We’ve all had that sensation of finding a stock or other investment that seems too good to be true.  Today’s post looks at one particularly cheap bank – Territorial Savings (TBNK), that seems like an easy purchase decision, and shares why it may end up more akin to a value trap.

There are five reasons we can think of to be bullish Territorial shares:

• Territorial Bank is cheap at a recent 73% of tangible book.
• Territorial buys back stock under tangible book value, which we always appreciate because not only does it support shares, but it grows book value.
• The bank is led by an elderly CEO, Mr. Kitagawa, who is 76, and some think may make the board more prone to sell the bank.
• The bank is one of only a handful of Hawaiian banks, and may help a deposit-hungry acquirer (deposits may soon become more valuable as rates rise).
• Great deposits (an unusual 64% of deposits in savings) may make it an attractive takeout candidate

The bank even channels the Aloha spirit to offer “exclusive” discounts on local hotels to “customers” for everyone to see on its website.

Finally, one investor friend even took a 7 hour flight to see management in person.  At least he got to visit Hawaii.

However, below is what owners of Territorial received, including dividends, relative to indices over the past 5 years:

The point of mentioning all this is that Territorial is a cautionary tale to explain why we invest in this sector the way we do.  Banks offer fantastic long-term tailwinds to shareholder-centric managements, but there are many, many Territorials in the public markets and below is why they post performance records like Territorial’s:

1.  Inefficiency

For every dollar of revenue, Territorial allocates almost 70% to operating expenses.  Shareholders get the orange section.

in contrast, a typical mortgage lender is far more efficient, spending about 40% on operating expenses.  An example is Axos (AX).  Shareholders get something like the orange at an efficient mortgage lender.

This matters because of what we might call “disappearing value” or “uncompounding”.

Consider that Territorial has generated around $60 million in revenue on average each of the last 9 years.  What if instead of spending 70 cents of every dollar of revenue, management could get by with spending 40 cents?  Even if they spent 60 cents instead of 70, Look below at how the savings could theoretically have compounded if Territorial were to have found ways to save that incremental $12 million and reinvest to generate 15% ROE, as Axos did:

The short answer at bottom right is they could have created around a half billion dollars of value for shareholders over that timeframe.  For reference, Territorial has a $356 million market capitalization.

But wasn’t the money being used for things like growth or franchise value?

Regarding growth, interest income was the same in 2021 as it was in 2012 – $60 million.

One issue is that compensation has been running over $20 million a year for the past decade for a ~$2bn mortgage portfolio lender.  That is substantial compensation for a straightforward mortgage-lender.  Comparing at Axos, compensation began at $20 million, but ended much higher.  The offset for Axos is tangible book grew since 2012 from $3.95 to $21.36.  At Territorial it grew from $20.24 to $27.49.

2. Incentives:

Territorial’s Chairman and CEO makes almost $2 million a year at age 76 without running a complicated organization.  He owns $5 million worth of shares (the CEO is the largest holder) and get $200,000 of dividends from an organization he has significant control over.  Is there an urgent need to sell?  If you wanted to sell, would you be able to pass regulatory concentration issues and get much premium (Hawaii is a concentrated banking market)?  Would a California bank want to manage a Hawaii company?

If you are already a pro-am regular, would you play more golf?

https://www.bizjournals.com/pacific/news/2018/01/11/2018-sony-open-in-hawaii-pro-am-tournament.html

If the goal is a great lifestyle and solid income, Mr. Kitagawa deserves credit for putting himself in good position.

3. Interest rate risk:  I won’t belabor this point except to suggest reading the yellow part from the 1Q 10Q.

With all this said, TBNK can be a reasonable short term position if management become interested in an aggressive repurchase around current levels.  Otherwise, please be careful and dig into the issues that can impair compounding – all that glitters is not gold.