Farmers & Merchants Bancorp: Book Value Increase Should Accelerate Again (OTCMKTS:FMCB)

Introduction

More than half a year ago, I expected Farmers & Merchants Bancorp’s (OTCQX:FMCB) book value increase to be slower than before as the California-focused bank had to deal with the rather abrupt increase in interest rates. While that’s good news in the long run as the bank’s net interest margin should increase as well, the problem with increasing interest rates is the mark-to-market requirement on the portfolio of securities available for sale.

It’s all about keeping the damage limited

The last time I had a look at FMCB was in June and at that point I was only able to base my opinion on the bank’s Q1 results. As we are now just a few weeks away from FMCB reporting its full-year financial results for 2022, I already wanted to check how my thesis was evolving.

Before diving into the specific issues related to the portfolio with securities available for sale, I think it makes sense to have a look at how the bank was performing in the third quarter and the three quarters leading up to the Q3 reporting date as ultimately the decrease in book value related to the revaluation of the portfolio of securities available for sale will be compensated by retained earnings.

During the third quarter, FMCB saw its interest income increase to almost $52M while the interest expenses barely increased at all: This resulted in a net interest income of $50.5M which is more than 25% higher than in the third quarter of the preceding year.

The bank really needs the net interest income (and thus needs strong net interest margins) to generate a profit as the bank’s total non-interest income was just $1.6M for the quarter. Granted, that also was caused by a $3M loss on the sale of investment securities available for sale, but even excluding that element, the total non-interest income would have been just over $4.5M. And seeing how the total non-interest expense increased to in excess of $24M, those few million dollars – although very welcome- would not have made a major difference in the net non-interest expenses.

Including the $3M loss on the sale of Securities AFS, the pre-tax and pre loan loss provision income was approximately $27.6M. The bank recorded a $1.5M loan loss provision which means the pre-tax income was roughly $26.1M and the net income came in at $19.5M for an EPS of $25.20 per share. Important takeaway here is that despite the loan loss provision and the loss on the securities AFS, the net income increased compared to the third quarter of 2021.

The total net income in the first nine months of 2022 came in at $55M, for an EPS of just over $70.

In an article published in 2021, I anticipated FMCB would be able to grow its book value per share by $60/year. That target will not be met in 2022. Not because the bank’s earnings were (or will be) disappointing as FMCB remains on target to report an EPS north of $90 while the dividend (on an annual basis) will be less than $20/share.

The main culprit is the value of the portfolio of the securities available for sale. The comprehensive income statement provided by FMCB shows there was an unrealized loss on the value of these securities to the tune of almost $40M and just over $25M on an after-tax basis.

That being said, FMCB’s book value actually still increased in the first nine months of 2022. The bank ended 2021 with an equity value of $463M and just under 790,000 shares outstanding for a book value of $586 per share. As of the end of September, the equity value was slightly higher but the bank had also repurchased about 2.5% of its share count (at prices above the book value) which provided an additional drag.

Dividing the $468M in equity over the share count of just under 771,000 shares results in a book value of $607 per share. Deducting the $18/share in goodwill and other intangibles results in a tangible book value of approximately $589 per share.

And as I expect the fallout of the portfolio of securities AFS in the fourth quarter of 2022 and Q1 2023 to be relatively limited, I think FMCB is in a position to slowly start to increase its book value per share again.

Investment thesis

In fact, I think FMCB has a good shot at accelerating its book value per share above the $60/share per year I originally had in mind. The effective pace will also depend on how fast FMCB is buying back stock: buying back shares at a 60% premium will boost the EPS (due to the lower share count) but will have a negative impact on the book value per share.

While I’m usually not too keen on paying 1.6-1.7 times the book value, I like FMCB for its strong loan book performance (and I’m looking forward to seeing the bank’s full year update) and focus on building book value rather than maximizing the dividend. The FY 2022 dividend will very likely remain below $20/share which means the sub-2% dividend yield does not make FMCB attractive for yield-focused investors. But I don’t mind investing in a bank where book growth value is an important driver.

I haven’t pulled the trigger on FMCB yet, but I’m getting increasingly interested. While I generally don’t like to pay a hefty premium to book, FMCB may actually be worth it.

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