Friendly Hills Bank Plans Dubious Branch Acquisition - FHLB

Shareholders should reject this ill-considered transaction

I want to highlight a situation playing out in Southern California at a small institution called Friendly Hills Bank. Put simply, Friendly Hills is attempting to purchase three branches from Bank of Southern California. This is a meaningful transaction for Friendly Hills, a $200 million bank. If completed, the bank will expand its branch network from 2 to 5 and increase its deposit base significantly. The purchase is subject to shareholder approval at the company’s shareholder meeting on June 22.

Shareholders should NOT approve this transaction.

The economic rationale for this branch purchase is dubious at best. Moreover, Friendly Hills is a chronic under-performer that has shown no ability to manage its own assets successfully, let alone the cast-offs of a successful bank.

Let us briefly examine the disappointing financial results that Friendly Hills has gifted its shareholders in recent years. The figures never tell the whole story, but in this case they tell us quite a bit.

• Net interest income: A bank’s “fuel” is the interest earned on its operating assets less the interest paid on its operating liabilities. Interest earned on loans and securities less interest paid on deposits, essentially. Without growth in net interest income, a bank will have a difficult time growing its profits. To some extent, a bank’s net interest income is at the mercy of changes in interest rates and the shape of the yield curve. But Friendly Hills’ performance in growing net interest income has been uniquely bad. From 2014 to 2019, Friendly Hills grew its net interest income at a paltry 4% annual rate. It is statistically unlikely that a bank growing its “top line” at 4% can provide reasonable shareholder returns in the long run absent meaningful returns of capital. Friendly Hill returns zero capital to shareholders.

• Efficiency: Friendly Hills consistently runs with an efficiency ratio in the high 70%s/low 80%s, managing once in a while to dip into the 60%s for a quarter. The efficiency ratio is a measure of a bank’s ability to control operating costs. A consistently high efficiency ratio indicates excessive compensation, a poor-quality branch network, marginal non-bank operations (wealth management, mortgage origination, etc.) or a combination of these. In Friendly Hills’ case, a large part of their poor efficiency comes from being a sub-scale 2 branch institution. It is beyond rare for a sub-scale institution to solve the issue by acquiring the unwanted branches of other banks.

• Return on equity: In the long run, a bank must “justify its existence” by producing a reasonable return on shareholder equity. Friendly Hills has failed continually in this regard. The bank’s return on equity rarely exceeds a figure that can be counted on one hand. Return on assets is mired around 0.45%.

If there are any positives to be found, Friendly Hills does have good capital ratios and stellar asset quality. But even this can be sub-optimal. A pristine loan book can indicate a lack of urgency in generating new loans, or an excessively conservative approach. One of the best ways for a bank to generate growth in quality deposits is by generating new loans, and Friendly Hills has not done so.

All in all, the data paints Friendly Hills as a bank that should consider selling itself, not a bank that should be more than doubling its branch network in a risky and expensive acquisition. When a mediocre bank buys assets from a much more profitable, better-run, more sophisticated bank, it is typically not the mediocre institution that is getting a good deal.

More broadly, I question the strategy surrounding branch acquisitions entirely. The American banking industry has rightly assessed that the number of physical bank branches has peaked and is now in permanent decline. Most banks are trying to reduce their physical branch network in favor of an improved online experience and better efficiency at remaining branches. (How convenient for Bank of Southern California. It gets to offload three extraneous branches without the expense of liquidating them!) I find it extremely unlikely that Friendly Hills will be able to generate attractive returns from 3 branches that Bank of Southern California has decided its customers do not need. If a branch acquisition strategy is to be considered at all, it should be focused on acquiring only the highest-quality locations that truly aid in customer acquisition, customer retention, and in building market share.

Recently, I heard from a Friendly Hills shareholder who will remain anonymous. This shareholders is opposed to the transaction and wished to share a qualitative assessment of the bank’s management as well as specific objections to the branch acquisition plan. I present the shareholder’s commentary below, unedited except for minor formatting changes. My friend Nate Tobik of OddballStocks.com heard from the same shareholder and uploaded the same commentary here.

OVERVIEW FHLB/BCAL BRANCH ACQUISITION

The saga of the acquisition agreement between Southern California Bancorp (OTCPK: BCAL) and Friendly Hills Bank (OTCPK:FHLB) continues. The former signed a definitive agreement whereby the latter will acquire three(3) branches at the same time they (BCAL) continue to buy other banks.

This is a story of two CEOs.

Meet David I. Rainer, Executive Chairman of Southern California Bancorp. He is a proven leader in growing and selling community banks and recently served as a founder, Chairman and CEO of CU Bancorp (Nasdaq:CUNB) and California United Bank (CUB) from 2005 through its sale in 2017. He served two terms on the Board of the Federal Reserve Bank of San Francisco, Los Angeles Branch. He is a member of the Board of Councilors at the USC School of Public Policy and a former Director of InBank, a Denver-based community bank. He served as a Director for Boys and Girls Club of West Valley, Inner City Arts, Junior Achievement, and the LA Urban League. All in all, a highly effective executive, banker, community leader, and the kind of guy we investors hope for when we invest.

Both founded a bank in 2005. The difference? Dave Rainer creates $705 million in equity value for shareholders, Jeffery K. Ball loses equity value and never returns a penny to shareholders. I wonder who the better negotiator would be?

Like Dave, superCEO Jeffery K. Ball is a pleasant and charming local figure who has operated the bank since inception in 2005. He too is an important man – Founder of Friendly Hills Bank in Whittier where he serves as President, CEO and Director and a member of the board of the Federal Home Loan Bank of San Francisco and Data Center, Inc., a bank technology company. He is a member of the Executive Committee and board of the ABA, President of the Whittier Host Lions Club, and Co-Chairman of the Legal Services Trust Fund of the State Bar of California. All in all, an impressive and community focused fellow.

As the Founder, CEO and President (for life) at Friendly Hills, Jeff is an engaging figure with his cast of original board members stuck at his side collecting fees all the way into their nineties. Great way to get paid without working.

Unfortunately, unlike Dave Rainer, superCEO Jeff Ball has not mastered growing or operating a bank, but is highly visible in associations, volunteer organizations and government panels. He enjoys his role as community leader without doing anything to help build value in the bank that pays his rather generous compensation package. All said, he is the neighbor you want, just don’t give him your investment capital.

Dave Rainer of SoCal Bank is a phenomenal leader and banker. He is strategic, focused, and develops good teams. Sometimes a little headstrong, but takes care of his employees, investors, and customers and has made magic happen throughout his career. Now he is starting again at SoCal Bank which will be a big win for all his shareholders. Luckily for his shareholders he ran across superCEO Jeff Ball of Friendly Hills, who has been unable to grow his franchise over 15+ years BUT has decided the future for his shareholders is buying the cast-off failed branches from one of the best bankers in the state. Kind of like buying anchors, tying them together, throwing them in the air, and hoping they fly … maybe there will be a miracle, more likely they come crashing down and sink the Friendly Hills boat. Bad news for shareholders, but Jeff will still get paid to save it, he has an employment agreement.

Just hoping the shareholders at Friendly Hills have their life preservers on. I’m sure the board of directors has lifeboats, like Jeff Ball’s five (5) year agreement because need to take care of the important people!

superCEO Jeff Ball, CEO and President for life, and his board of directionless directors have decided to spend millions of shareholder dollars and take an unprecedented risk by buying three (3) failed (not successful) bank branches from one of the smartest and most successful bank CEOs in California who is DUMPING them.

A reminder, Jeff does lots of good things for his community, just like Dave Rainer. However, Jeff has failed to grow the value of Friendly Hills Bank in 15+ years and not returned a penny to shareholders but has transferred 7% of the equity of the business to executive management and the board of directors at below the book value and market price … good for them, not so much for investors.

Friendly Hills Executive Management and Board’s decision is perplexing in the lack of awareness leadership has in this small investor-owned businesses where a charismatic, flawed, ego-driven leader is held to impossibly low standards by a captive board of directors that doesn’t know what to do. While he’s a nice man, Mr. Ball fails to rise to even the lowest performance standards while being generously compensated. This seems to bother no one, especially the board members who nominally represent shareholders between rounds at the country club and drinks at the 19th hole.

This is a stock, FRIENDLY HILLS (“FHLB”) no one without a deep sense of optimism or a deeper streak of masochism should consider. It is unfortunate for everyone involved, but especially those large and long-time shareholders at Friendly Hills.

If there is a chance to be in front of a group, Jeff Ball will be there! Imagine the financial results if he put the same energy into developing the institution that has paid him excessively generously over the last 15 years. During superCEO Jeff Ball’s tenure at Friendly Hills, he and his 3-person management team have paid themselves well over $15+ million in personal compensation – WHILE shareholders’ equity is worth LESS than the initial monies invested fifteen (15+) years ago. This is not responsible stewardship.

Shareholders should be up in arms at the June 22nd shareholder meeting and reject this attempt to hide Jeff’s trail of failures with an even greater debacle. Vote against this acquisition.

Getting shareholders to vote on without providing a clear understanding of the risk is his specialty. Just days before the announcement of this branch acquisition, the board granted superCEO Jeff Ball and two of his senior team received five (5) year and three (3) year guaranteed employment contracts respectively with large payments and benefits transferring additional control to insiders.

Even if shareholders tried to understand the decision, the pro-forma financial page provided to them in the proxy DOES NOT accurately represent the actual four (4) or more years of increased operational expenses, deposit fall-off estimation, investment income reduction, and significant annual expense increase in an institution with the highest expense ratios in its peer group. This poorly managed franchise has a management team that long ago lost track of their obligation to operate the business to benefit the shareholders instead of themselves – they act as if they own and are entitled to control the bank and benefits of ownership without actually making an investment or bearing the commensurate costs.

When a real company takes a risk, they require a plan and key performance indicators to make sure they increase their capability as an organization. According to the disclosures, the board of directors reviewed models and sought relevant information core to the evaluation in making this critical financial decision.

How about giving the same information to shareholders so that they may make an informed decision?

Mr. Ball, those poor fellows whose money you took years ago need to know what to expect. For a transaction representing a 50%+ increase in the deposit base or a bank that was already not lending appropriately, and a significant increase in overhead, you need clear goals and objectives. Where is the plan for success with this big new acquisition? Likely Mr. Ball doesn’t really know what to do.

Maybe call Dave Rainer, you just bought his trash for big money, he was going to have to pay for those leases for years, but you took them off his hands, maybe get some tips?

Plainly stated, the board has lost its independence and it is time for a change. The board of directors have a “duty of care” to represent shareholders, not pander to a management team so they can pretend to be businesspeople while board members get low-cost options and board fees.

At a time when the rate of branch closures has been doubling every three years, this acquisition is a questionable decision. These are not successful branches being added to a bank that knows how to integrate. They are bad leases, a few employees SoCal Bank doesn’t want, deposits from customers that one of the best bankers in California won’t provide lending relationships for and an infrastructure that needs to be upgraded.

Is buying failed branch locations a good strategy to grow outreach? Between 2012 and 2015, the closure rate for bank branches was 0.81% per year. From 2015 to 2018 the rate reached 1.6% per year. Based on that and other factors, by 2030 fewer than 16,000 branches will likely remain, similar to the unit count in 1965 just about when superCEO Jeff Ball was born, coincidence?

If the strategy is to use a branch network, why not buy GREAT locations within the bank’s specific target communities and demographics (if Jeff knew what that meant), but obviously superCEO Jeff Ball knows things his strongest competitors don’t. Questionable.

This is the most important financial decision made in the bank’s history, and NO independent third party has been engaged by the board as part of the evaluation process. I hope the board members did a great job understanding the risks, because if this goes badly shareholders will come asking lots of questions. Understanding is a critical component of any evaluation by shareholders, board members and regulators – where is the information? Where is the expertise, where is the thinking?

As a lark, information from the proxy was provided to several experts in the Community Banking investment community. In discussions with four (4) separate senior leaders in local California Community Banks, and two (2) senior investment bankers in Community banking, all reported they believe this acquisition will have a detrimental impact on the performance of the bank, the capital base, performance, and financial viability of Friendly Hills. Some of them simply laughed when they reviewed it, unfortunately it won’t be as funny to shareholders.

Board of Directors, where are you?

Apparently, the board thinks poorly considered decisions should require NO disclosure before a vote is ratified by shareholders. Friendly Hills reported publicly they were represented by an investment banker … please disclose the fairness opinion. Piper Sandler has not publicly disclosed an opinion on the viability of the transaction to the shareholders. If it is strongly worded and supports this brilliant decision, then publish it!

SO, Board of Directors, how about you do your job, disclose the investment banker work product so shareholders can determine for themselves the opportunity, and the quality of the analysis before you burn a pile of shareholder money using strategies from the 1990s. Maybe offer to step down from management and use your contacts to recruit real operational leadership like Mr. Rainer and build a sustainable franchise that rewards shareholders instead of management?

Last, to the board of Friendly Hills why don’t you think about the items below. Help shareholders understand why there is not a published business model and plan to address the issues outlined, yet you expect us to vote for a half-baked acquisition plan. This is a horrible decision, and you are choosing your superCEO’s ego over your responsibilities to the community members who have trusted you over the last 15+ years.

Time to protect us, the shareholders, or step down.

Concerns:

Fixed & personnel expenses post-merger increase > 1/3 without offsetting loan income.

No history of generating the volume of good loans necessary to support the increased deposit base thus exceeding the ability of Friendly Hills to maintain lending standards or to have permanently high expenses.

The model in the Proxy shows deposits increasing by 50% with no reduction or run-down in the pro-forma.

Non-interest Expense increases by $1,728,000 annualized but are not projected beyond first year. These expenses will continue or increase but investment income will decrease rapidly.

Interest income model represents a $1,800,000 addition with no adjustment for reduction of deposits, the interest rate environment, or the risk, and costs of fixed income investments in the current macro climate.

No customers who are transferring their deposits have lending relationships. Many if not all either don’t qualify or will leave as soon as they experience the name change on the door.

Expense of the acquisition, which provides non-sticky deposits (not loans or loan customers), and increased expenses from personnel and facilities, is amortized over 10 years hiding negative financial impact and reduction of working capital misrepresenting the actual costs of the acquisition.

In summary, superCEO Jeff Ball has diluted shareholders equity, given shareholders no return in 15+ years, and Mr. Ball and the management team have lived high on generous salaries, and great benefits using other people’s capital. It is time for things to change.

Please can large shareholders insist the board help us little guys or select a board that will.

Hopefully the answer is clear, Dave Rainer is the better negotiator, but superCEO Jeff Ball and his board still believe they got the better end of the deal, just ask them. Don’t let this be another small bank run into the ground to support the egos of a few overpaid and over important big shots in a small California town.

Our conclusion:

Buy BCAL

Burn FHLB

******

I sincerely hope Friendly Hills shareholders will assess the likely economic outcomes of this proposed branch acquisition and rightly reject the plan as a speculative moonshot meant to distract from management’s years-long record of well-compensated inadequacy.

Alluvial Capital Management, LLC does not hold shares of Friendly Hills Bank for client accounts it manages. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.