NSBC - North State Bancorp

[oddballstocks]

I don't post ideas here often, but I thought I'd highlight something I came across this weekend that might be worth looking at.

 

North State Bancorp (NSBC) a North Carolina bank is effectively going private by electing to switch to S-corp status.  They will either:

1. Pay shareholders $9.75 in cash

2. Issue a 10 year note par $9.75 with a 6% rate

3. Allow investors to try to secure one of the 10 open S-corp share slots.

 

The transaction is at about 1.5x TBV, so what I'd consider 'fair value'.  But this is a decent bank, growing nicely, 10% ROE.  In the letter to shareholders management stated they want to start to return a significant amount of capital going forward. 

 

The opportunity is in the bonds or the s-corp shares.  The bonds are about double the going rate for similar 10-yr paper.  Maybe there's an opportunity to buy shares in size, receive bonds and then resell back onto the market 50% higher?

 

For anyone looking to get involved in an s-corp bank this might be an easy way to get in.  Buy shares, talk to management and convert.  You could end up with some additional tax issues (they're not terrible, I own an S-corp and it's just an extra K-1 to deal with), but also huge dividends going forward.  Given their growth I could see this yielding about 10% to start and fast forward 5-10 years and you might be receiving a dividend equal to your cost basis per year.

 

I wrote the thing up in more detail on Seeking Alpha: http://seekingalpha.com/article/3275165-north-state-bancorps-unique-going-private-transaction

 

Another weird fact about this bank.  The CEO seems to really like themes, i.e. each annual report has a theme to it.  Last year was basketball, everything was discussed with a basketball analogy or reference.  This year was different, don't remember exactly, but same idea.  I've never seen that before, it's different for sure.

 

I own some shares, I'll probably take the cash. 

[TwoCitiesCapital]

Thanks for sharing. Interesting situation!

[bigbadwolf]

I like the idea.  You know much more about banks so not sure if my ideas are correct - but here they are.  My general question is why the conversion to the S corp?  I think it could be short sighted. 

 

1. You are taking a liquid asset and turning it illiquid. S corp legal limit is 100 - if over you convert back to C corp. They claim to have 85 or so or so families already and will take 10 more shareholders bumping up close to 95.  So, now if I want to sell my shares to an outsider I cannot if others in my family own shares as I would drive total shareholder count over 100.  The only path to liquidity that I see is that a) sell to other existing shareholders or b) have the corp buy back my stock.  What will this do to my sales price? It could be harder to realize FMV if my target sells group is small.  You are essentially trapped.

 

2. Upon S conversion, the entity becomes taxed as a flow-through.  I almost wonder if this S conversion is more tax driven by the investor base.  Do the main investors need to generate passive income to free up suspended passive losses so they want the flow through income?  Maybe shareholders want to see some income from the bank.  They don't want a dividend as it is double taxation; they don't want to sell their C corp stock and recognize large capital gains.  It is a neat concept - why not convert to S so I can get one level of tax and also free up some passive losses from other flow-through investments with this passive income?

 

3. It's not really a dividend - its a distribution/return of capital.  You are required to pay your share of taxes based on flow-through income.  You need to reduce the tax impact from the cash distributed by the S corp to calculate true return.  Will they distribute all free cash flow or just enough to cover taxes? 

 

4. Built in gains tax on C to S conversion locks you up for 10 years.  This could be a significant issue.

 

5. I guess you save some costs by removing the public listing but you still have normal bank  regulatory compliance costs. If you distribute most earnings, you can't growing the bank. Can they handle the regulatory burden across a smaller asset base vs. getting bought out and having synergies from overhead savings.

 

6. A large chuck of their income is from mortgage origination - Raleigh housing is exploding right now as the population continues to grow - what happens when the housing market slows?  How are their earnings impacted? 

 

All in all it is a neat idea to convert to S - out of the box concept.  I just think there are a lot of issues to weigh before I would try to be a shareholder.  I do like the bonds if they are liquid - I haven't heard if you will be able to trade them or not yet.

[bookie71]

One of our local banks did this and it turned out very well.  The BIG (Built In Gains) taxis manageable IF you are careful. For a small profitable  bank it can workout very well as you are skipping one layer of tax. (It was way out of my league when it happened,but one of my clients did it .

[oddballstocks]

I like the idea.  You know much more about banks so not sure if my ideas are correct - but here they are.  My general question is why the conversion to the S corp?  I think it could be short sighted. 

 

1. You are taking a liquid asset and turning it illiquid. S corp legal limit is 100 - if over you convert back to C corp. They claim to have 85 or so or so families already and will take 10 more shareholders bumping up close to 95.  So, now if I want to sell my shares to an outsider I cannot if others in my family own shares as I would drive total shareholder count over 100.  The only path to liquidity that I see is that a) sell to other existing shareholders or b) have the corp buy back my stock.  What will this do to my sales price? It could be harder to realize FMV if my target sells group is small.  You are essentially trapped.

 

2. Upon S conversion, the entity becomes taxed as a flow-through.  I almost wonder if this S conversion is more tax driven by the investor base.  Do the main investors need to generate passive income to free up suspended passive losses so they want the flow through income?  Maybe shareholders want to see some income from the bank.  They don't want a dividend as it is double taxation; they don't want to sell their C corp stock and recognize large capital gains.  It is a neat concept - why not convert to S so I can get one level of tax and also free up some passive losses from other flow-through investments with this passive income?

 

3. It's not really a dividend - its a distribution/return of capital.  You are required to pay your share of taxes based on flow-through income.  You need to reduce the tax impact from the cash distributed by the S corp to calculate true return.  Will they distribute all free cash flow or just enough to cover taxes? 

 

4. Built in gains tax on C to S conversion locks you up for 10 years.  This could be a significant issue.

 

5. I guess you save some costs by removing the public listing but you still have normal bank  regulatory compliance costs. If you distribute most earnings, you can't growing the bank. Can they handle the regulatory burden across a smaller asset base vs. getting bought out and having synergies from overhead savings.

 

6. A large chuck of their income is from mortgage origination - Raleigh housing is exploding right now as the population continues to grow - what happens when the housing market slows?  How are their earnings impacted? 

 

All in all it is a neat idea to convert to S - out of the box concept.  I just think there are a lot of issues to weigh before I would try to be a shareholder.  I do like the bonds if they are liquid - I haven't heard if you will be able to trade them or not yet.

 

Good questions.  I'll take a stab, although I'm no expert on s-corps, even though I have one myself.

 

1. Management didn't spell this out, but turning an S-corp essentially means taking it private.  There are a number of other s-corp banks, and they do trade among a small set of accredited investors who are familiar with these.  One other factor, with the going private I wonder if any individual holders will be pushed over a threshold where they'll require regulatory approval.

 

2. It's absolutely driven by taxes and the desire to return capital.  Management said so in the letter.  They said their desire is to return significant capital to shareholders and doing it via s-corp is the best method.

 

4. Didn't know this existed, do you have more details?

 

5. I don't believe this is driven by delisting, they are already delisted.  There is nothing to save.  They just want to pay out more in capital.

 

6. Excellent point...if I were becoming an S-corp shareholder this is something I'd want management to answer.

 

I'm not sure if anyone knows whether the bonds will be traded.  That's the big question, if they are then that's the route to go.  What's it take to trade a bond?

[Tim Eriksen]

3. dividends from C- Corps aren't tax free either.  S-Corp distribution (at your individual tax rate) is still taxed lower than a fully taxed C-corp (35% plus tax on dividend)   

 

4. I doubt the bank has much in the way of built in gains.  Since as far as I know they don't hold any investments or loans that whose market values are much more than their carrying value, it should have no impact on the bank.

 

 

[thepupil]

Is getting 6% debt really all that sexy for lending to a small little community bank?

 

Leucadia 8 yr bonds are at 5%, 30 yrs are at 7.15%.

Fairfax 4/2026 USD's are at 5.3% YTM and 6.7% current yield since they are premiums (so you get more reinvestment opportunity which I'd prefer in a rising rate environment).

 

Is it worth 70 bps to sacrifice liquidity (the LUK's and FFH's are not that liquid for corps but they'll definitely be more liquid than this rinky dink little issuance).

 

I think LUK and FFH are much more diverse and much better credits. I wouldn't reach for the north state's (or count on them trading to a 5% YTM). Just me.

[TwoCitiesCapital]

Is getting 6% debt really all that sexy for lending to a small little community bank?

 

Leucadia 8 yr bonds are at 5%, 30 yrs are at 7.15%.

Fairfax 4/2026 USD's are at 5.3% YTM and 6.7% current yield since they are premiums (so you get more reinvestment opportunity which I'd prefer in a rising rate environment).

 

Is it worth 70 bps to sacrifice liquidity (the LUK's and FFH's are not that liquid for corps but they'll definitely be more liquid than this rinky dink little issuance).

 

I think LUK and FFH are much more diverse and much better credits. I wouldn't reach for the north state's. Just me.

 

Well I think you have to consider the price in which you're getting the bonds at. The stock currently trades at $9.41 (was much lower before this post). You get $9.75 worth of bonds in exchange. That's a 3.6% return up front plus an additional 70 bps relative to the other credits you mentioned. Sure, it's not crazy cheap relative to the other credits, but over the course of 5 years you're talking about about a performance boost of some 7.25% which equates to roughly 140 bps of compound out-performance per year over a 5 year time horizon or 11% out-performance for an additional 100 bps per year if you hold the full 10 years.

 

Certainly not much to write home about, but an additional 11% over the life of a bond is a pretty significant amount by the end period - it just doesn't seem like it in any given year.

 

 

[thepupil]

fair points, obviously much more interesting at price of original writeup.

 

I'm just saying it 360 over and 6% absolute (or a little more for when you account for the spread to closing, which there is deal risk to) isn't juicy enough to get me to buy a bond that has zero institutional appeal and will most certainly trade violently down should the bank's fortunes turn as all retail securities do and only retail would ever own this. Without institutions to price this, it's negatively convex to credit and duration risk (little upside , plenty of downside ).

 

I mean folks don't like a $100MM issue, much less a $20MM one, a pretty tiny bond fund or insurance co would have to own the whole damn thing to make it a material position.

 

The bond market is frothy but I just think there's much better ways out there to be a yield pig if one must be a yield pig. 

[oddballstocks]

fair points, obviously much more interesting at price of original writeup.

 

I'm just saying it 360 over and 6% absolute (or a little more for when you account for the spread to closing, which there is deal risk to) isn't juicy enough to get me to buy a bond that has zero institutional appeal and will most certainly trade violently down should the bank's fortunes turn as all retail securities do and only retail would ever own this. Without institutions to price this, it's negatively convex to credit and duration risk (little upside , plenty of downside ).

 

I mean folks don't like a $100MM issue, much less a $20MM one, a pretty tiny bond fund or insurance co would have to own the whole damn thing to make it a material position.

 

The bond market is frothy but I just think there's much better ways out there to be a yield pig if one must be a yield pig.

 

All great points.  I just want to mention that there is almost a second market for banks.  That is there are investment banks, funds, and hedge funds that ONLY invest in these sorts of issues.  There will be community bank institutional interest in this for sure.  It's just not a large brand name fund everyone knows.  There are plenty of bank only players.  Which as an aside I find very fascinating itself.  I think banks are the only sector that has this thriving closed ecosystem.

[bookie71]

More than you ever wanted to know about the BIG tax

http://www.aicpa.org/publications/taxadviser/2012/march/pages/anderson_mar2012.aspx

http://www.taxlawforchb.com/2013/09/s-corp-sales-built-in-gain-and-2013/

http://www.srr.com/article/valuation-impact-built-gains-tax-liability

[bigbadwolf]

BIG applies to off-balance sheet intangibles like goodwill.  Buy-out at 1.5x book.

[Tim Eriksen]

BIG applies to off-balance sheet intangibles like goodwill.  Buy-out at 1.5x book.

 

I am not sure I fully understand your comment.  Are you implying that if the bank was sold in the future for stock or cash that BIG would apply?  I can see if they sold parts for cash it would, but not the whole bank.  Regarding the parts if they have a fairness opinion now at 1.5x book that is likely close to what most of the parts (a certain branch and its related deposits and loans) are worth.  I really don't see how BIG is going to come into play in this situation in any material way.

[oddballstocks]

BIG applies to off-balance sheet intangibles like goodwill.  Buy-out at 1.5x book.

 

Is this considered a buyout though?  The majority shareholders remain the majority shareholders.  They're buying out potentially 30% or less of shareholders.  If someone steps in and wants to become an S-corp holder with a 5-9% position that piece of the pie shrinks.

 

There isn't a new entity here, they are just filing differently.  I'd say compared to peers and other banks 1.5x TBV is a very fair value.  But then again this is a going concern, not a buyout.  The same entity before remains after this transaction.

 

I'll find out more when I receive the packet in the mail, but they had an investment bank advising them on this.  I'm sure they are aware of the issues considering the whole deal is done for tax purposes.

[bookie71]

BIG applies to off-balance sheet intangibles like goodwill.  Buy-out at 1.5x book.

BIG applies to any appreciated asset (Real estate, personal property, construction in progress. etc.)