HomeTrust (HTBI -1.22%) is in the banking "sweet spot." It's large enough thanks to having a high lending capacity, broad product offerings, and the third-largest deposit share. At the same time, it retains the attractive qualities of a smaller community bank with a history dating back to the early 1900s, quicker loan decisions, greater knowledge of local markets, and superior customer service. 

Continued consolidation should provide strong growth
From 1996-2011, five hometown mutual saving banks joined the HomeTrust banking partnership. HomeTrust doesn't follow the standard M&A playbook. Although new partners operate as a division of HomeTrust, they have their own local management teams, boards of directors, and employees. HomeTrust allows them to preserve their operating culture while providing access to improved products, expanded locations, and support. The resulting larger and more efficient partnership is better able to compete against larger national banks.

HomeTrust should have no problem finding suitable targets given the multiple incentives to merge. Moreover, microcap banks should not be able to command pre-crisis multiples given overall lower revenue, increasing regulation (e.g., higher capital requirements and costs), and general overcapacity despite significant branch reduction over the past decade.

This "roll up" acquisition strategy provides multiple benefits, including rapid geographic expansion and growing economies of scale. Moreover, HomeTrust typically acquires banks trading at a low price-to-book value ratio. In July 2013, it acquired BankGreenville Financial for 0.91 times book value, including contingent consideration.

Fundamentals continue to improve
HomeTrust is benefiting from positive industry tailwinds due to continuing economic growth, which acted as a headwind only several years ago.

In the quarter ended in September, net income almost tripled to $3.3 million from $1.2 million in the year-ago period, driven by a $2.3 million recovery from the allowance for loan losses and a $906,000 decrease in real estate-related expenses.

Source: SEC 10-Q and 10-K filings.

The net interest margin decreased five basis points to 3.74% because of the yield on interest-earning assets declining faster than the rate paid on interest-bearing liabilities. However, the conversion to stock form of ownership in July 2012 provided additional capital to grow the loan portfolio and expand through acquisitions. This resulted in a growing interest-earning asset base, as shown in the chart below.

Source: SEC 10-Q and 10-K filings.

Two remaining areas of concern are declining organic loans (due to weak borrowing demand) and lower refinancing activity (due to rising interest rates). Both should eventually rebound as the local economy continues to recover, driven by higher tourism and new job creation. HomeTrust expects changes at Fannie Mae and Freddie Mac to provide increased opportunities to originate high-quality and attractively priced residential loans. 

Shift toward lower funding costs and lower risk loans
There are three key drivers that should result in greater profitability and lower risk. First, CDs (excluding the BankGreenville acquisition) decreased $21.2 million in the September quarter because of lowered offered interest rates. This is part of a reduced emphasis on higher-cost time deposits and a shift toward lower-cost checking/savings accounts. The net result should be a faster return to net interest margin expansion.

Second, HomeTrust is actively preparing for the coming rise in interest rates by selling longer-term fixed-rate mortgage loans in the secondary market. It is retaining adjustable-rate mortgage loans, which should result in faster loan repricing.

Third, as a result of the recession, HomeTrust is much more disciplined in the underwriting process. It increased residential lending standards by requiring lower debt-to-income ratios, higher credit scores, and lower loan-to-value ratios.

The shift away from construction and development loans (e.g., 15% of total loans in 2008 compared to 2.8% currently) and toward one-to-four family loans (e.g., 34.5% to 50% in the same period) should result in a significant reduction in loan portfolio risk, which deserves a higher multiple.

Being well-capitalized has multiple benefits
HomeTrust exceeds the well-capitalized leverage ratio requirement by three times, as well as exceeds new capital rules scheduled to go into effect in 2015.

This strong capital position provides three key benefits. First is the ability to reward shareholders as evident by the completion of a 5% buyback in December 2013. There's also less chance of dilution from a secondary offering, which might otherwise be required to raise capital levels. It also places less constraint on any future M&A activity.

HomeTrust also has approximately $115 million of high-yielding (because of tax-exempt status), low delinquency municipal leases that could be sold to generate additional liquidity. Any resulting taxable income may be shielded by $47.4 million in deferred tax assets. 

Peer comp
The positive fundamentals mentioned above would be largely irrelevant for investors if they are already reflected in the valuation. However, HomeTrust trades at a P/B of only 0.87. While there may be other community banks trading at slightly lower valuations, consider that many of these banks are micro caps and trade over the counter, which brings greater risk. Many also have fewer resources (such as less lending capacity because of a lower asset base), which makes it difficult to compete against larger community banks, much less larger national banks.

Close peer CommunityOne Bancorp (NASDAQ: COB) also has improving fundamentals (such as a recent return to profitability, improving net interest margin, and lower credit losses), but its P/B is significantly higher at 3.36. While the return on equity of 21% deserves a premium to book value, there's little room for further multiple expansion as the current valuation prices in most of the impressive recovery.

Another peer following a similar growth-through-acquisitions strategy is VantageSouth Bancshares (NYSE: VSB). It trades at a P/B of 1.04, despite mixed results in the quarter ended in September (e.g., 9% loan growth offset by a declining net interest margin and rising loan-loss provision). 

Given that HomeTrust faces similar challenges as VantageSouth, I believe the multiple for the former should rise to the level of the latter.

And although the current low single-digit ROE may appear to be a valuation-limiting factor, it should rise because of continued accretive acquisitions, a strengthening local economy (e.g., more loans at higher rates), lower funding costs, and higher net cash income provided by the tax assets.

Bottom line
Even though the banking industry has come a long way since the lows in 2009, there are still values to be found in overlooked and undervalued small-cap banks with company-specific growth drivers.