unemployment benefits, funding for second round of PPP loans, funds for schools and vaccines along with regular appropriations. Included in the bill was $9 billion for ECIP.
The US Department of Treasury website states that ECIP “was created to encourage low- and moderate-income community financial institutions to augment their efforts to support small businesses and consumers in their communities. Under the program, Treasury will provide up to $9 billion in capital directly to depository institutions that are certified Community Development Financial Institutions (CDFIs) or minority depository institutions (MDIs) to, among other things, provide loans, grants, and forbearance for small businesses, minority-owned businesses, and consumers, especially in low-income and underserved communities, that may be disproportionately impacted by the economic effects of the COVID-19 pandemic. Treasury will set aside $2 billion for CDFIs and MDIs with less than $500 million in assets and an additional $2 billion for CDFIs and MDIs with less than $2 billion in assets.”
The maximum amount any CDFI or MDI could receive was $250 million. Institutions with assets in excess of $2 billion were limited to receiving 7.5% of assets. Those between $0.5 billion and $2.0 billion were limited to 15% of assets. Lastly, those under $0.5 billion were eligible for up to 22.5% of assets. A typical bank has equity equal to approximately 7-10% of assets, thus larger banks received an amount nearly equal to their existing equity, medium size banks roughly twice, and smaller banks three times their equity. (The tilt toward smaller banks made them the most attractive as investments in our opinion.)
4 Perpetual noncumulative preferred stock means that the stock does not have a designated redemption timeframe. It lasts, in theory, in perpetuity. Noncumulative means any missed dividends do not have to be recouped. They are just skipped. Preferred stock is part of equity, thus counting in terms of Tier 1 capital ratios. Preferred stock dividend payments are not deductible to the bank.
The dividend rate is zero for the first two years. After year two it will vary based on how much the bank increases its qualified lending to low- and middle-income borrowers. Between year three and ten, if lending increases less than 200% of baseline pre-COVID lending amount (i.e., 2019 levels) the dividend rate will be 2%. If qualified lending increases between 200% and 400%, the rate will be 1.25%. If it increases greater than 400% it will be 0.5%. After year 10 the rate is fixed based on average annual lending increase in years 2 through 10 (see 8/11/2021 Senior Preferred Term Sheet at https://home.treasury.gov/policy-issues/coronavirus/assistance-for-smallbusinesses/emergency-capital-investment-program).
Until next time! - EP