Please note: A version of this column was published briefly on Tuesday before a discrepancy dictated that the column be reconsidered. I apologize for any inconvenience or confusion this may have caused. Today's is an updated column with revised conclusions.
I began this series of articles about recent IPOs on the premise that many were of a higher quality than what we'd seen in recent years, while simultaneously most investors remain averse to risk. I thought this dichotomy might present some compelling valuations, and with a few recently public companies we considered, it did. I now believe Jefferson Bancshares
This little company became listed on July 2, selling 6.6 million shares at $10 each, raising $66 million. With a market value of just $116 million, Jefferson is not widely followed and is relatively thinly traded. Lately, about 40,000 to 80,000 shares have traded hands daily.
A small, traditional local bank
I learned a good deal about the financial services industry by taking part in a comprehensive Motley Fool study that culminated in the addition of Mellon Financial
That said, the company's current business is relatively straightforward.
Jefferson Bancshares is the holding company for Jefferson Federal Bank. The bank is a "community-oriented financial institution offering traditional financial services within its local communities through its main office and two drive-through facilities in Morristown [TN]." (You can almost smell the apple pie baking. Mmm, crusty goodness.) Services include personal banking, auto and real estate loans, and business banking.
Founded in 1963 and employing about 60 people in a county of 59,000, investors are not likely to buy Jefferson in anticipation of gangbuster earnings growth. Growth at such small operations is usually sporadic, so you would likely buy this company, instead, as an undiscovered value stock. On that basis, there might be an opportunity here.
A "small" valuation
Jefferson's second-step conversion from an S&L resulted in share count acrobatics, and the $66 million stock sale provided a big boost to the firm's equity. Both events affected book value, a measure that is very relevant to bank stocks.
A company profile claims that Jefferson has a book value of $18.63 per share, but that's the firm's "historical" book value as stated in the prospectus. Following share dilution from the IPO (including the addition of a company-sponsored charity arm funded with Jefferson stock), the firm's current book value -- and the number investors should focus on -- is about $10.90 to $11.10 per share.
The stock was recently $13.90, or 125% of book value. According to SNL Investor, the publisher of Thrift Investor, healthy thrift valuations typically range from 100% to 250% of book value, putting Jefferson at the low end of the range. From a second source (Multex), the average multiple given to S&L banks is 194% of book value, a price Jefferson is well below.
Moreover, the average price-to-book value given to thrifts in Tennessee, where Jefferson operates, is higher than average, and larger thrifts in the state have been acquired for 200% of book value or greater. Industry acquisition activity and book value multiples in Tennessee have been above average partly because there are few acquisition targets for acquirers.
All this does not mean that little Jefferson's stock should rise to 200% of book value on rabid speculation. That would promptly overvalue the stock. But since management's goal is to increase book value, and it has done so steadily for years, the implications are -- from this price and given the environment -- that these shares have modest downside risk and decent upside potential.
Provided that the business looks healthy, this young stock could support a price of around 145% to 150% of book value (still well below average), or about $16 per share, which is approximately 15% above today's price. Ideally, then, book value would grow attractively each year, and the stock price with it.
Recent results
For the year ended June 30, 2003, net income rose 48% to $3.6 million. In the fourth quarter, net income was up 10% to $830,000. Growth rates are almost sure to remain sporadic like this. Meanwhile, the company added approximately 2% to 3% to book value in the most recent quarter.
On an earnings basis, a quote feed claims Jefferson has a P/E of 7, but that's based on an old share count. Jefferson actually earned about $0.38 to $0.43 per share for the year ended June, putting it at over 33 times earnings and making it anything but cheap on an earnings basis (the industry's average P/E is 14). This is partly because Jefferson is over-capitalized after its IPO; it needs to start using some of its new capital to increase earnings power.
So, it's only on the more important book value measure that there's apparent value in the shares, while the high P/E makes me temper the stock's potential book value multiple to about 150% (although that is partly arbitrary on my part). Also tempering its potential book value is the fact that portions of new equity could be erased as it gets invested.
Other key financial metrics to consider with banks include return on assets (ROA), return on equity (ROE), non-interest income, and non-performing asset risk. Regarding the final metric, Jefferson has an above-average number of subprime loans (17% of total), so it faces above-average risk. However, management is decreasing subprime loans (they were recently 23% of total loans) and maintains reasonable provisions for loan losses.
On profitability measures, Jefferson scores well for a small operation, though not outstanding on a national basis, with recent ROA of 1.32% and ROE of 10.25%. It earns most its income on interest, rather than fee revenue, which lowers profitability ratios and increases interest rate risks. Management states, "If interest rates increase 3%, the net value of our assets (our net portfolio value) will decrease by 18%."
This risk is real. Lately, interest rates have been ticking up.
Looking ahead, management states, "Although we have selected possible branch locations, we do not otherwise have any specific plans or arrangements for expansion and we do not now have any specific acquisition plans." They do want to grow, though, and existing plans for the near future include increasing loan offerings, emphasizing commercial real estate, and adding new financial services. IPO money makes such additions easier.
Conclusion
In recent correspondence, former Fool writer and now money manager Warren Gump said, "I've actually found these kinds of companies [can make] excellent investments. It often takes them a little while to figure out what to do with the capital, but they usually implement a dividend [Jefferson already pays a modest one], buy back shares, and improve returns over a two- to four-year time horizon. (They are also often bought out by competition.)"
Overall, we have steady profits at a good little bank filled with good people (I've spoken with several of them). But this column is nothing close to complete research. Be sure to print and read the company's SEC filings for more insight. There's plenty to learn.
Meanwhile, quote feeds are providing incorrect information about share count, book value, dividend, and P/E, demonstrating another risk of recent IPOs: outdated third-party and public information.
But behind all this is a community bank that only has one person (the CEO) making more than six figures a year; that had insiders buying the stock in bulk at the IPO price; and that trades at about 1.25 times book value, below industry averages. It's a recent IPO that shows there might be value to be had.
Jeff Fischer is a Motley Fool analyst. The Fool has a full disclosure policy -- to view a writer's holdings, check his or her profile. If you like looking for undervalued small companies like Jefferson, you might like Fool co-founder Tom Gardner's new Hidden Gems newsletter.
