Community bank value investor Tim Melvin advocates a position in Cape Bancorp, Inc. (NASDAQ:CBNJ). Cape recently announced the acquisition of a local bank, is trading below book value and is a favorite of activist investors.

To gain further insight into the stock, Melvin spoke with CEO Michael Devlin in an exclusive interview with Benzinga.

Introduction

You're in the Atlantic area of New Jersey. How are conditions in the real estate market of your service area right now?

There is some pretty high-profile news about the gaming industry in Atlantic City and for probably 25 to 30 years, that was a very solid industry, sort of recession proof. We've had the closing of four properties within this calendar year and the reduction of staff of more than 8,000 people. In a county the size of the Atlantic County, these are big numbers and roughly 60 percent of these people are estimated to live within the county, so that is a negative for us.

On the flipside of that, this section of New Jersey from Atlantic County down to the very tip of the Peninsula over Cape May has a series of barrier islands and these islands would have seasonal businesses, summer vacation businesses, summer homes, boardwalks, amusement rides, and both this year and last year were great years for the people on those islands. So, our customers that are involved in the seasonal business have done very, very well.

A third component of the business that we do here is we have a fairly large interest in commercial fishing; Supplying these folks with ships mortgages and business loans and commercial fishing has done extraordinarily well. We have the fourth-largest fleet in the United States... and solid business that was not impacted by the downturn at all. And so, if we have a three-legged stool here, two of them are fine and one is not doing too well.

We also expanded westward about four years ago, putting offices in suburban Philadelphia on the New Jersey side and on the western suburb side. That generates a lot of business for us and we just recently announced the purchase of a troubled condition bank in Cumberland County which is also in South Jersey. So, we have some westward plans that I think will mitigate some of the negatives in our home base, too.

Are you targeting specific industries in the region?

No. As we have moved westward into the suburban Philadelphia area, we picked up a little bit more manufacturing and C & I lending, which we do like as a diversification from down here. On the barrier islands we would have hotel business and in places like Cape May bed and breakfast businesses. In South Jersey the bigger industries would be agriculture, which we do not lend to and service businesses.

Growth

In 2013, Cape exited its residential lending program, which is about 35 percent of your loan portfolio. Are you going to be focusing more on the commercial side of the business?

Residential loans are not a big part of the commercial banking picture to begin with and then once we were combined and the dust of the recessions settled, we opted to get out of that business. In part for the regulatory burden and in part because it is a business of scale, and we just felt that if we're putting resources to something, resources to the commercial side was going to be more productive for us than trying to beef up our residential mortgage business to compete with the likes of Wells Fargo.

In your service area you have all the big banks right around you. Do you have any plans to market against those guys or try to take share from them on the deposit or the loan side?

We've been thoroughly successful in having a sufficient level of deposits at prices that we like to fuel our loan growth and I think we probably continue with that kind of strategy. From a pricing point of view, we would be much more comfortable to price the way the big players do rather than some of our smaller competitors. But again, our focus is strictly, ‘Do we have enough funding to do what we need to do on the earning assets side?’ and that seems to have worked well.

For a small community bank, we have an awful lot of the electronic features that millennials would want to have. We do a lot of digital marketing to that group and we seem to be doing it fairly successful. So, I think the focus that we have on that thing is to be sufficient and I don’t see that changing as we go forward.

Cape’s expansion into the Philadelphia area is using marketing development offices rather than traditional branches.

Yes. When we combined two institutions to create Cape roughly six and a half years ago, we had a branch network of 20 and we're down to actually 13 and a half now [one branch is drive-up only].

At one point in my career I started a bank that was branchless in the late 80’s, which was fairly a novel idea at the time. So, I’ve always been a person who has been skeptical of the value of a real extensive footprint and we very carefully watch the productivity of each one of our branches. I think it is a delivery system that appeals to a certain segment and does provide a value, but you have to be looking all the time to make sure that it’s giving you all the value that you want.

Financials

Since 2011, you have done just an incredible job of bringing down non-performing assets. It was over 4 percent and now you’re down to mid-one percent as performing assets to total assets. Can you tell us about that process?

It was one of the more painful parts of my banking career. It is amazing how much attention troubled credits absorb from a corporate point of view. I think it was just kind of diligent work of trying to get through it. We did sell some loans, but most of them we have worked through and I think we worked through fairly successfully. Per the most recent numbers, we’re probably under 1 percent for troubled loans to total loans and that was kind of a goal we were hoping to achieve.

Cape Bank has over a 100 percent of reserves to troubled loans. Can you talk about the conservative approach?

I think part of it is the residual of having higher reserves and then as you actually resolve the issues, the ratio tends to get a little skewed initially.

I think that we have a lot more caution here now than we ever did before, in terms of size of relationships that we want to have and much more scrutiny to deals. Also, there’s been a total change on the staffing here in terms of Chief Loan Officer and Chief Credit Officer, and most of the key commercial loan officers in the last four years are new.

Colonial Bank, which Cape will be acquiring, has a higher percentage of non-performing assets. Is that something you are looking to bring down?

Yes, and that was actually a big decision going into this decision. I will say, they are a company that has made tremendous progress in reducing their troubled credits. Although not at a good level, they are at a much more reasonable level than they were a year ago. I think that by the time this deal would close, it will probably even look better than it does today.

That said, there’s still a lot of work to go in getting into where they need to be. We certainly had the staff here that can deal with that and we understand South Jersey as a market. So, I think we’re fairly realistic in understanding the value of troubled credits. In today’s environment between regulators and accountants, people tend to account for the values of these troubled credits fairly accurately because there’s lot of eyes looking at what you’re doing. We think it’s accurately reflected in their books and we are taking it fairly generous mark on the portfolio as it is and we’re certainly buying it, I think, at a very attractive price.

M&A

You recently announced the acquisition of Colonial Bank. About 60 percent of their loan book is residential mortgages. Will that put you back into the residential business or will you let it be a runoff business?

It will be a little runoff business. We’ve already made it pretty clear that we will not be keeping their residential lending staff. That is just a product line that we don’t offer. There is a certain value in those assets because their yield is fairly attractive, but it’s not a product that I particularly like for its interest rate risk characteristic.

It looks like we might have a respite in terms of rising interest rates; maybe they won’t be rising quite as fast as we had thought, even six months ago. Longer term, I didn’t know that they are attractive assets to have, so that is something that we would not be adding to.

What kind of impact will this acquisition have on the book value of Cape Bank?

It looks like it’s going to be between two and three years for us to do the earn back on the book. We do it expect that should be accretive to earnings in excess of 20 percent.

There has been a lot of talk around the community bank sector about consolidation as the number of banks continues to come down. Do you see that continuing?

Absolutely and I probably see that even for institutions like ours. We will be $1.5 billion, which I think is certainly a viable size for community bank. But, I also think that there’s going to be this push towards consolidation for the next 10-year period of time.

I don’t know if that’s a bad sign. As you had mentioned earlier, there are regulatory burdens. We have a few banks in my marketplace that are under $200 million and frankly, I don’t know how they can do that... If you have a staff of 30, you need to have six people that don’t generate income. That can be a real hard thing to do and to make any kind of reasonable return on your equity. I think that there is going to be consolidation and if you are a good CEO, you have to be open to that possibility as a buyer and seller.

Shareholders

Cape has very strong insider ownership. Officers and directors own about 19 percent of the bank and 8.5 percent is owned by your ESOP. Do you feel that having skin in the game makes the folks at your bank more focused?

Ownership focuses people well, but I also think we have chosen a team of people here who are just very good professionals. They understand the market and they understand what we’re trying to do. I think we have created a good work environment; a very collegial approach to management that many people seem to thrive within.

So, I think it’s a combination of two things. Good people who would be diligent regardless of their level of ownership, plus the ownership brings in a further focus.

You are getting ready to inherit two activists: Larry Seidman and Joseph Stilwell. Have you spoken with them?

Well, Larry Seidman has probably owned stock in all of the banks I’ve ever had, so I know him well and I like him. I’m one of the presidents that think he is a very smart man and I don’t think he has ever raised an issue that wasn’t worth considering. He understands banking and he understands how to create value in banks.

Mr. Stilwell, I don’t know at all. I know his name, but I don’t know his approach, so I can’t really speak about him. Throughout most of my career I have always had institutional investors and often activist investors. I have always tried to run a bank with the thought that I’m here for the shareholder value creation and we don’t have a lot of things layered on the focus on taking good care of management. I think we have reasonable payment plans and compensation plans, but the focus is on creating value for shareholders and if you have that kind of attitude, if you are shareholder friendly, you don’t normally have difficulties with your large shareholders.

Industry Outlook

You’ve been in this industry 40 years and been very successful in it. Going forward, how do you see things playing out over the next decade for Cape Bank and community banks in general?

We talk about this frequently with the move towards the digital delivery of goods in all fields, including ours, and it’s hard to understand how do you allocate resources to things that are digital as opposed to things that are traditional because we still have a large customer base that does the traditional kind of thing.

If you look at lobby traffic, if you look at transactions done in branches as opposed to electronic transactions, it is dramatically shifting in a very short span of time. I don’t see that changing. If you think back four or five years ago, we didn’t have mobile banking, we didn’t have an app for tablet use, and that is a fairly common form of people doing business with us now.

To predict 10 years out, I’m not even sure what the technology will permit people to do. You have to be fairly agile to respond to all of these things in the world, so I think it will be very challenging; pretty interesting but very challenging.

After the credit crisis there is wave after wave of new regulation and a lot of banks are having a hard time dealing with it. How are you guys dealing with all these new regulatory cost and pressure?

I think I’m probably a little bit off the normal with my thoughts on this.

I’ve been in banking close to 40 years. I started two banks and sold them. I have been involved in a heavily regulated industry my entire life. It’s sort of a price you pay to be in this industry and the most productive approach to this I think is to just accept that that’s the given.

I’ve have had a very good rapport regulators my entire career and I still do. It is burdensome. You do put more money to this by putting people in areas that are not direct generators of income, but I think it’s just a factor of being in the business. I do believe that there are sizes where a bank can just be too small to effectively deal in this and I think that we’re above that level.

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