Virginia National Bankshares Corporation (OTCQX:VABK) is a five-branch community bank serving Charlottesville, Virginia, with an additional branch in distant Winchester, Virginia. Virginia National Bankshares belongs to a small cadre of local community banks, often with concentrated geographic branch networks around college communities, such as Auburn National Bancorporation (AUBN), which have historically carried premium valuations.
Virginia National had not previously been especially appealing for this reason. However, the recent drop in community bank valuations in the face of coronavirus-induced concerns and lower benchmark interest rates has changed the dynamic. Virginia National’s shares declined by nearly a third without any subsequent recovery, eliminating virtually all of the company’s premium valuation relative to broader community bank segment peers. In the process, Virginia National’s dividend yield rose to an above average 4.8% based on a dividend of $1.20 per year.
Our view is that the company presently represents a highly appealing opportunity for income-oriented investors. The dividend is well-covered by current operating results while our analysis suggests net interest margins – and earnings per share – will stabilize as average deposit rates decline over the course of the year. In addition, the company’s position in an appealing geographic region should benefit the company over the long term, providing an additional potential for capital appreciation.
Net Interest Margin
Virginia National’s earnings per share declined over the last year largely due to compression in net interest margin and higher operating costs. The trend continued into the first quarter although results were boosted by loan swap fee income, mitigating the impact of lower net interest income and higher operating expenses.
A particular concern for the market has been the company’s rather sharp drop in net interest margin. Net interest margin declined to 3.2% in the last quarter from 3.8% in the prior-year period, a rather sharp deterioration which directly impacts earnings. The company’s net interest margin has declined sequentially each quarter since the first quarter of last year, providing a persistent headwind for earnings.
However, much of the decline in net interest margin is driven by the company’s deposit interest rates rather than average rates on interest earning assets. Deposit interest rates continued to increase into the first quarter despite declining benchmark interest rates and have, in fact, more than doubled over the last two years. The company, in the short term, is highly sensitive to changes in average deposit rates as deposit rates tend to lag changes in benchmark interest rates and, more importantly, changes in rates applicable to the company’s variable rate loan portfolio.
However, we expect this trend to mitigate and ultimately reverse over the course of the year. The return to near zero benchmark interest rates will likely cause deposit rates to decline back to those experienced prior to the brief return to rising benchmark interest rates. The decrease in interest expense will be led by average rates paid on the company’s money market and savings accounts, which rose quickly with higher interest rates, as well as on certificates of deposit, the majority of which mature and reprice during the second quarter.
In the meantime, while the company’s currently variable rate loans rerated to lower rates rather quickly, this effect should abate going forward since the majority of the company’s interest earning investment securities and loans – nearly two-thirds of the overall portfolio – won’t experience rate changes outside of any refinancing activity for at least three years.
Source: Winter Harbor Capital / Federal Financial Institutions Examination Council
The result should be a material reversal in net interest margins which we project will rise back to approximately 3.5% over the next one to two years. The result is estimated earnings per share of around $2.25, well above the current dividend rate.
The other primary consideration from a dividend standpoint is Virginia National’s asset quality and the potential need for loan loss provisions. Virginia National’s asset quality experience has been quite robust over the last few years and although charge-offs have recently been elevated relative to community banks as a whole, this appears to be driven by the company’s more aggressive than average approach to charging off loans rather than keeping them as nonperforming assets.
Virginia National’s past due loans remained rather consistent during the first quarter at $3.8 million, less than the company’s present allowance for loan losses of $4.7 million. Nonaccrual loans, which declined both sequentially as well as from the prior-year quarter, were a mere $273,000 while charge-offs during the most recent quarter were well below those of the prior-year quarter. As a result, although the company’s allowance for loan losses is somewhat below that of the typical community bank at around 0.85% of total loans, the allowance far exceeded the company’s nonaccrual loans as well as past due loans.
The performance of the loan portfolio necessitates ongoing attention, particularly with respect to the company’s 46.8% allocation to commercial real estate loans, but the company’s asset quality performance has been remarkable. The low allocation to riskier construction and land loans, at only 4.5% of the total portfolio, also adds a measure of protection. It’s thus difficult to foresee any impending risks in the loan portfolio unique to the company, which would result in unusually elevated loan loss provisions that could impact the reliability of the dividend.
Virginia National pays a quarterly dividend of $0.30 per share ($1.20 per year) for a dividend yield of 4.8% on the current share price. The dividend yield is above average for community banks yet only represents a payout of about 55% of projected earnings – on the upper end of the community banking range but not so high as to suggest risk to the dividend. The company would be able to absorb a reasonable level of erosion in net interest margins and loan loss provisions before the dividend payout ratio rose to less sustainable levels.
The dividend thus looks quite secure – especially in light of the company’s historically strong asset quality performance and likely improvement in net interest margins into next year.
Virginia National’s shares are reasonably valued at the current market price ($25.00) at just 89% of tangible book value and a projected forward earnings per share multiple of 11. The discount to book value is warranted given expectations that the company’s return on average equity in coming years – projected to be approximately 8.0% – is somewhat below average for the community bank sector. A significant deterioration from the current market price strikes us as unlikely, barring unexpectedly excessive deterioration in the loan portfolio providing a measure of safety for conservative investors.
Virginia National Bankshares may not offer significant growth in earnings in a persistently low interest rate environment but the company nonetheless serves an attractive market with a durable economy. The composition of the deposit base and loan/securities portfolios suggests the company should maintain a reasonable net interest margin which easily supports the current dividend.
Income-oriented investors should consider the company’s solid 4.8% dividend yield a consistent and reliable source of investment income. The potential for incremental capital appreciation as the company continues to grow its core business provides an added attraction, especially should the company manage to recapture its previous premium valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.