Earlier posts in this series can be found here.

Background

Citizens Republic Bancorp, Inc (CRBC) is a regional bank in the midst of a turnaround, focused on growing its retail/consumer bank franchise in Michigan and neighboring Midwest states. In the latest quarter (Q1 of ’10), the bank posted an $85 million loss. So, you know, if the idea of owning a bank in Flint, Michigan, doesn’t do it for you, perhaps heavy losses might. More to the point, though – while plenty of investors are overlooking CRBC for obvious reasons, higher loan loss provisions and a strong capital base I believe help make a solid long-term investing case for CRBC at recent levels. More on this shortly.

CRBC offers banking and financial services through over 200 offices and 267 ATM locations throughout Michigan, Wisconsin, Ohio, Iowa, and Indiana. Ranked by assets, CRBC is the 49th largest bank holding company in the U.S.. containing year end 2009 assets of $11.7 billion assets and $8.5 billion in deposits. Citizens has no exposure to sub-prime loans, CDOs or CMOs.

The company offers these services:

Specialty Commercial – provides a wide range of lending and depository services to players in real estate market, middle-market companies and local government.

Regional Banking – provides banking and financial services to both commercial and retail clients with a focus towards consumer, residential mortgage, commercial and industrial, small business, private banking and treasury management.

Wealth Management – with $3 billion assets under administration the segment offers a broad array of asset management, financial planning, estate settlement and administration, credit and deposit products and services.

The company’s primary source of revenue is interest income, which constitutes 85% of total income, with the rest coming from non-interest revenue including fees and other charges related to financial services.

CRBC has a significant portion of loan portfolio tied up in commercial and residential real estate. About 70% of this portfolio comprises of borrowers located in Michigan, while the rest includes borrowers from Wisconsin and Northern Ohio. These states have, as you have probably heard, seen some tough times lately. Therefore CRBC on a precautionary basis recently increased its loan loss allowance to greater than 4%, almost double to the industry median of 2.2%.

The Investment Case

Consistent with the economic recovery, the bank’s credit quality and core earnings are improving. For instance, CRBC reported a 6.5% decline in total non-performing assets in the last quarter as well as lower delinquent loans. As the economy continues to improve, I expect CRBC to see an increase in lending. So one way to view CRBC is as a favorable bet on eventual credit recovery – providing you have a relatively high degree of confidence in its strategy to conserve capital, stabilize credit and return to profitability, as I do. Again, I believe the bank will become profitable again in Q1 of 2011, as per my model here.

Key Factors

Strong Capital Levels – CRBC has maintained approximately $400 million in capital above the minimum regulatory requirements. I view its strong capital base as not only a cushion but as having the potential to help CRBC better capitalize on an eventual increase in credit demand.

Improvement in Credit Quality – CRBC’s credit trends show continued signs of stability. As a percentage of loans, its reserve levels improved in Q1 ’10 by 500 bips. Delinquencies were down 7.3%, in line with an improvement in non-performing assets. While earnings losses will continue over the near term, I believe the improving macro environment will help the bank to cut down bad assets. CRBC also recently sold a portion of its nonperforming residential mortgages, which will further improve the company’s balance sheet.

CRBC trades at a significant discount to tangible common book value – Despite having an adequate capital base, CRBC is trading at one of the lowest price to book multiples in the sector. At around 0.6x TCBV, Citizens currently trades at a discount to peers, which trade closer to 1.25x TCBV. Short-hand relative valuations are always tricky, particular these days, but in conjunction with looking at core earnings, which I’ll mention later, they can nonetheless help underscore certain pricing discrepancies.

Returning to profitability early next year – As per the above, I believe the bank will become profitable in the first quarter of 2011 on the back of higher interest spreads and lower loan loss provisions. (For Q1 ’10 the bank earned an interest spread of 2.74%. All things being equal, I think the company will be able to post an improved interest spread of 3.09% by Q1 ’11.)

More importantly, though, I think improving asset quality will eventually provide CRBC with the ability to lower its provisioning requirement for bad assets (loan losses as a percent of NPL goes from the current 77.9% to 70% for Q1 ’11 in my model.) With an improving (read: slightly less horrific) real estate market, there should be a gradual decline in defaults, too, which translates into NPL as a percent of the loan portfolio dropping from the current levels of 5.56% to 4.75% by Q1 ’11.

And – more jargon coming – a note on TCBV. Generally, tangible book value is computed by deducting intangible assets, start-up expenses, and deferred financing costs from the firm’s normal book value (BV). Given the economic turmoil out there, though, I believe tangible common book value (TCBV) is a better measure to gauge what the common shareholders can expect to receive if the firm were to go bankrupt and all assets liquidated at book value. (This is strictly hypothetical and just to be conservative, mind you. I place a very low probability on this actually happening at CRBC.) So, I backed out preferred equity, intangible assets and all the assets from discontinued operations from book value to arrive at TCBV per share of approximately $1.60 for Q2 ’10E. We’ll see how that looks later today when Q2 earnings come out.

What’s it Worth?

The investment case for CRBC is fairly simple. That said, there is a high degree of uncertainty inherent in valuing CRBC shares.

Depending on your approach, values can range everywhere from $1.50 per share to $4.00 – though the latter seems to hinge on unrealistic assumptions. So what’s the real intrinsic value? Somewhere in between – and likely closer to the low end of that range.

Here’s a back-of-the-envelope approach to valuing shares that may ultimately be more useful than my earlier model:

If you annualize Q1 results, CRBC will produce $134M in pre-tax, pre-provision (“core”) earnings over the next twelve months. I believe (and Q2 results out later today should shed some light on this) that they’ll more realistically do $150M in core earnings over that same time.

So if you exclude loss provisions (and adjust for cash earnings and one-time expenses) then Citizens should earn $0.38 per share before tax.

Let’s say CRBC is unable to use its net operating loss as a tax shield and has to pay 35% tax on those earnings. On an after tax basis, then, CRBC would produce $0.25 per share in core earnings.

If the economy and real estate in particular recovers to a more normalized level, loan-loss provisions would probably decline to the adjusted average of $0.05 per share.

At that point, CRBC will be showing $0.20 per share in annualized after-tax, after-provision earnings. If we presume those shares deserve a P/E ratio of 11, then CRBC shares are worth $2.20 each.

Now, and this is an important point, management of the bank isn’t sitting around trying to figure out how they can someday reach $0.20 per share in after tax earnings. The bank is effectively already doing it – but it’s getting obscured by huge loan loss provisions. And what’s the right way to look at those?

I contend CRBC has been extremely conservative about classifying its loans, based on (1) the actions it has already taken, (2) comparisons with its peers, and (3) because its “swat team” approach to working with troubled borrowers appears to be working reasonably well. So while the Street appears to be assuming that most of the nonperforming loans on the company’s books won’t be recovered, the reality is that some will be. And that’s important to remember when considering this:

For the purposes of financial reporting, CRBC has already assumed the worst for its portfolio of nonperforming loans. In the first quarter, for instance, reserves for future loan losses stood at 4.3% of the bank’s total loan portfolio – more than two full percentage points above its peer group average. Since 5.6% percent of CRBC’s loans were classified as nonperforming, then before the 4.3% reserve becomes too light, nearly 80% of all loans currently classified as non-performing will have to become completely worthless – or new loans made during one of the best lending environments in recent history would have to suddenly go bad.

I believe either outcome is highly unlikely. In fact, the levels of non-performing assets, delinquent loans and watchlist loans have been decreasing sequentially at CRBC– trends I anticipate will continue.

In other words, CRBC should be through the worst of it in terms of impact to their earnings. The vast majority of those earnings are of good quality, mind you, as per the cash yield of 5.4% on its existing loan portfolio. And because the bank is asset-sensitive, earnings will improve further once interest rates start to rise.

And, yes, those back-of-the-envelope calcs above are a rough ballpark estimate based on assumptions that may or may not prove to be true. (Some could in fact be smashed to bits later this afternoon when Q2 earnings are released.) In conjunction with other valuations, however, including my semi-formal sell side model, peer analysis and plain old book value, I believe it’s safe to say that CRBC shares currently priced well below what they’re worth.

Then the question becomes:

Why are shares cheap?

For three years the price of CRBC shares could be pretty easily explained by business performance and the resulting negative sentiment. These days, however, performance is improving, albeit modestly, while poor sentiment remains. During the beginning of that three year snapshot, the stock’s price basically mimicked broad market and macroeconomic factors that resulted in, surprise, mounting bad loans and a deterioration in credit quality. The stock, which was trading at more than $10 per share until April of 2008, has been wallowing since, mostly for very good reason.

For instance, shares took it on the chin in early 2008 when management reiterated a weak outlook for the year. The broader sell-off, however, seemed to be triggered by Q2 2008 performance, which came in way below analysts’ estimates. Performance then was marked by lower than expected net interest income, higher expenses, flat fee income, and an approximate doubling in net charge-offs. At the same time, the company also suspended its quarterly cash dividends to preserve capital.

I think that was prudent, mind you, but management (and analyst) expectations nonetheless deteriorated materially as that year progressed – and which were brought to a head when management failed to meet its expectations to return to profitability later that year. In addition, the exit of Chairman and CEO Bill Hartman in February of 2009 seemed to go over like a fart in church on the Street.

Continued struggles with the loan book and a subsequent downgrade in CRBC’s long-term and short-term Issuer Default Ratings (IDRs) by Fitch in the second half of 2009 also added to the company’s woes.

That said, at this point in the cycle, and as mentioned above, things have changed and/or are in the process of changing for the positive. So why are shares still cheap right now, then?

Overblown Threat of Dilution

Of the rational concerns about the company’s shares floating around out there, I believe the most common is “the risk of dilution,” but I find even that a bit short-sighted. CRBC received TARP funding of $300 million in Q3 of 2008. So while the threat of dilution is certainly understandable, here’s why I don’t view it as an immediate concern:

Management has clearly stated in a recent analyst meeting that it does not anticipate repaying TARP funds in the near future. Further, they intend to “aggressively pursue” capital-enhancing opportunities that would be non-dilutive to its common shareholders. Like selling branches in Iowa, for instance. So, while the risk of dilution certainly exists, the risk of that dilution happening in 2010, for instance, is very low.

I’m not turning a blind eye to this issue, but I am trying to underscore that (1) dilution will most likely be much less severe that the Street currently believes and (2) trying to quantify the eventual impact right now is pointless. There is simply no rush to repay TARP over the next few years. Being able to capitalize on those funds during one of the best lending environments in recent memory is a very good thing for CRBC. I also happen to like that TARP shields the company from low-ball acquisition offers.

More to the point, though – one of the major factors that all banks keep in mind while evaluating when to repay TARP funds is the expectation of profitability going forward. Until CRBC reaches sustainable profitability again, the bank’s focus is on maintaining strong capital levels – to basically be on the lookout for ways to preserve cash and enhance liquidity. The company already suspended dividend payments for its trust-preferred securities and TARP-preferred stock, despite having the cash to pay for both on its books (saving about $5.0 million each quarter.) So it seems pretty clear that the company’s game plan is to make it through this downturn safely, and then look for conversion options once it is more obviously on the road to recovery – and presumably at what I believe should be a much higher stock price.

As a result, I don’t lose much sleep worrying about the risk of dilution at current price levels. Let’s see where we are this time next year. And while I can understand the short’s case for CRBC, which seems to hang on that risk of dilution, I suspect that issue will resolve itself as improved performance begins to become more evident.

Next in this series – why the Michigan economy is not as bad as you might think.

Supporting Charts & Graphs

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