Bridgepoint Education (BPI)

BPI is an odd lot tender idea posted on a couple different locations already. Here's the offer to purchase. The tender is for 19% of BPI's outstanding stock at a price of $19.50. The offer expires December 11, 2013. Odd lots (less than 100 shares) are given priority. A conditions exists such that BPI may cancel the tender in the event the stock or the general market falls 10% or more. Based on today's BPI price, this would be a fall of 15%. With $432mm in the bank and an expected cost of a little over $200mm, financing is not a concern.

With the stock trading around $17.83, the returns look like this before tax and commissions:

	Success	Fail
Cost	17.83	17.83
Proceeds	19.50	15.17
% return	9.4%	-14.9%
% annualized	166%	-83%

The "fail" scenario is based on the price that BPI would need to reach to trigger the possibility of canceling the tender. Although possible, this seems much lower probability given the stock has risen since the announcement, the limited amount of time to expiration, and an earnings announcement that could cause increased volatility is not scheduled to occur. For such small amounts, that's good enough for me.

With such a large repurchase, it also seems worth investigating a longer term purchase of the stock.

Disclosure: Long BPI

PD-Rx Pharmaceuticals, Inc. (PDRX)

PDRX is a small unlisted pharmaceutical services company. They offer a full spectrum of medications and specialized services. For example, one of the services PDRX provides is a turn-key solution to physicians that dispense medication directly to their patients by providing pre-counted prescriptions. I am not an expert in the medical services field by any stretch - and there is naturally some controversy surrounding prescription dispensing physicians given the apparent conflict of interest - but on a quantitative basis PDRX is fundamentally cheap. Shares currently sell for around $3.00, and as I outline below, I believe them to be worth at least $4.95.

Quantitative considerations

Below is condensed balance sheet over last five years. Net current assets value (NCAV) in the table below is defined as current assets minus all liabilities ahead of the common.

June 30, 2012 2011 2010 2009 2008 Cash & Equivalents 3,885,618 3,083,988 1,818,320 2,144,120 1,952,845 Accounts Receivables 1,506,042 1,984,697 1,603,028 1,862,260 1,532,612 Inc tax Receivables 126,674 0 999 0 200,001 Inventories 1,591,046 1,924,072 1,673,621 1,282,776 1,017,371 Other 170,106 222,770 234,899 123,485 126,194 Total Current Assets 7,279,486 7,215,527 5,330,867 5,412,641 4,829,023 Net PP&E 1,076,973 956,182 966,404 967,249 799,755 All Liabilities 1,238,679 1,759,088 1,014,556 1,349,647 1,511,487 NCAV per share 3.41 3.08 2.43 2.29 1.87 NCAV + PP&E per share 4.02 3.62 2.98 2.83 2.32 NCAV/share CAGR 16.3%

Comments:

• NCAV per share is currently $3.41 relative to the share price of $3.00
• NCAV per share has grown at a compound annual rate of 16% since June 2008
• There is no debt as of June 2012
• 61% of the assets on the balance sheet consists of cash and cash equivalents

Typically a company selling for less than net current assets is one in perpetual decline, losing money year after year and burning substantial cash. PDRX on the other hand has been consistently profitable and cash flow positive. Below is the five year summary of its financial performance. "Adj inc" in the below table is defined as net income plus depreciation less capital expenditures.

	Year ended June 30,
	2012	2011	2010	2009	2008
Net sales	25,553,544	23,887,231	19,358,270	26,919,498	26,426,268
Op Income	1,130,280	1,822,851	390,240	1,474,471	1,093,734
Op Income %	4.4%	7.6%	2.0%	5.5%	4.1%
Net Inc	705,159	1,131,019	242,472	912,952	706,434
Net Inc %	2.8%	4.7%	1.3%	3.4%	2.7%
Tax rate %	39.1%	38.7%	39.8%	38.0%	38.1%
CFO	1,170,319	1,481,124	(133,689)	569,667	205,701
Depreciation	146,597	127,375	115,830	111,863	107,579
Capex	(268,705)	(115,948)	(104,781)	(283,179)	(119,471)
Adj Inc	583,051	1,142,446	253,521	741,636	694,542
Shares Out	1,769,326	1,769,326	1,774,898	1,774,898	1,774,898
EPS	0.40	0.64	0.14	0.51	0.40
CFO/share	0.66	0.84	(0.08)	0.32	0.12
Adj inc/share	0.33	0.65	0.14	0.42	0.39

Comments:

• Earnings, cash flow from operations, and adjusted income averaged 0.42, 0.37, and 0.39 per share over the last 5 years.
• Cash flow has been positive in all except one of the previous 5 years.
• Earnings and adjusted income have been positive in each of the previous 5 years.

Miscellaneous qualitative considerations

• Qualitatively I don't see any obvious reason why PDRX should fail to achieve performance in the future similar to its historical record. Granted, I am not at all a specialist in healthcare or medical services companies.
• Although the financial released seem robust, they are somewhat minimalist and are released only once a year 
• The financials do not include the auditor's (Grant Thornton) opinion, but the company provided this to me upon inquiry and the opinions are unqualified for each of the previous four years provided 

Valuation

Using a very simple and rough method, I estimate PDRX's value to be at least $4.95 calculated as follows:

Earnings measure (5y avg Adj Inc)	0.39
Discount rate	10%
Earning power value	3.85
Excess cash (50% of balance)	1.10
Value estimate	4.95

This ignores the possibility of growth or decline. PDRX has a huge cash balance of $2.20 per share. As illustrated in the above, I assume roughly half of that is excess and distributable. 

Conclusion

Based primarily on the quantitative considerations above, PDRX appears quite cheap. If modest growth assumptions are used instead, it looks incredibly cheap. However I am not an expert in this business, and am not able to conclude if growth or decline is more likely. For these reasons, I have initiated a position but have made it a relatively small position in the neighborhood of 2-3%.

Disclosure: Long PDRX

InfuSystem Holdings, Inc. (INFU)

INFU is a risk arbitrage idea with attractive annualized return potential.

The company has been the subject of a recent activist campaign led by Ryan Morris of Meson Capital Partners. After acquiring an 8% position in the company, he replaced management and appointed himself executive chairman. After taking over the board, Morris attempted unsuccessfully to shop the company. The most likely reason for the lack of interest appears to be the announcement by the Centers for Medicare and Medicaid Services to subject INFU's pumps to a competitive bidding process.

In May, Morris sent a letter to the board expressing interest in putting a bid together to take the company private in May. The board agreed under the condition that Morris take a leave of absence as the executive chairman. Morris agreed, remaining on the board but stepping down from the executive chairman role.

On July 17, Morris sent another letter with a good faith indication of interest to take the company private at a price between $1.85 and $2.00. With the stock trading around $1.75, the gross returns are the following if the deal goes through at the end of the year:

Deal Price	Return	Annualized
$1.85	5.7%	13.4%
$2.00	14.3%	35.3%

A deal is still subject to due diligence, and receipt of third-party financing. The latter appears to be lined up, again subject to due diligence.

The deal looks to have a quite high probability of going through in one form or another. The shareholder base is relatively concentrated, and I think Morris likely knows where they stand. As was made public before the indicative offer, management has also recently adjusted their contracts to include change of control provisions providing for "cash award payments" in the event of a transaction involving greater than 50% of the stock. How convenient for them. The CEO and many of the board were recently appointed following Morris' gain in control, and I suspect they will also keep their jobs.

In any case, there's also reason to think that the deal could get done at a higher price. Morris purchased approximately 60% of his position at $2.25. To avoid the further appearance of conflicts of interest (recall that Morris is still on the board), I think it somewhat likely that the price either goes through at the high end of the range, or gets pushed to $2.25. In its letter responding to the offer, management stated that it "continues to believe that the value of the Company is above your proposed offer range of $1.85 to $2.00 per share." I expect Morris will counter with the competitive bid discussed above, but the incentives appear to be to get the deal done, and even the low range is reasonably attractive.

Worst case and the deal does not go through, the company does not appear to be overvalued. The rebid risk is real, but I'm willing to accept this given the other factors in play.

Disclosure: Long INFU

Chambers Street Properties (CSG)

CSG is an odd lot tender idea courtesy of Whopper Investments. Here's the offer to purchase. The tender is for 5% of CSG's outstanding stock at a price between $10.10 - $10.60, at $0.10 increments. The offer expires June 19, 2013. Odd lots (less than 100 shares) are given priority if tendered lower than the Purchase Price.

With the stock trading around $9.60, the returns look like this before commissions:

Purchase Price	Return	Annualized
$10.60	10.42%	228.4%
$10.50	9.37%	193.1%
$10.40	8.33%	161.3%
$10.30	7.29%	132.7%
$10.20	6.25%	107.0%
$10.10	5.21%	83.9%

The strategy would be to tender at the last possible moment (in case a better price is offered by the market) at the lowest possible price of $10.10 (to guarantee participation).

This appears to be a good way to put a small amount of money to work, especially if one can spread around multiple accounts. Now if only I could find 850 of these a year.

Disclosure: Long CSG

First Citizens Bancorporation, Inc (FCBN)

Having gone through the majority of the banks traded on the Pink sheets, one thing I've learned is that community and smaller regional banks are not very good businesses. Granted, I have only looked at banks with readily available financials.

The issue I take with most of these smaller banks is that they're just too small. The economic value of a bank is determined in large part by the relative cost of its deposits. A small deposit base leads to a high cost of deposits (salaries, overhead, etc. spread over fewer deposits raises the cost of those deposits).  That may be obvious to most investors, but it became clear to me after seeing many banks with cost of deposits consistently in the 4-5% range with long-term treasuries and AAA bonds yielding 3.2% and 4.0% respectively. At current interest rates, a bank with deposits costing 4%+ relies on extending further along the "risk curve" or reduced capital levels to make any money at all. It's hard to come up with a conservative estimate of intrinsic value for such a bank. At least these are my current views.

That being said, I did come across a number of strong banks - such as NACB, FBTT, CNBA, JTNB, CLDB - but these looked richly priced. I also came across FCBN, which looked like both a strong bank with a reasonable price tag (recently $625).

Although I did not eventually get enough comfort to establish a position, I post my thoughts/analysis as a means to flush out my thoughts and to keep a record of my reasoning and also to hopefully learn to prevent future errors in judgement and analysis.

The analysis below is organized according three key areas of focus for analyzing banks:

• Cost of liabilities
• Return on assets
• Asset quality and reserve adequacy

Cost of Liabilities
The higher the cost of liabilities, the fewer options a bank has to safely earn a profit and the more speculative the situation generally becomes. The main liability on a bank's balance sheet are the deposits. So keeping the cost of deposits low is the key to making money in banking.

Other liabilities are of course important also, but generally this money is provided to the bank at market rates so in a sense is an economic "wash", neither adding nor detracting directly to the value of the equity (an interesting discussion of this and bank valuations is given by Geoff Gannon here). This logic largely appears to hold for FCBN (i.e., although some of the rates on the debt and preferreds appear a little above current market, overall adjustments to equity would not be significant).

Below is a table showing my computation of "all-in" cost of deposits, as well as some other interesting statistics.

	Dec-12	Dec-11	Dec-10	Dec-09	Dec-08	Dec-07	Dec-06	Dec-05	Dec-04	Dec-03	Dec-02
Avg core deposits	6,963.1	6,985.0	7,102.3	6,349.4	5,261.5	4,844.2	4,584.0	4,118.7	3,706.8	3,375.9	3,156.4
Non-interest income	119.8	110.8	153.7	221.2	88.7	80.4	69.0	66.3	58.4	57.7	52.6
Non-interest expense	253.5	246.9	242.6	218.4	196.2	181.6	168.5	152.8	144.3	131.8	125.9
Net-non-interest expense	133.7	136.1	88.9	-2.8	107.5	101.2	99.5	86.5	85.9	74.1	73.3
Interest expense on deposits	16.5	33.6	65.6	76.8	107.6	129.0	98.6	58.5	37.3	40.7	53.3
Adjustments (1) (2)	14.3	53.5	50.2	126.8	2.2	-1.2	0.3	1.2	1.7	1.7	1.7
Cost of deposits	164.4	223.2	204.7	200.8	217.3	229.0	198.3	146.2	124.9	116.5	128.4
Cost of deposits %	2.36%	3.19%	2.88%	3.16%	4.13%	4.73%	4.33%	3.55%	3.37%	3.45%	4.07%
AAA bond yield	3.80%	3.85%	5.04%	5.26%	5.05%	5.33%	5.40%	5.29%	5.36%	5.54%	6.17%
Spread	1.44%	0.66%	2.16%	2.10%	0.92%	0.60%	1.07%	1.74%	1.99%	2.09%	2.10%
Demand Deposits/Total Deposits	12.7	11.2	9.6	9.3	8.9	8.8	9.4	9.7	9.8	9.5	9.4
Peer	9.4	8.6	7.4	7.3	6.9	6.9	7.4	8.9	10.1	10.2	10.5
FCBN Percentile	71	72	67	67	72	69	68	55	49	50	45
Total Overhead/Total Assets	3.1	3.0	2.9	3.0	3.1	3.1	3.1	3.1	3.4	3.5	3.6
Peer	2.8	2.8	2.8	2.8	2.9	2.7	2.6	2.7	2.9	3.0	3.1
FCBN Percentile	68	63	59	63	61	73	74	69	73	73	71

(1) During and after the financial crisis, FCBN purchased a number of failed banks in FDIC assisted transactions, and simultaneously entered into loss sharing arrangements with the FDIC. Losses in excess of those expected on the date of purchase create a receivable from the FDIC which is offset by non-interest income. Also, FCBN booked a large one-time discount purchase gain in 2009 associated with the purchase of a failed bank from the FDIC. Despite many years remaining on these loss-sharing contracts, I consider these items to be non-recurring in nature and exclude them in my estimation of the bank's earning power.

(2) Removes realized gains/losses on sale of securities from non-interest income. In recent years FCBN has posted realized gains, which is not surprising given the generally downward trend of interest rates over the last decade. However over time I expect these gains to offset by losses when rates increase, and so I do not view this income to be indicative of future earning power. These are approximate for 2003 and 2002 because the figures were not available.

Comments:

• Despite being skewed by the loss sharing arrangements with the FDIC, the cost of FCBN's deposits have consistently been favorable relative to market rates for money proxied here by long-term AAA bond yields
• Observing the overhead/assets ratio, the relatively low cost of deposits seems to stem from the high high percentage of demand deposits, rather than exceptional operating efficiency. Non-interest income has also benefited from a modest amount of mortgage banking income (gain on sale of loan securitizations).
• Including deposits acquired, average core deposits have grown at a healthy annually compounded rate of 8% over the previous 10 years; there is also not a reliance in any way on brokered deposits
• As a percentage of total deposits, demand deposits have steadily increased in absolute terms and relative to peers

Return on Assets:

On the asset side of the balance sheet:

	Dec-12	Dec-11	Dec-10	Dec-09	Dec-08	Dec-07	Dec-06	Dec-05	Dec-04	Dec-03	Dec-02
ROAA	0.75	0.71	0.90	1.54	0.82	1.03	1.05	1.09	0.90	1.08	1.12
Peer ROAA	1.02	0.87	0.49	-0.24	-0.16	0.97	1.24	1.29	1.28	1.26	1.28
FCBN Percentile	29	36	64	90	69	52	30	29	22	31	35
NIM	3.18	3.39	3.51	3.67	3.75	3.86	3.97	3.94	3.77	4.11	4.44
Peer	3.62	3.67	3.57	3.29	3.42	3.51	3.55	3.58	3.50	3.52	3.84
FCBN Percentile	24	32	41	66	62	65	67	63	57	72	73
Loan-to-Deposit Ratio	61.11	65.53	67.22	76.18	85.79	82.79	78.64	79.75	79.24	78.21	72.66
Peer	77.41	78.19	79.86	84.28	92.77	93.33	89.94	88.53	87.53	86.26	85.00
FCBN Percentile	23	23	25	32	30	25	24	33	33	34	26
Avg loans	4,426.7	4,662.3	5,138.4	5,165.0	4,478.7	3,931.7	3,652.8	3,308.3	2,956.4	2,586.3	2,319.5
Total int income	252.4	286.1	330.4	321.9	329.2	352.6	309.7	244.9	189.1	190.7	200.6
Loan losses	20.1	23.5	56.7	72.3	30.0	9.4	5.6	4.1	0.7	9.6	9.9
Net int income	232.3	262.6	273.8	249.6	299.2	343.2	304.1	240.8	188.4	181.1	190.7
NII/Avg Deposits	3.34%	3.76%	3.85%	3.93%	5.69%	7.08%	6.63%	5.85%	5.08%	5.37%	6.04%

Comments:

• FCBN's ROA has generally been in the lower 1/3rd of its peer group
• Based on the loan-to-deposit ratios, FCBN seems to have been consistently underloaned
• Avg gross loans have grown 6% annually
• FCBN has been consistently profitable through the financial crisis 

Asset Quality and Reserve Adequacy

Like getting comfortable with an insurance company's reserves, getting comfortable with a bank's reserve adequacy and credit culture is critical to evaluating a bank for investment purposes. This is tough, particularly because FCBN's accounting is somewhat muddled by the deals with the FDIC. Also, so far I've relied purely on financial statements and UBPR regulatory reports. This is not ideal for understanding the credit culture (better would be to talk to employees and competitors).

The table below contains the percent of total for of FCBN's loan book.

Loan mix % (including noncovered loans)	Dec-12	Dec-11	Dec-10	Dec-09	Dec-08
Construction & Development	6.9	9.0	11.9	12.1	11.6
1-4 Family Residential	43.5	41.7	39.9	41.9	44.0
Home Equity Loans	12.8	13.5	13.4	14.1	14.4
Other Real Estate Loans	25.5	25.6	23.5	21.7	19.7
Owner Occupied Non-Farm Non-Residential	19.8	18.9	17.2	16.2	15.0
Commercial & Industrial Loans	6.4	7.2	8.8	8.0	6.7
Loans to Individuals	12.2	11.0	10.3	11.0	12.6

The higher than average concentration in riskier construction and development and home equity loans is noteworthy.

A few (certainly not comprehensive) credit quality statistics follow:

Risk Grades - Not covered loans	Dec-12	Dec-11	Dec-10
Pass	3,747.06	3,750.70	3,933.53
Special Mention	145.94	156.69	161.04
Substandard	186.58	226.72	291.66
Doubtful	0.00	0.03	0.01
Loss	0.00	0.21	0.14
Total	4,080	4,134	4,386
Not Pass % of total	8.2%	9.3%	10.3%

Aging Analysis - Not covered loans	Dec-12	Dec-11	Dec-10
30-89 Days Past Due	1.18%	1.06%	0.96%
90 Days or More Past Due	1.55%	2.15%	2.90%
Total Past Due	2.72%	3.21%	3.86%
Current	97.28%	96.79%	96.14%
90 Days Or More Past Due and Still Accruing	0.27%	0.28%	0.36%

Reserves - Not covered loans	Dec-12	Dec-11	Dec-10
Gross noncovered loans	4,080	4,134	4,386
Nonaccrual loans	96	126	111
Avg impaired loans	137	147	107
ALL	63	71	82
Charge-off ratio	0.65%	0.76%	0.86%
ALL/Nonaccrual loans	66%	57%	74%
ALL/Avg impaired	46%	48%	76%
ALL/Gross loans	1.54%	1.72%	1.87%

Comments:

• The risk grade and loan aging analysis both indicate a somewhat steady improvement in credit quality
• Overall, the reserves ratios seem low relative to peers. 
• For example, usually ALL/Nonaccrual loans is at least 100%. It's possible that this is well less than 100% because the bank - in conservative fashion - is quick to charge off loans. 
• However, charge-offs are consistently lower than peers suggesting either better than average credit quality or slow recognition of credit deterioration
• Further, ALL/Net Losses is also lower than most peers
• For conservatism's sake, raising the reserves to 100%-150% of nonaccrual loans would reduce book value $40-100 a share.
• The above comments combined with the relatively high concentration in riskier construction & development, and home equity loans is a little concerning to me

Other general comments

• FCBN does not disclose an interest rate sensitivity table, making it difficult to assess the impact of a rise in interest rates. It is likely that the mortgage banking activities would be reduced.
• The assumptions FCBN uses in its pension accounting seem quite optimistic. 
• That is, they expect to earn an 8% after-tax return on plan assets with the 59.8%, 29.5%, and 11.6% of plan assets in equities, bonds, and cash respectively. 
• Looking prospectively: with long term AAA bond yielding ~3.8%, and 3-month LIBOR ~0.3%, they're banking on an after-tax return of close to 12% out of their equity portfolio (generously assuming a 15% tax rate).
• Looking historically: they have earned 4.8% annually compounded:

	2012	2011	2010	2009	2008	2007	2006	2005	2004	2003	2002	2001
Beg of Year FV	104.5	99.6	83.3	71.2	82.4	75.7	65.7	55.4	49.9	42.6	41.2	39.1
Return	7.6	3.4	9.5	9.8	-13.7	4.1	5.2	3.4	3.8	5.4	0.1	0.9
Return %	7.3%	3.4%	11.4%	13.7%	-16.6%	5.4%	7.9%	6.2%	7.6%	12.7%	0.3%	2.4%
Annual Return	4.8%

• Berkshire Hathaway assumes an expected rate of return of 6.6%, with much of this capital being allocated by arguably the best investor that ever lived (and his protege).
• Even though they're not allowing additional plan participants, their pension plan seems big enough that over long periods I fear these assumptions could have a pretty significant impact in terms of present value. Anther natural concern is that this optimism extends into other facets of their accounting or possibly their credit culture.
• Their are probably more accurate ways to adjust for this, but my line of thinking is: I want to know how much in additional assets must be contributed today to reach the same future value under each set of assumptions. Assuming (1) an expected rate of return equal to their historical returns (a still generous 4.8%), and (2) a 20-year time horizon, this amounts to nearly $115 per share of assets today.

Summary and Overall comments

Overall FCBN has a strong deposit base and cheap funding, but has a few offsetting negatives including

• Overcapitalized/underloaned: this provides cushion to cover losses, but this is at the expense of relatively weak performance on the asset side of the balance sheet
• Accounting concerns
• Possibly be under reserved 
• Aggressive pension assumptions
• Somewhat high overhead costs relative to deposits

From a quantitative standpoint, FCBN appears relatively cheap even after adjusting for some of the items described previously:

Current Shares	821,400
Deposits	6,963,127
Interest spread	1.40%
Pre-tax earning power/ Share	119
Deposit growth assumed	2.7%
Post-tax yield assumed	10.0%
Pre-tax yield assumed	15.4%
Per share value	940
Per share pension issue	-115
Per share reserve issue	-70
Net estimate	755
2/3 of estimate	503
Price	625

However, given the qualitative negatives discussed (which makes the valuation estimate dubious), I am currently not comfortable enough to initiate a position. I plan to follow this company and work to better understand the credit culture and asset quality.

Disclosure: None