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LONG OPPORTUNITY: FGBI (NSDQ)

FGBI: MULTIPLE PRICING ANOMALIES IN SMALL CAP BANKING STOCKS


Disclaimer The opinions expressed in this presentation by Lateral Capital Management, Inc. (“LMCI�) are not an investment recommendation and are not meant to be relied upon in reaching an investment decision. LCMI and its employees, consultants and contractors are not acting in an investment, tax, legal or any other advisory capacity. The opinions expressed herein address a limited number of aspects regarding a potential investment in securities of the companies mentioned and are not a substitute for a comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations as to its accuracy. LCMI recommends that potential and existing investors conduct a thorough investment analysis of their own, including a detailed review of the companies' SEC filings, and consulting a qualified investment advisor. This material is based on information obtained from sources believed to be reliable, but the reliability of that source information. Any opinions or estimates constitute a best judgment as of the date of this presentation and are subject to change without notice. LCMI explicitly disclaims any liability that may arise from the use of this material. 1


Executive Summary Small cap regional US banks currently trade inversely to their ROEs (i.e. higher ROE = lower P/E) 

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After adjusting our sample for potential indicators of financial stress – including high short interest, low equity ratios, high dividend payout ratios, etc – the inverse relationship persisted  Large cap US banks have a traditional positive relationship between ROA and P/B Within the small cap sample, one of the most dramatic examples of high ROE and low P/E is First Guaranty Bancshares (“FGBI”). Several reasons have been offered for this counter-intuitive outcome, including FGBI’s location in an energy rich state (LA) which has been impacted by the collapse in crude oil prices However, LA is rich in shale gas reserves and has material oil refining capacity but very limited crude oil production Moreover, FGBI has a strong track record of above-average growth combined with over-provisioning for future loan losses and holding excess equity capital. All of which suggest its ROE results are sustainable We consider the current FGBI market valuation to be unduly punitive  It trades at a discount to large cap US banks despite not being subject to the “systemically important” big bank regulatory constraints  FGBI also trades at a discount to all US listed regional banks  Its intrinsic value premium to the current stock price is 50% in our “base” case and closer to 100% in our “realistic” case under both a DDM and a REIC model  Future interest rate increases will only improve this margin of safety in the current equity market valuation of FGBI

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Table of Contents 1. Banking Sector Valuations 2. Risk Adjusted Valuation 3. Fundamental Drivers 4. Operational Performance

5. Risk Assessment 6. Normalized Earnings? 7. Relative Value 8. Intrinsic Valuation


Section One

Bank Sector Valuations


Traditional Relationship Between ROA and Book Multiples As one might expect, large cap US money center banks & US commercial banks demonstrate a positive, significant relationship between returns on assets and book trading multiples

Figure 1

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Small Cap Regional Bank ROE & P/E ratios The traditional relationship is inverted for small cap regional banks. The higher their ROE, the lower their trailing P/E multiple

Figure 2

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Section Two

Risk Adjusted Valuation


Small Cap Bank Sample Adjusted for Risk Factors To determine if other risk factors might explain the inverse relationship between ROE and P/E multiples, we excluded from our sample small cap regional banks with high payout ratios, high loan/deposit ratios and/or high short ratios

Figure 3

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Risk Adjustmented Sample Relative to “Normal� P/E & ROE Relationship After excluding the banks with potentially higher risk factors, the inverse relationship between ROE and P/E persisted. We focused the rest of our analysis on the particularly wide disparity of FGBI

Figure 4

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Section Three

Fundamental Drivers


FGBI Has Underperformed its Small & Large Cap Peers Part of this dramatic underperformance over 2016 has been attributed to FGBI’s location in an “energy rich” state (LA) at a time of declining crude oil prices

Figure 5

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Oil Production in Close Proximity to FGBI’s Operations Has Been Declining The crude oil price declines should not be a material influence on FGBI’s loan base as crude oil production in nearby oil basins had been declining for many years

Figure 6

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Louisiana Crude Oil Production Has Flatlined Since 2004 The rapid increase in tight oil production outside of Louisiana (“LA�) means that its share of national total crude oil production (convention & tight oil) has declined while its nominal production has been stable

Figure 7

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Nearby Shale Gas Production Had Been Increasing However, Haynesville shale gas production decline rapidly after the natural gas price declines in late 2011 / early 2012. Unlike tight oil, LA has an abundance of shale gas reserves

Figure 8

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The Natural Gas Supply Response Was Immediate & Dramatic The LA natural gas production drop in 2013 and subsequent years is far more important to FGBI than the decline in crude oil prices, because of the production composition of LA’s hydrocarbon reserves

Figure 9

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As a Major Oil Refining State, LA Benefits From Lower Crude Oil Prices Far from being a risk to FGBI’s loan book, the reduction in crude oil prices benefits LA oil refineries, which are reflected in the LA Non-Durable Manufacturing Output numbers

Figure 10

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FGBI’s Loan Book Has Residential Real Estate Exposure Despite the reduction in natural gas prices and shale gas production, housing prices in LA have continued to recover since the 2007/8 financial crisis

Figure 11

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The Equity Markets Correctly Recognizes The Role of Macro Forces In recent years, the FGBI stock price has moved higher with natural gas spot prices and lower with crude oil prices. And as expected, lower interest rates (higher bond ETF prices) exert a negative influence on the FGBI stock price

Figure 12

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A More Accurate Representation of Crude Oil Price Impacts While macro relationships often shift over time, for the time being, we would posit the following series of inter-dependent relationships and their impact on the FGBI stock price. Which is to say, that lower crude oil prices since 2015 cannot explain the disconnect between the FGBI ROE and its P/E multiple

Figure 13

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Section Four

Operational Performance


FGBI Has an Enviable Track Record of Book Value Growth If the FGBI ROE & P/E disconnect is not attributable to lower oil prices, could it be explained by FGBI’s historical operating performance? We do not believe so

Figure 14

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Indeed, FGBI’s Profitability & Other Metrics Have Been Improving Figure 15

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Moreover, FGBI Has Grown Much More Rapidly Than LA Even if crude oil prices were a net-negative for LA, it is still the case that the growth in FGBI’s loan book has decoupled from LA’s economic growth rate

Figure 16

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FGBI Has Been Redeeming Security Investments and Increasing Loans The growth in net loans since 2011 has not come at the cost of its balance sheet. FGBI has been simultaneously redeeming its securities and investments assets

Figure 17

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FGBI EPS Reflects the Impact of Gas & Oil Prices (and Production) FGBI’s EPS declined for several quarters during the natural gas decline in 2011/12 and has retained a historically high EPS during the recent crude oil price collapse

Figure 18

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Section Five

Risk Assessment


FGBI Exceeds FDIC / FRB Requirements for a “Well Capitalized” Designation On several metrics, FGBI has substantial excess capital which supports future RWA growth Figure 19

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Several Risk Metrics Have Inched Up Since 2013 But Remain Subdued Figure 20

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The Full Extent of the Natural Gas Downturn is Apparent in LA’s GSP… [ ] Figure 21

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… Which Is Reflected In FGBI’s Loss Provisioning In hindsight, FGBI overprovisioned in 2010/11 which was prudent Figure 22

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The 2010 to 2013 Over-Provisioning Was Reversed in 2014 [ ] Figure 23

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Section Six

Normalized Earnings?


Rotation from Investment Securities to Customer Loans It has been argued that as FGBI disposes of its securities portfolio and increases its loan exposure it has been realizing unsustainable EPS benefits from gains on sale of securities. Based on current figures this trend will continue for several years

Figure 24

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Adjusting for Excess Capital & Security Gains, FGBI is Mispriced The equity market mis-pricing of small cap regional banks is only further highlighted by adjusting FGBI’s results for excess capital and security gains

Figure 25

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Section Seven

Relative Value


Large Cap US Banks Offer Compelling Value But FGBI Is Cheaper Figure 26

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Compared to US Regional Banks, FGBI is Compelling Value Figure 27

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Section Eight

Intrinsic Valuation


Target Capital Ratios for Our Intrinsic Valuation Forecasts Figure 28

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We Determined FGBI’s Intrinsic Value Using a DDM & a REIC model Figure 29

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Our Base Case Valuation Appears Conservative Over A Range of Inputs Figure 30

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The Upside Valuation Does Not Rely On Aggressive Assumptions Figure 31

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With So Much Excess Capital, FGBI Should Also Be Valued With a RIEC [ ] Figure 32

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Recap FGBI is one of those rare situations where the current stock price cannot be justified by any of the apparent market concerns regarding risks, returns, future developments, etc while providing upside exposure to a rising interest rate environment 

Small cap regional US banks trade at P/E multiples inversely to ROE 

FGBI’s operations are largely confined to LA which is not a material tight oil producer 

Indeed, LA benefits from lower crude oil prices which feed into its refinery margins

LA housing prices (which could impact FGBI’s real estate loans) ere impacted by lower natural gas prices & production, but appear unaffected by lower crude oil prices

FGBI has grown tangible book value per share at a 6% CAGR since 2008 despite excess capital and below average GSP in LA 

Non-performing loans and reserves all appear reasonable

The gain on disposal of investment securities is expected to continue for several years; while any reduction in gains on disposal due to higher future interest rates would be mitigated by a higher NIM on FGBI’s loans

After adjusting for gains on disposal of securities and excess capital holdings, FGBI is even more undervalued with a pro-forma 12% ROE and a sub-10x P/E multiple

While large cap banks are currently cheap on a trading multiple basis, FGBI is not constrained by the regulatory burdens that are imposed on large cap US banks and has even more favorable relative trading multiples 

FGBI has one of the highest ROEs and lowest P/E multiples in the small cap banking sector

FGBI also exhibits favorable relative value multiples when compared to all listed US regional banks

Using conservative assumptions, and over a wide range of inputs, FGBI is materially undervalued on both a DDM and a RIEC basis

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