Virginia Is for Bankers

With nearly 1,000 publicly traded commercial banks in the United States, finding the best performers can be a real chore. Fortunately, by using a screening tool, I was able find an interesting bank right in my home state: Virginia Financial Group (NASDAQ:VFGI). This growing regional bank shows a lot of promise and sports a valuation compelling enough to land it on my watch list.

Virginia Financial Group operates 35 branches in central and southwest Virginia under names like Virginia Heartland Bank and Planters Bank & Trust. With homespun names like that, how could you not trust them with your money? All kidding aside, this small-cap bank with almost 100 years of experience has earned the right to be taken seriously.

By the numbers
First of all, Virginia Financial Group has three characteristics I screened for:

• Its market capitalization is under $1 billion. These smaller regional banks can easily fly under Wall Street's radar. They are also easier to follow than the larger ones. Ever tried to read financial behemoth JPMorganChase's (NYSE:JPM) earnings release? It's not pleasant, trust me.
• Its three-year annual net interest income growth is greater than 10%. Consistent growth in net interest income is vital, because it's a bank's main source of revenue.
• Its efficiency ratio is less than 60%. The efficiency ratio measures management's ability to control expenses. In the competitive world of banking, efficiency is key.

As any Fool knows, a screen is only a starting place for your research. The real investigation should continue in the financial statements. Let's see what we can dig up.

Virginia Financial Group key statistics (Dollar figures in millions)

Data provided by Capital IQ, a division of Standard & Poor's.

This table shows some favorable balance sheet trends. We can see that loans are growing nicely, and nonperforming loans (loans that might not be repaid) are at a minuscule 0.1% of total loans. Customer deposits -- which provide cash to fund those loans -- are also increasing at the same rate as loans, which reduces the need for more expensive borrowing arrangements.

It's important to note that much of the deposit growth is coming from checking deposits, the cheapest source of funds available. If a bank can attract only high-cost deposits like CDs, it will suffer from hefty interest expenses to its customers. That is not the case with Virginia Financial Group.

Moving to the income statement, net interest income -- the difference between what a bank pays to obtain funds and what it gets for lending them -- has grown at a steady 10% clip for the last four years. That's a decent performance, but nothing to write home about. Expansion plans were halted last year when the company encountered some regulatory issues. But in October, these hurdles were cleared, and now the company is free to expand as it pleases. At least two new branches are planned for this year, and I expect these new branches will provide a catalyst for future growth in net interest income.

Noninterest income -- comprising mostly wealth management fees and bank service charges -- has been somewhat stagnant. Fees and service charges are important revenue streams for most banks. Unlike interest income, noninterest income is not subject to the whims of the current interest rate environment. As an investor, I like to see a bank maximize its noninterest income, so this trend is something to keep an eye on.

On a more positive note, Virginia Financial Group has been keeping its expenses in check with a relatively low efficiency ratio (defined as operating expenses divided by total revenue). In the most recent quarter, the company even managed to drop its efficiency below 60%.

Betting on Old Dominion
Like many small regional banks, Virginia Financial Group depends on the state economy. According to the Federal Deposit Insurance Corp., Virginia is one of the fastest-growing states, and unemployment rates are well below the national average. Much of the recent growth has been attributed to new home building and the real estate boom. Small regional and community banks in Virginia have experienced solid loan growth across the board as a result.

The fastest-growing markets are in central Virginia, where the company has the majority of its branches, with several more planned for 2006. Management lists one of its primary growth markets as Charlottesville, right in the heart of the state. Having lived in Charlottesville (home of the Virginia Cavaliers) for several years, I was impressed with the number of new homes and businesses being constructed every day.

Based on the FDIC statistics and my experience, I think Virginia offers some fantastic opportunities for regional banks. These thriving markets are sometimes underserved by giant national banks like Bank of America (NYSE:BAC). As one of the largest regional banks in the state, with top market share in many counties, Virginia Financial Group will be able to reap the benefits of these opportunities.

The bank watch list
Despite all of its potential, Virginia Financial Group still trades at a slight discount to other high-performing regional banks at around 15 times earnings. Perhaps that discount is deserved due to the past regulatory problems. However, if it can fulfill its expansion plan while maintaining credit quality and monitoring expenses, I would expect it to trade in a P/E range of 18 to 20. In addition, it pays a healthy dividend yielding 2.4%.

Of course, there are risks involved when considering a regional bank. As a small-cap company, the stock price can take big swings due to any number of factors. The company's results are tied heavily to the Virginia economy, so any downturn in the real estate market or consumer credit can hurt earnings. Changes in the interest rate environment would also have an impact on earnings. Furthermore, management's paltry 2% ownership of the company does not exactly inspire confidence.

Nevertheless, I'm going to put this company on my watch list and check in on the year-end results to see how the expansion plan is faring. The other companies on my list have been discussed by the Fool. Stephen Simpson has written about Arkansas-based Bank of the Ozarks (NASDAQ:OZRK), and I looked atCenter Financial (NASDAQ:CLFC) and Nara Bancorp (NASDAQ:NARA) as interesting plays in the Korean-American banking niche.

Sometimes you have to dig deep to find a top-notch bank. But the reward can often be worth the effort.

Small Bank Watch List

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Joseph Khattab is a Motley Fool research analyst. He does not own shares in any of the companies mentioned. He appreciates your feedback.