In my search for good regional or local banks to invest in, I came across FS Bancorp (NASDAQ:FSBW), the holding company on 1St Security Bank of Washington who served the Puget Solid communities for over 100 years. The bank started out as a cooperative bank, upgraded to a state-licensed cooperative bank in 2004 and to a share savings bank in 2012. The bank currently operates 21 branches in the region and has total assets in excess of US$2.2 billion making it a sizeable operator in the region.
An expanding balance sheet leads to stronger financial performance
FS Bancorp’s interest and dividend income rose about 10% to $96.4 million thanks to the increase in total assets. And while more deposits were accepted as a funding source, total interest expense actually fell from $14.7 million to $9.7 million. And the combination of lower interest expense and rising interest income obviously resulted in a very impressive increase in net interest income, which went from $74.1 million to $86.6 million.
FS Bancorp also makes money from the sale of loans it makes. That helped the bank weather the 2020 pandemic year as they made nearly $50 million in profits selling these loans.
Loss provision income before tax and credit losses was about $48 million in fiscal 2021 (compared to nearly $63 million in fiscal 2020), but as you can see in the image above, the difference can be made up fully explained by the much higher records profits from the sale of loans in 2020.
It’s also interesting to see how the amount of loan loss provisions has fallen to just $0.5 million in fiscal 2021, as provisions recorded in 2020 appear to have been sufficient. Earnings per share for fiscal 2021 were about $4.42, but that’s based on the average share count of nearly 8.5 million shares. Since the bank ended the year with fewer than 8.2 million shares outstanding, earnings per share are likely to increase in 2022, with all other elements unchanged.
A significant portion of the loan book consists of “home improvement” loans.
As you can see, a significant portion of profit is driven by FS Bancorp’s ability to sell the loans it makes. That makes it harder to “estimate” the bank’s financial performance, since it’s not entirely clear how much money the bank could save, including in staff costs and other overheads, by not selling loans it originated. And just to give you an idea, the bank sold about $1.44 billion in loans and originated about $1.35 billion in new loans in fiscal 2021. Meanwhile, about $1.67 billion in loans were sold in 2020, while the bank raised about $1.73 billion in new loans. It is very difficult to attempt to calculate the contribution from the sale of loans as there is no fixed timing of how long an original loan will remain on FS Bancorp’s books.
That’s the “swing factor” and I prefer to focus on the elements of the balance sheet that FS Bancorp controls. And more specifically, I’m interested in the $1.73 billion loan book.
About 60% of these loans are related to real estate, with CRE and construction and development loans accounting for about half of the real estate loan book. The other half relates to residential real estate.
I was very interested to see the indirect home loans on the balance sheet as they make up about 20% of the total loan portfolio. These loans, for example related to the purchase of new windows or an HVAC system for a home, are offered by the sellers of these items and are taken over by FS Bancorp. This is a very interesting niche in which FS Bancorp is expanding very significantly as the total amount of Home loans have increased by nearly 20% while the amount of commercial loans has decreased. However, the amount of commercial loans excluding the PPP loans increased from $162 million to $184 million.
The image above also shows that the total allowance for loan losses exceeds $25 million, which is relatively high considering that the total nonaccrual loans are relatively low at less than $6 million at the end of 20221 is.
Of course, we also need to keep an eye on the total amount of delinquent loans, but it looks like FS Bancorp’s reserves are sufficient. Apart from that, more than $34 million of the loans were classified as “watched”, “special mention” and “low quality” as you can see below. Fortunately, a significant portion of these loans relate to real estate, and thanks to the presence of collateral, actual losses should remain limited. I am more “concerned” about the nearly $20 million in commercial and industrial loans that did not qualify in the pass category.
That being said, FS Bancorp has come a long way since late 2020 (see below) when total loans in these three riskier categories totaled over $112 million, with nearly 30% of commercial real estate loans failing the ‘pass’ category. . But in 2020 and 2021, pretty much every single home improvement loan ranked very high when determining credit quality, so I definitely understand why FS Bancorp has expanded into this niche.
Profits from loan sales are both the main driver and the greatest uncertainty in FS Bancorp’s valuation. It’s virtually impossible to estimate how much money the bank will make in any given year from the sale of some of the loans it originates and that explains why the bank is trading at less than eight times its profit. And since the dividend yield is relatively low ($0.20 per quarter at a dividend yield of 2.6%), FS Bancorp doesn’t attract income-seeking investors either.
There is value, however, as the bank ended 2021 with a book value of over $30/share and a tangible book value of $29.50. Since FS Bancorp has aggressively bought back its shares and the majority of its profits remain on the balance sheet, I expect the bank’s tangible book value to surpass $32/share by the end of this year (barring any sudden surprises in the loan sales department), what makes the bank fairly cheap at current levels. Perhaps a small position is warranted, but I have to keep in mind that issuing and selling loans is an important part of the business model here.