Esquire Bank (NASDAQ: ESQ) Part 2
Part Two of the writeup will include a ratio analysis section and other sections on valuation, risks, tailwinds and a conclusion. To borrow from Young Jeezy, “Let’s get it.”
RATIO ANALYSIS
The ratios below were taken from Analyzing and Investing In Community Banks. It is referred to as “the book” in the rest of this section and was referenced extensively in my Plumas Bancorp writeup.
Balance Sheet Ratios
Tangible equity ratio – Esquire performed very well here. Its tangible equity ratio has been at least 1.5x the recommended amount since going public. The 2021 tangible equity ratio of 12% means that if the value of Esquire’s assets fell by 12%, then the stockholders would be wiped out. Another way to say this is that Esquire is leveraged about 8.33 times.
Liquidity ratio – This was a ratio where Esquire unfortunately fell short of expectations. Per the book, you’d like to see a liquidity ratio of 15 – 25%, but the bank’s ratio trended downward to as low as 5% in 2018 before increasing substantially to 14% in 2021. Per the book, regulators tend to worry if the liquidity ratio falls to a low number, but what a truly concerning ratio is seems to be subjective and wasn’t described in the text. A low liquidity ratio indicates that a bank may have a hard time funding its liabilities or that it’s confident that it isn’t expecting large withdrawals from its clients. I’d hope for the latter and not the former.
Loan to deposit ratio – Esquire scored well here. A bank is said to be “loaned up” when the ratio approaches 85%. This means that the bank has the right mix of loans and other interest-earning assets.
Borrowings to deposits – Esquire performed exceedingly well here as it did not have any current borrowings as of year-end 2021 and has not had any since going public. This ratio indicates that the bank has a fantastic deposit gathering strategy.
DDA/Total Deposits – The DDA stands for “Demand Deposit Accounts”. It is important to note that these are non-interest bearing deposits. Again, Esquire knocked it out of the park. I would think of this ratio as a kind of a margin of safety for the bank. Esquire currently has a ratio of 40% which is almost unheard-of. This ratio means that only 60% of the bank’s total deposits are interest bearing. It allows the bank’s management to make mistakes while remaining profitable. Finally, this ratio indicates that the bank has a fantastic deposit gathering strategy.
Income Statement Ratios
Return on average assets – Per the book, this is the best “pure” measure of a bank’s profitability as it removes the effects of leverage. A bank with a return on average assets approaching 1.5% is hard to find. Esquire has managed to flirt with or exceed that percentage for the last three years indicating that it is quite a profitable institution.
Return on average equity – Per the Fed, the average return on average equity was just under 12% in 2019. I had to use 2019 data as I could not find it for 2020. Esquire exceeded this by about 2% although it dipped sharply in 2020. Return on average equity jumped to 13% in 2021. The Fed discontinued return on equity data for all US banks so I went to bankregdata.com instead to find what I was looking for. Per the data on its site, the average return on average equity for all US banks in 2021 was 12.24% meaning that Esquire slightly outperformed on this metric.
Net interest margin – Esquire’s net interest margin of almost 4.5% was robust and almost double the average net interest margin of US banks. Like the return on average equity data, the Fed stopped publishing net interest margin data, so I had to go back to bankregdata.com. Per the site, the average net interest margin for US banks in 2021 was 2.33%. I’m beating a dead horse here, but this healthy margin indicated that Esquire has a very low cost of funds which comes from a lost cost deposit base. Please refer the DDA/Deposit ratio above for further explanation as to why this is a good thing.
Loan loss ratio – The book did not indicate what a “good” loan loss ratio is and I couldn’t find a free data source for it. Bankregdata does provide it, but I used the site too many times and now get paywalled when I access it :/. Obviously the lower the ratio the better. The thinking here is that you don’t want a bank losing money on its loans. Esquire’s loan loss ratio increased to 1.29% in 2021 due to reclassifying loans from held for investment to held for sale which resulted in a $9 million charge off. These loans were related to the NFL Concussion Settlement Program and were sold in April of 2022.
A detailed explanation about the sale of these loans was provided on p. 8 of the Q2 2022 10-Q. Quoting the page directly, “On April 1, 2022, the Company sold its legacy NFL consumer post-settlement loan portfolio to a variable interest entity (VIE) in exchange for a nonvoting interest valued at $13.5 million where the Company will remain as servicer of the loan portfolio at the discretion of the VIE manager. The Company’s investment is considered a significant variable interest, but it does not have the power to direct the activities that most significantly impact the VIE’s economic performance. Therefore, the Company is not considered the primary beneficiary of this VIE and does not consolidate the entity in the Company’s financial statements. The Company’s maximum exposure to loss is limited to the carrying amount of its investment and accounted for under the equity method which is presented within other assets on the Consolidated Statement of Financial Condition.”
Efficiency ratio – Per the book, a bank with a ratio of 55% is doing a really good job. Esquire’s efficiency ratio has dropped from an eye watering 81+% to its current ratio of just over 55%. I would expect this number to drop further because the bank is a branchless institution and has a fantastic deposit gathering strategy.
Non-interest expense/average assets – I’m still in the dark about this one because I couldn’t find what a “good” non-interest expense to average assets ratio is. Esquire’s ratio has hovered a little over 3% since going public which is more than Plumas’, but not too far off. This will be something to keep an eye on as time goes on.
Non-interest income/average assets – Esquire’s non-interest income is derived almost solely from merchant processing. The book stated that not all non-interest income is created equal and things like asset management and accounts fees are best as they require small amounts of incremental capital and generate healthy returns. Esquire does not have an asset management division and account related fees generate minimal amounts of income for the business, but non-interest income to average assets has ticked up every year since it went public due to the continued increases in merchant processing volumes.
Asset Quality and Reserve Coverage Ratios
Non-performing assets to loans (NPA ratio) – Per the book, you want the NPA ratio to be between 0.40-1.25% during good economic times. Esquire is safely under this threshold, but did have some non-performing assets over the last couple of years regarding loans related to the NFL Concussion case.
Loan loss reserves to gross loans – Per the book, this ratio should ~1.50% of gross loans. Esquire was safely above this benchmark but dipped below it in 2021.
Loan loss reserves to NPA’s – This was considered the most important reserve ratio in the book. A safe ratio is 200+%. As you can see, Esquire is well above that. This ratio tells you two things. The first is that over time you want a bank to be able to conservatively estimate what its loan losses will be. Second, you want to know that the bank will have the necessary funds to cover its losses.
Three Other Interesting Factors About Esquire’s Loan Portfolio
There are three additional factors that make Esquire’s loan portfolio stand out. The first is that the bank is “asset sensitive”. I mentioned in my writeup on Plumas Bancorp that Analyzing and Investing in Community Bank Stocks discusses a community bank’s asset/liability structure. Esquire is an “asset sensitive” bank because its ratio of interest-sensitive assets to interest-sensitive liabilities is greater than one. What this means is that, on average, if rates increase in the short to medium term, then net income will increase. If rates decrease, then net income will decrease. Per the book, an important note about the asset/liability structure is that “…the greater the proportion of DDAs to total deposits (see above), the more asset sensitive the institution and that … as a general rule it’s better to be asset sensitive than liability sensitive.” The rationale for this is simple. If most or all a bank’s interest rate sensitive assets reprice upwards, but only 50-60% of the liabilities reprice upwards then you can see how that would positively affect net income. This is the case for Esquire given that 40% of its deposits are non-interest bearing.
The next section of the chapter discussed adjustable-rate loans versus fixed rate loans. This is the second additional factor that makes Esquire’s loan portfolio stand out. To quote the book directly, “All else being equal, the greater the ratio of a bank’s variable-rate loans to its fixed-rate loans, the more asset sensitive the institution’s balance sheet. After all, if a bank’s balance sheet is comprised entirely of fixed-rate loans, and deposits of varying duration, its margin would get crushed as rates increased - deposit rates would climb as asset yields remained the same. Conversely, if the bank’s balance sheet is comprised entirely of variable rate loans and deposits of varying duration, there would have to be some net benefit to rising rates – all asset yields would climb as interest rates increased, but some deposit rates would remain the same.” Esquire’s variable rate loan portfolio made up 55% of the total loan portfolio as of year-end 2021. While this percentage wasn’t as high as Plumas’, I don’t think there is a cause for concern considering how unique Esquire’s operating and lending model is.
Lastly, the same section of the book mentioned being aware of borrowings and how they are used by management. The author was skeptical of any bank using borrowings to increase yield via arbitrage strategies. This is the third additional factor that makes the bank’s loan portfolio stand out because Esquire has no borrowings besides its capital leases. So, at least for now, you don’t have to worry about this being an issue.
VALUATION
There are a host of bank valuation metrics. Nearly all of them rely one or more of the following factors: interest rates, growth rates, and dividend payments along with treasury rates and the fancy-schmancy “equity risk premium”. You can really get in the weeds and convince yourself of improbable outcomes by trying to work out mathematical sorcery, so I’m going to try and keep it simple. As a kicker, the book stated that the best way to value a bank long-term was the dividend discount model. However, Esquire only started paying dividends in Q1 and Q2 of this year. I don’t think less than one year of them is useful for a dividend discount model.
In my originally writeup I wrote that diluted EPS had CAGR’d at 46% between 2015 and 2020. In 2021, diluted EPS was $2.26 per share which dropped the CAGR between 2015 and 2021 to 44%. That’s still a healthy increase, but I’m not going to assume that much of an increase every year. I simply projected diluted earnings out five years at increasing rates of 15% and 20% per year and throwing a 15x multiple on it. Please note that I think both growth rates and the 15x multiple are conservative given how great this business is.
A 15% increase in diluted earnings per year from 2021 estimated earnings at the time of my original writeup through 2025 estimated earnings equaled $3.32 per share and a 15x multiple gave you a $49.80 stock. A 20% increase in estimated diluted earnings per year through 2025 equaled $4.11 per share and a 15x multiple gave you a $61.61 stock. To arrive at the per share amounts I simply took 2020’s per share earnings and increased them at a 15% or 20% rate every year through 2025. Please note that this valuation assumed an unchanged number of outstanding shares. In my original writeup, this produced a five-year CAGR of 15.72% - 20.75% from the then share price of ~$24.00.
A 15% increase in diluted earnings per year from 2022 estimated earnings through 2026 estimated earnings equals $4.55 per share and a 15x multiple gives you an $68.19 stock. A 20% increase in estimated diluted earnings per year from 2022 through 2026 equaled $5.62 per share at a 15x multiple gives you an $84.35 stock. To arrive at the per share amounts I simply took 2021’s per share earnings and increased them at a 15% or 20% rate every year through 2026. Please note that this valuation assumes an unchanged number of outstanding shares. These multiples produced a five-year CAGR of 11.26% - 16.09% from today’s current share price of ~$40.00.
Risks
Niche Focus on the Litigation Industry – Esquire focuses heavily on gathering deposits from and lending to litigation firms and law firms in the United States. This means the bank’s future success is reliant on the outlook and prospects of that industry as a whole and its ability to offer unique products and services to it. Also, if you have issues with the litigation and mass tort industry then this business might not be for you.
Geographic Risk of Real Estate Loans – This was mentioned in the “Risk Factors” section of the most recent 10-K. Per p. 26 of the document, “Unlike larger financial institutions that are more geographically diversified, a large portion of our business is concentrated primarily in the state of New York, and in New York City in particular. As of December 31, 2021, 56.9% of our loan portfolio was in New York and our loan portfolio had concentrations of 45.5% in New York City. If the local economy, and particularly the real estate market, declines, the rates of delinquencies, defaults, foreclosures, bankruptcies and losses in our loan portfolio would likely increase. As a result of this lack of diversification in our loan portfolio, a downturn in the local economy generally and real estate market specifically could significantly reduce our profitability and growth and adversely affect our financial condition.”
On the flip side, New York City and the surrounding tri-state area are very desirable places to live and command high land/real estate values which has led to rents and new mortgage values increasing year after year outside of the occasional global pandemic and financial crisis. Stable price increases aside, you are dealing with New York City finances (a particularly dense but interesting subject) and the subsequent chicanery/political machine that comes along with city and state politics, taxes, business regulations and real estate laws. You’re also assuming that Esquire is good at underwriting its real estate loan portfolio.
Interest Rates – In my original writeup I wrote, “There’s a real and highly probable chance that rates will stay at historically low levels for at least the next year or so. While that won’t be good for Esquire short term, I think that the company has protected itself from this due to its business model... Maybe we’re in a situation like Japan where our Central Bank will buy more and more financial assets or maybe the Fed is afraid of letting rates going over say 3-4% due to the high risk of large defaults or maybe this will all work itself out and rates will rise to “historically normal” levels. I think worrying about this kind of stuff and trying to underwrite it is pretty meshuga. I think you’re better off judging Esquire on its own merits and adhering to Buffett’s “if you’re right about the business you’ll make a lot of money” quote.”
The first part of that paragraph hasn’t aged well. Interest rates have ticked up considerably over the last twelve months. I think the second part of the paragraph still applies. Worrying about interest rates is still meshuga although rising rates will help Esquire in the short to medium term because it is an asset sensitive institution. I would continue to focus on the Buffett quote more than anything else because Esquire has a great thing going.
Tailwinds
I asked myself some very broad questions about Esquire to try and judge the growth runway for the business. The first was, “Will the legal industry require specialty lending services for the foreseeable future?” The answer was most likely, “Yes.” The second was, “Is this market large and is it growing?” The answer, again, was most likely, “Yes”. If you need validation for this answer I would drive on your local highway and look at billboards and note the dollar amounts of legal settlements and payouts that personal injury and mass tort lawyers in your area have won for their clients over the years. I feel like the number is only going up which indicates that either the market for these settlements is consolidating into mega firms or it is a truly massive and still fragmented. I will comment more on this in the next paragraph. Third, “Does Esquire have a good business model, and does it look good financially?” From what I’ve researched and written here, I’m going to say that the probabilities favor a “Yes.” Apologies for sounding like Marv Albert in this paragraph.
You can take away some very interesting insights from the business in its investor presentations. One of them that I will highlight is the data about the bank’s growth opportunities in the litigation market. I know I’ve written about the size of it a couple of times in this writeup and I will mention the actual numbers now. Citing Towers Watson data, U.S. Tort actions are estimated to consume 1.5-2.0% of US GDP which works out to $345 billion – $460 billion. That is no small figure and presents a huge growth runway for Esquire’s Commercial Litigation-Related Loans. For those of you who are from outside the U.S. and don’t live here, I’ll explain why this is the case. We Americans love to sue each other. I mean, we love it. If there’s any kind of accident or perceived misdeed in a business transaction, someone is most likely going to get sued. The United States is the most litigious country on Earth and I don’t see this unique aspect of our culture slowing down any time soon. Suing each other isn’t as American as a cheeseburger, but it’s pretty close.
The bank also highlights its barriers to entry in public filings. It claims that its banking model does not compete with non-bank finance companies (please see above in the “Business Model” section in Part One of this writeup for a refresher) and that it has management expertise, brand awareness, regulatory/compliance, and loads of experience that other companies in this space do not. For full transparency, I think Esquire absolutely competes with the other non-finance companies in the litigation/law lending space, but its business model is just better. As I stated above in the “Business Model” section in Part One, the bank is able to offer more products at better prices and still make a healthy margin. I also believe that the bank has built a network effect. More and more law firms have started to migrate towards the bank and the results have shown this. More and more cheap deposits are flowing in which create cheap funding which is what a great banking business is built on. It is a virtuous cycle.
There was a fourth question that I asked myself when trying to assess Esquire’s long-term growth prospects. My question was, “Does the New York City area have a large real estate market and is merchant processing an area where they can increase non-interest revenues?” The answer again is most likely “Yes”. As far as real estate lending goes, the bank cites data from the NYC Department of Finance stating that New York City properties total $1.3 trillion in market value. This gives the bank’s real estate lending segment a lot of room to grow and choices on who it lends to. Lastly, there is merchant processing. The Q2 2022 Investor Presentation states that the payments industry grew to $9.5 trillion in 2021. The size of that market makes me feel like Esquire has a long runway to keep gobbling up share in the merchant processing space. The bank is confident in its ability to keep growing merchant processing income too as it stated on p. 28 of the Q2 2022 10-Q, “We believe there are various and significant barriers to entry to this market including, but not limited to, our clear industry track record for 10 years, extensive in-house experience, deep relationships with non-bank acquirers, and our unique approach to servicing these small business merchants and their respective verticals.”
Conclusion
For ~15x earnings today, you have a business that has best in class operating metrics, a differentiated lending model, a robust real estate lending portfolio and a sizeable amount of non-interest income via merchant processing and is basically the only show in town in terms of what it does with the ability to conservatively CAGR its estimated diluted EPS in the low to mid-teens percentages over the next five years. The only thing I don’t like about it is its bonus and stock award programs. No business is perfect, so it’s something I must deal with. I’ll conclude by saying that I don’t think businesses like Esquire come around very often and that like Best of the Best, if I had the money and regulations weren’t a factor, I’d personally like to own all of it.
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Please reach out to me at possiblevalueresearch@gmail.com, @PossibleValue on Twitter and @Heshy on MicroCapClub with any comments, concerns or questions. Lastly, don’t forget to tell someone that you love them.
*** Remember that this isn’t investing advice. Consult a trusted financial or investment advisor before making any kind of investment decision. ***
Disclosure: I do not own shares in Esquire, but I would if I had the money.