Pacific Mercantile Bancorp (NASDAQ: PMBC) is one of the best community banks to invest in, according to community bank stock-picking expert, Tim Melvin. Located in southern California, Pacific Mercantile has significantly cleaned up its balance sheet in recent years and is expected to have phenomenal loan growth.

To gain deeper insight into the business, Melvin spoke with CEO Steve Buster on everything from industry consolidation to Pacific Mercantile's unique entertainment lending business.

Business Conditions

You guys are in Orange County, California. That was one of the hardest hit areas in the recession. How are conditions today?

Well, it’s interesting, Tim. You’ve always heard what goes down goes up, and it’s true that Orange Country got hit pretty hard in the Great Recession and all of California, but it’s a resilient county and it’s part of our blessing right now, because the county has really bounced back in a very healthy way.

The fact is we have just over 5 percent unemployment in Orange County, and we are blessed with a lot of VC capital. In fact, LA and Orange County together are the fourth most active region for startups since 2013. So, it’s startups, and small and medium business that generate jobs the most and so, we’re really blessed with a pretty favorable economic environment. I can say that if I had to be based anywhere, I’d pick right here, and we don’t need to go anywhere else to benefit from a turnaround and growing economy.

Pacific Mercantile is primarily a business focused bank and you have heavy exposure to both commercial real estate and commercial and industrial loans in your portfolio. How’s the commercial real estate market?

It has recovered remarkably. There are active investors for commercial real estate, vacancies are relatively low, prices are increasing regularly, and I would say it’s close to a medium-hot market.

It’s not overwhelming. It’s not ballooned. It has foundation under it, but it’s very warm, if not hot in terms of a good market. So, developers are favorably disposed. But, you know, there’s a lot of restrictions to build in California and it’s difficult to get new projects started. It has negatives, but in a way, it’s positive because it’s going to start holding down the prospects of a bubble again.

Growth

In the last earnings release, you referred to your newly revised business plans and some of the things you expected to do going forward. Can you elaborate on that a bit?

It is relationships. Commercial and industrial is our priority. We pick certain niches that we emphasize in that marketplace. We are excellent entertainment lenders. There are probably only five or six banks that know how to do it. We have a seasoned team that is very good about it, very knowledgeable about lending into the entertainment field.

When you surround opportunities with VC capital, UCI, the University, Chapman College, it has an effect similar to Silicon Valley and Stanford. It sets up a nice opportunity with this capital coming in to finance businesses beyond the startup stage and now emerging and growing and we are very good at that. So, our C & I business, if you include both, the CRE related to that and our other specific portfolio that’s label C&I, it is growing probably 22 to 23 percent per annum. It’s a very good, healthy clip.

Could you tell me a little bit about what entertainment lending comprises of?

So, films are being made in Hollywood and there are various investors that lend to these limited liability of needs. There’s usually a producer, a company that’s done many films, the actors and the technical staff; they need financing. It sounds dangerous but, in fact, when you know what you’re doing, we have never taken a loss in this business and we’re quite good at it even though investors sometimes get hurt.

Since 2012 there has been a drastic improvement in non-performing assets. How have you accomplish that?

Pacific Mercantile is, I think, a most unusual bank. With the great recession, people saw opportunities of turnaround and for some reason ours did not turnaround actively with aggressive management of the assets, which includes liquidating your problem loans and trying to re-establish a different direction.

So, we’re kind of late to the table but that’s what makes us a good opportunity now, because we have focused on cleansing the balance sheet over the last two years and have had very, very good experience.

We were helped by an up market and new, fresh capital from the Carpenter Group, who invested in the company and gave us the capital to be able to form, for example, a special PMAR company that deals with problem loans. We were able to clean up our portfolio very drastically over the last two years because of that.

You guys are projecting strong loan growth throughout the rest of this year, and you are one of the only banks I’ve talked to that’s doing that. How exactly are you achieving the type of loan growth?

Well, first of all, let’s look at the marketplace: 80 percent of banking is controlled by the big banks, the banks too big to fail. I can tell you, people don’t like banking with them. They bank with them because they have the services they need whether be online banking or a local office or brick and mortar that’s convenient. Whatever the reason, they’re banking with them, but when you talk to them, they don’t particularly want to bank there.

And then, you have segments of community banking. I would not want to be a $500 million bank because a $500 million bank has not only trouble with a lack of economies of scale, but they also will not have the standing products that make them competitive, particularly in the treasury area. As you get to $1 billion, up to $10 or $15 billion, you’re in a sweet spot.

People love to bank when you have the big bank toys, but you provide community bank attention and relationships. We know their name when they come in the office, but we also have all types of online banking services that allow remote deposits, various treasury products that they might need, wire transfers and online. We give them all those things that a sophisticated bank can do, but we know their name and we know their business. I have found that when you have professional people which we now have recruited and secured at this company, we have an ordinate amount of wins when we’re pitching the business. We win six or seven out of 10, and that is attributing to our growth.

Improving Financials

The Carpenter Group owns about a third of the outstanding shares of the bank, as I recall. Can you tell us a little bit about that relationship and how it came about?

Carpenter and his organization have been around for 40 years, and they have some very good professionals. They used to specialize in starting up banks, getting their charters, finding the capital forum, providing guidance on establishing policies and practices, and they have a long, long track record. They started to fund, with outside investors coming in to invest, in turnaround banks.... That is where our money has come. They put a significant amount of capital in us and that’s what’s given us the flexibility to be able to deal with some of these problem assets on a rapid basis.

Carpenter has a number of years that they can hold these shares. We sort of expect that they will because there’s a lot of upside to their minds to the shares. The nice thing about working with Carpenter is the way they operate. They feel that if they put in good management and help ratify a sound business plan, and build for the long run, they will add incremental value so it could be sold in some transaction or sold in the marketplace to everybody’s benefit.

Looking Forward

In the aftermath of the recession we’ve seen a whole new wave of regulations. A lot of banks are having a problem with this. Are you guys having difficulty dealing with the new regulations?

Yes! You see a lot of the big banks settling [with the government]. Bank of America, $16.5 billion. Chase was about $13 or $14 billion. They’re getting hammered…

We, at Pacific Mercantile, came to the conclusion over a year ago at we have to exit this [the mortgage business]. It cost us a great deal of money. It hurt a great deal, in that we had to let over a 100 people go and it hurt a great deal that we would not be able to serve the mortgage community that needed our type of attention. But, we could not compete in that business with these regulations. We had to reduce our regulatory risk and we have.

Now, we get praise from the regulators. We are very compliant. We have turned the bank around, I think they are quite impressed with the disciplines we’ve put in place, but we’ve had to orient that strategy away from the higher risk regulatory environment.

QM is not going to go away and the rules are established for the big banks, but have to be lived by the community banks. If you go below that, there is a squeeze because credit unions pay no taxes and have no CRA requirements. So, they’re subsidized and the top banks have economies of scale with big standards that can get away with that because they have teams of lawyers.

The community banks are really going to get squeezed in that particular business… We are happy we’ve made that decision and bit the bullet because I wouldn’t want to be facing that for the next two or three years. It’s only getting worse.

What do you see going forward for community banks in general and your bank in particular?

For the small community banks, I think they will capitulate to consolidation with larger banks. It won’t be the big banks buying them, but there will be a consolidation to the multi-billion dollar smaller banks by the $500 million and less community bank. I think that is a wave.

Secondly, the community bank population has shrunk so much that I feel there is a real opportunity for the remaining survivors to fill the niche of what clients really want. I think we’re going to have a very healthy environment for some years. We have a good economy in Southern California. We have an opportunity to bring strong products and counseling, a relationship approach to clients that they appreciate, and we are not the low cost provider; we are a high value provider…

By focusing on relationships and not commercial real estate development, we are now growing our deposit base quickly and that’s the underside to your cost relative to your income and increasing your margins. That is why we have the C & I relationship approach. Banks that focused on that in community banking, I think, will thrive and the ones that have specialized in mortgages I think will be in great pain. That’s my opinion.

See more of Melvin's work at Banking On Profit.