Provident Bancorp

Recently Fully De-Mutualized, Heavily C&I Focused, Innovative, Now Highly Overcapitalized, Small-Cap Greater Boston MSA Bank that a) Trades at 1x Book (Peers at 1.4x) b) is Poised for a Significant Step-up in Shareholder Payouts and Continued Heady Growth and c) is a Clear Takeout Candidate When It Becomes Eligible to Sell Come Late 2022

Background

Provident Bancorp (“PVBC”) is a recently (October 2019), fully de-mutualized, small,

New England bank that has provided banking services for almost 200 years (founded in

1828). Despite its lengthy operating history, PVBC has evolved rapidly over the last

decade in terms of management orientation (innovative and forward thinking), growth

of its Commercial & Industrial business and “branch lite” go to market strategy.

Given:

1) its highly overcapitalized balance sheet (by virtue of its recent equity offering).

2) an intent to continue to deliver meaningful but disciplined growth.

3) a number of “bank de-mutualization investment pros” as shareholders that will

surely bring pressure to bear, if necessary, to repurchase stock and payout

dividends.

4) a new board chair that’s proven and sold his last bank (commercial banking

focused Centrix Bank in 2014) for >2x price-tangible book.

5) a current Price/Tangible Book Value that suggests 40% upside for it to trade inline

with its median peer – and Provident is a better than peer median bank.

6) a very sticky shareholder base (by virtue of its de-mutualization process,

significant ESOP and insider ownership, strong stock performance and more

modest than peer stock volatility) and limited sell-side coverage creates

meaningful upside pressure for the stock as more institutions invest in the

Company.

Provident has the runway to be 50% higher by YE 2020 and a potential 2x+ by YE 2022

should Provident decide to sell (which is eminently possible . . .arguably likely).

The Set-Up and Investment Thesis for Provident Bancorp

1. PVBC is differentiated by the degree of its commercial orientation (89% of its loan book is focused on Commercial & Industrial (C&I) and Commercial Real Estate) and the types of C&I that PVBC originates which results in compelling margins.
quickly than enterprise value loans ytd with 22.7% growth. Renewable energy loans now represent ~15% of C&I loans and ~7% of the total loan book.
What this focus on C&I broadly, but enterprise value and renewable energy loans specifically, means to Provident is a) faster loan growth (10.9% YTD for Provident which is 4x the 2.7% growth for its median peer) and b) net interest margins (NIM % in the table on the prior page) that dwarf the peer group (4.44% for PVBC vs. 3.07% for the median peer).

What the focus on these loans also means is less of a need for a branch footprint.

With Provident having only modest and decreasing exposure to residential real estate and consumer lending, it has less of a need to have an expensive branch network that’s aimed at residential and consumer loan origination.

This focus on the high growth, high margin enterprise value and renewable energy loan markets should also contribute to Provident’s being an attractive acquisition
target. Any of its larger peers that are underexposed to C&I and trade at higher multiples may find Provident’s loan book/origination infrastructure particularly interesting (namely Cambridge Bancorp and Brookline Bancorp).

2. Provident’s October 2019 2nd step de-mutualization offering should allow for

continued rapid growth, a near term dividend announcement and stock buybacks.

It is typical in 2nd step de-mutualizations that 50% of the proceeds are dividended down

to the bank and the rest retained at the parent. It is always easier to dividend down to

the operating company than up to the parent (which typically requires requlatory signoff

and has limitations). Assuming that Proivdent leverages its new equity at the bank

8:1, that allows for $450mm of additional loan growth which would be a ~50% increase

to the current size of Provident’s loan book. Provident plans to grow in a disciplined

manner and effectively put that new equity to work over the next few years.

Additionally, Provident has made it clear that it wants to institute a dividend and the

bank recognizes that there are many investors, particularly bank stock investors, that

won’t own a bank stock that doesn’t pay a dividend. I believe with 99% likelihood that

dividend payouts will start in 2020. When a dividend is implemented, it should prove

another catalyst for Provident’s shares.

Finally, with regards to buybacks in January 2017 Provident received a “non-objection

letter” from the Federal Reserve with respect to its request to repurchase up to 625k

shares (1,263k shares based on the recent stock split) of stock. Based on the stock-split

and modest repurchases to date, Provident should have ~1.2mm shares remaining on

its repurchase authorization which amounts to 6% of shares outstanding. Provident

cannot, due to its recent 2nd step de-mutualization offering, engage in share repurchase

activity again until the one-year anniversary of that 2nd step de-mutualization offering

(so October 2020). But with a more liquid stock and ample excess capital on its balance

sheet, it should be expected that stock repurchase activity will pick-up come late 2020.

Provident has both the capacity (~2x the Tier 1 Capital Ratio of its median peer) and

authorization to deliver meaningful shareholder payouts. The question is merely when

shareholder payouts will ratchet up.

3. Playing into both the capacity and ability to make meaningful shareholder payouts,

Provident has a couple major shareholders that are likely to push the issue namely

FJ Capital Management and Castine Capital Management.

FJ and Castine own 11.5% and 5.5% of Provident Bancorp, respectively as of September

30, 2019 (pre the recent offering). Both firms are bank/financials specialist investment

firms that have occasionally taken an activist approach (13-Ds) to their holdings. While

I don’t see them likely to go full on 13-D, there’s a reasonable likelihood that they

would press Provident management to establish a meaningful dividend and increase

stock repurchase activity if the Company dragged its heels on doing so. For the record,

I don’t think FJ and Castine will need to do so because Provident’s management “get it.”

While less well known outside the financial services investment arena, FJ’s and

Castine’s ownership in Provident Bancorp is a very positive sign for investors. Per its

website, FJ Capital Management is a “fundamentally driven” investment advisor “that

invests in the US financial services industry,” with an emphasis on the consolidating

community/regional banking sector.” {bolding done for emphasis}. While Castine

Capital management keeps a lower profile, they are bank stock specialists and

Provident represents ~1.7% of their most recent 13-F holdings.

4. CEO and independent Chair position company to deliver outsized growth, integrity

in their banking services, and a fundamental shareholder value orientation.

CEO & President David Mansfield has been with Provident since 2001 when he came to

the bank as CFO. Prior to joining Provident, David was a bank examiner for both the

Officer of the Comptroller and Currency and the FDIC. David is both a CPA and a

CFA. In my multiple calls with David doing my due diligence on Provident, David has

embodied the characteristics of a regional bank CEO who’s highly likely to have

continuing success: he’s forward thinking, seemingly unflappable, approachable and

intently focused on growing the business in a disciplined manner. With David’s

background, he brings a high level of credibility that there shouldn’t be any major

blow-ups on his watch.

David recently brought Joe Reilly, a proven, highly accomplished commercial banker

onto Provident’s board in June of 2018 and made him Chairman of the Board in April of

2019. After spending over 20 years working for other banks in senior positions, Joe

started Centrix Bank in 1999 as the first dedicated commercial bank in New Hampshire.

He grew the bank to over $1bn of assets in just 15 years and sold the bank to Eastern

Bank for over 2x tangible book value in 2014. Importantly, even though Joe has been on

Provident’s board for 18 months and as chair for eight, he only just (this quarter)

became unencumbered by a five-year client non-solicitation agreement he had with Eastern Bank. Point being, Joe is highly liked and connected. The customer

relationships he’s built over 40 years of business banking in Provident’s target region can only help Provident’s growth outlook. The fact that he’s also transactional and was

a willing seller in the past (at the right price) is likely to make Provident that much more actionable when the bank becomes eligible to sell.

When combining the high integrity, capabilities and proven success of Provident’s CEO and independent Board Chair, Provident Bancorp shareholders can take comfort that they have a strong management team aware of and capable of delivering on their fiduciary duties to their shareholders.

5. Compco, and likely growth trajectory, suggest that Provident should be trading 50% higher by YE 2020 and reasonably at >2x its current valuation by YE 2022.

2015 2016 2017 2018 2019 ’14-’19 CAGR
Actual Net Income (2015-2018) $3,823 $6,339 $7,915 $9,325 $11,011 30% with 2019 extrapolated based on 9 mos
With rapid growth in its high margin C&I business and the bank putting to work the net proceeds from its 1st step de-mutualization transaction which happened in 2015, Provident is on track to deliver a 30% net income CAGR over the 2015-2019 period (YTD 2019 net income is extrapolated through YE). Ratcheting down net income growth expectations to a 20% CAGR over the next three years (which I believe to be

conservative) and assuming that Provident will institute a 1.5% dividend in 2020 (and

that dividend to grow at a 20% CAGR through 2022), tangible book value should grow

as follows.

As highlighted in the comparable company analysis on p. 3, the median bank in

Provident’s peer group trades at 1.4x P/TBV. Provident’s superior growth outlook,

differentiated business and likely takeout interest (to be discussed) come 2022 suggest

that Provident’s warranted P/TBV should be at a premium to its median New England

peer bank. For the sake of projecting Provident’s warranted stock price over time, the

analysis above assumes a growing warranted multiple on Provident’s book value and a

P/TBV by 2022 that is in-line with a reasonable take-out valuation.

Running an alternative scenario where net income growth over the next three years is

consistent with the past four years (30%) but the multiples of book don’t grow as

significantly, still leads to a highly attractive warranted value progression.

While organic net income growth is likely to significantly outpace peers over the next

few years, book value multiple expansion is what’s likely to lead to superior stock price

performance.

6. Surveying the history of bank de-mutualizations suggests that there’s a high

likelihood that Provident will be consolidated by a larger institution. Piling on to

that Provident’s differentiated C&I loan origination engine and its board chair Joe

Reilly in place (a leader who’s proven to be transactional and a willing seller at the

right price), that likelihood increases meaningfully.

S&P Global Market intelligence published an excellent article on January 16, 2019

entitled “Banks celebrate their 3-year mutual conversion anniversaries.”

https://www.spglobal.com/marketintelligence/en/newsinsights/

trending/17DgXbkuiKRzKKPHr1LJtA2

Regulators will preclude a deal for three years post de-mutualization. But come

October 2022, Provident will become able to be acquired for the first time in its near 200

year corporate history. Small New England banks with differentiated services, quality

operations and attractive footprints are acquired with great frequency. While

Provident has a great runway ahead of it on an organic growth basis, I will be little

surprised if Provident is acquired within the first year or two after it’s eligible to trade.

7. Shareholder composition suggests highly sticky core shareholder base suggesting

broad upper pressure on the stock absent poor operating performance by the bank.

By virtue of how Provident went public, its high quality (heavily overcapitalized and

long corporate history), its low volatility strongly performing stock and its significant

inside ownership, Provident has a very sticky shareholder base.

Given a) that the 13-F filing data is as of 9/30/19 and the most recent offering closed

10/11/19 and b) the stock has done very well since the offering, the complexion of the

ownership is likely to look meaningfully different as of the next reporting period. That

said, a few things worth appreciating.

1) Investors in the 1st step de-mutualization have enjoyed a 23% CAGR in stock

performance over 4+ years and are generally very happy. And anyone who’s

done the work should know that the stock still looks very cheap.

2) The shares in both offerings were sold to either a) customers and employees of

the bank and/or b) people living in the communities in which Provident

operates. Based on the bevy of people I know that have participated in these

offerings and their generally conservative, “yankee” New England nature, they

aren’t the IPO flipper types.

3) Institutional ownership is very low in this bank largely because they haven’t

been able to accumulate a lot of stock. With this recent offering and share split,

liquidity in Provident’s stock has increased meaningfully.

That all suggests an attractive trading dynamic. As institutions work to increase

exposure in the name, due to the stickiness of current shareholder base, absent an

unforeseen soft patch in Provident’s operating performance the pressure on the stock

price will be to the upside.

Total Shares from 13F Filers (gives effect to 2.0212:1 stock split) 8,634,239

ESOP Shares

Purchased in 1st step de-mutualization (gives effect to stock split) 721,568

Purchased in 2nd step de-mutualization 817,000

Total Shares in ESOP 1,538,568

Shares owned by Executive Officers and Directors 989,994

Total ESOP + Executive Officers and Directors 2,528,562

S/O 19,484,489

ESOP and Exec Off & Directors as a % of

Total 13%

13-F Filers 44%

Other Unidentified / Principally Retail 43%

Cumulative Performance of participants in 1st step Demutualizion 151%

Cumulative Performance of participants in 2nd step Demutualizion 24%

Further, there is only one sell-side firm/analyst (Compass Point’s Laurie Havener

Hunsicker), who’s covering the company. There is ample room for more sell-side firms

to pick up coverage of the Company including Sandler O’Neill who advised on the 2nd

step de-mutualization. For those with access, Laurie at Compass Point did a bang-up

job on her initiation report on the Company. Further, this is anecdotal but my

understanding from the company is that institutional interest in having investors calls

with senior management has picked up materially since completion of the 2nd step

offering.

Risks

Liquidity risk – While Provident’s average trading volume over the last few months

has been ~87k shares per day (or ~$1.1mm per day at current prices), that includes a lot

of activity post deal close. On most days, Provident trades about half that amount.

With limited liquidity, risks include if there’s significant selling volume how that may

impact the stock and how limited liquidity may cause the stock to run as significant

institutional investor interest manifests itself.

High growth enterprise value and renewable loan books are only “lightly

seasoned” – Provident has not gone through a weak economic cycle with C&I (and

specifically the enterprise value and renewable energy loan books) as large a % of its

loan book as it is now. How this book performs during the next down cycle will be of

critical importance to how Provident bank’s operations and stock price fare. That said,

taking on the enterprise value loan book specifically, Provident only lends on a secured

basis and at less than a 50% loan to value and less than 3x debt to EBITDA on a secured

debt basis with no more than 5x debt to EBITDA (inclusive of sub debt or owner

financing) on those credits. Based on my diligence on Provident’s approach to

enterprise value loan origination (specifically search loan financing), Provident runs a

highly disciplined practice liaising with two of the best business schools in the country

(Stanford and Harvard) and putting itself in a position to have superior credit

outcomes.

High growth enterprise value and renewable loan books will eventually demonstrate

slower growth. Provident has guard rails on these businesses and is only willing to

have so much of their loan book based on pure cash flow loans. The company believes

it still has at least a couple years of runway before coming up against those guard rails,

but at some point Provident will hit its internal targets specifically in the enterprise

value loan side of the business. In Renewable Loans – Provident is increasingly

focusing on some seemingly highly attractive opportunities in financing electricity

storage projects in New York State. There is clearly room to grow meaningfully in this

loan book.

Low ROE and above peer P/E – by virtue of Provident’s de-mutualization and limited

near-term levers to return excess capital to shareholders, ROEs are low and P/E is high

relative to the median peer. This is by and large a timing issue. As Provident puts its

excess capital to work (happening now), institutes a dividend (in all likelihood very

soon) and re-engages in share repurchase (come late 2020), ROEs will gravitate higher

and Provident should continue to have superior earnings growth relative to peers.

Remaining BancAlliance exposure – BancAlliance is a group of ~200 community banks

that originate C&I loans to diversify their middle market lending business. While

Provident hasn’t sourced a loan through BancAlliance since early 2017 and has stated

that it doesn’t anticipate sourcing any more loans through BancAlliance, as of Q3

Provident still had $9.2mm of exposure to BancAlliance originated loans. This level is

down from $13.9mm at YE 2018 and $12.4mm as of June 30, 2019. While a small overall

exposure, YTD the net charge off rate on loans from this portfolio has been 32% of those

retired ($1.5mm of charge-offs on $4.7mm of loan retirements). Provident is clearly

winding down exposures generated from BancAlliance. But if Provident continues to

charge-off its remaining exposures to substandard rated loans from this portfolio

($4.5mm of the remaining $9.2mm) at the rate it has ytd on the other charged off loans,

then it would result in an additional ~$963k after-tax charge or $.05 per share (net of

reserves). In my discussions with management, they made it clear that they learned

their lesson on their participation in that program and have little interest in outsourcing

origination of future commercial loan activity.

Slowing Regional or National Economy/Recession – Provident is a regional bank in the

greater Boston and Manchester/Nashua, NH MSAs. To the extent that Provident’s

primary regions of business undergo a regional slowdown or we suffer a national

recession, Provident will be impacted.

Conclusion

Sometimes big opportunities come in small packages. That’s PVBC stock. The

Company is sufficiently differentiated, adeptly managed, superiorly positioned from a

growth perspective and compellingly inexpensive. Provident is likely to be a multiyear

compounder with a great outlook for 2020 and a potential 2x outcome within the

next three years. Buy PVBC.

Disclaimers:  All information gathered from sources believed to be accurate, but the accuracy of the information cannot be guaranteed.  Past performance is no indication of future results.  A number of points made in this update are a matter of opinion and opinion is subject to change without notice.