I'm Buying Prudential Bancorp

I really like to invest in bank demutualizations, and my Special Situations portfolio is back to buy another one: Prudential Bancorp . In October, the bank completed its second-step conversion, making it a fully public institution, but it trades at just 73% of tangible book value. That's tremendously cheap for a profitable, albeit slightly, bank. So I'm stepping up to buy the stock.

The business and special situation
Prudential maintains seven locations in the Philadelphia area and $525 million in assets, making it a tiny bank. But what it lacks in size, it makes up for in valuation. The stock trades at just 73% of tangible book value. That's incredibly cheap for a profitable bank.

But let's not put too fine a point on profitability here. Return on equity topped out at 5.5% in fiscal 2010, and ran just 2.9% in fiscal 2013. Profitable, yes, but certainly not gushing cash. There's such a huge margin of safety in the valuation that I think we're safe buying this bank.

Prudential focuses heavily on residential mortgages, the most plain vanilla of banking operations. About 90% of its loans fall into this category. And credit metrics have been trending favorably for some time. In the last five years, non-performing assets peaked at 3.3% in 2012 -- elevated but hardly drastic -- then fell to 1.2% in fiscal 2013. I expect to see this continue trending down.

The bank relies heavily on "stickier" sources of financing such as checking and savings, with about 60% of deposits. The remaining 40% are time deposits. I like to see the high reliance on stickier funding.

The bank is stuffed to the gills with extra capital. That's largely a function of the recent capital raises, but even before that the bank was overcapitalized. Now, the bank has average equity of 18.7% of assets. Tier 1 capital-to-average assets is 24.7%. So don't worry about this bank running out of money.

The special situation here is that Prudential demutualized in October, raising a ton of capital and converting to a fully public institution. The move should allow the stock to trade at a higher multiple, and makes it more likely to be acquired, the usual route for most demutualized banks.

As part of its demutualization filing, the bank indicated that it had funneled 42% of its proceeds into the holding company, which could be used for possible acquisitions, dividends, or buybacks. It legally must wait at least a year before it can begin buybacks; with the stock at these levels, I would be extremely disappointed not to see aggressive buybacks. A buyback at today's valuation is an immediate winner for shareholders and rapidly increases tangible book value per share. Buybacks are one of my key tests to determine whether management is interested in doing right by shareholders. The bank can begin share buybacks in about six months.

Often you'll see a bank trading well below tangible book, and management goes out and buys another bank trading above tangible book. Just as buybacks are one of my key tests for management competence, acquisitions are another. In other words, if management is buying another bank, that acquisition should be pretty cheap if management has the possibility of buying back its own stock at around 72% of tangible book. That's a huge hurdle rate for any investment. Newly raised cash often gets managers in a fit of acquisition hunger. I will quickly sell if I see such a boneheaded move.

Of course, Prudential is exposed to rapidly rising interest rates, as pretty much all players in the banking sector are.

Foolish bottom line
My Special Situations portfolio will be buying $500 of this cheap and profitable bank, and will look to add more. At just 73% of tangible book value, it's hard to imagine this profitable bank becoming any cheaper.

Interested in Prudential Bancorp or have another stock to share? Check out my discussion board or follow me on Twitter, @TMFRoyal.

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Jim Royal has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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