Security Federal Corporation (SFDL)

Executive Summary / Key Takeaways

• Margin Expansion Through Disciplined Balance Sheet Management: Security Federal's net interest margin improved to 3.17% in Q3 2025, driven by adjustable-rate loan repricing and the elimination of expensive Federal Reserve borrowings, demonstrating effective liquidity management in a volatile rate environment.

• Small Scale, Steady Returns: The bank's 59% jump in quarterly earnings reflects strong credit quality and cost control, but its 0.80% ROA and 6.74% ROE significantly trail regional peers, highlighting structural profitability constraints inherent in its sub-$2 billion asset base.

• Community Franchise as Defensive Moat: Founded in 1922 and headquartered in Aiken, South Carolina, Security Federal's deep local relationships and integrated insurance/trust services provide deposit stickiness and pricing power in rural markets that larger competitors cannot profitably serve.

• Digital Transformation Lag Creates Vulnerability: While the bank has invested in data processing and digital banking, its limited technology capabilities relative to regional peers like SouthState and United Community Banks expose it to fintech disruption and higher customer acquisition costs, particularly among younger demographics.

• CDFI Certification Represents Binary Outcome: The bank's pending CDFI recertification by December 31, 2025, offers potential access to $82.9 million in low-cost ECIP capital and federal funding programs, but a recent Executive Order limiting CDFI Fund operations introduces uncertainty that could materially impact future growth initiatives.

Setting the Scene: The Community Bank in a Digital Age

Security Federal Corporation, founded in 1922 and headquartered in Aiken, South Carolina, operates a classic community banking model that has survived a century of economic cycles. The company functions as a single operating segment, aggregating its banking divisions and subsidiaries under one strategic umbrella. This structure reflects a deliberate choice to maintain local decision-making authority rather than pursuing the diversified business lines that characterize larger regional banks. Through its wholly-owned subsidiary Security Federal Bank, the company accepts deposits and originates loans to individuals and small businesses across South Carolina and Georgia. Two additional subsidiaries—Security Federal Investments, which manages the securities portfolio, and Security Federal Insurance, which offers auto, home, and business insurance—provide limited but meaningful diversification beyond traditional banking spreads.

The Southeast regional banking landscape presents a classic barbell structure. At one end, mega-cap banks like Bank of America (BAC) and Wells Fargo (WFC) leverage national scale and digital platforms to capture mass-market consumers. At the other, fintechs such as Chime and SoFi (SOFI) offer frictionless digital experiences that appeal to younger, tech-savvy customers. In the middle, regional players like SouthState Corporation with $65 billion in assets and United Community Banks with $27 billion in assets dominate metropolitan markets like Augusta and Columbia through dense branch networks and sophisticated treasury management services. Security Federal, with $1.61 billion in assets and 19 branches, occupies a distinct niche: serving rural communities and small towns where relationship banking still matters, but where scale disadvantages become increasingly pronounced.

The bank's recent strategic moves reveal management's awareness of these constraints. In May 2022, Security Federal accepted $82.9 million in preferred stock from the Treasury's Emergency Capital Investment Program (ECIP), treating it as Tier 1 capital to support lending in underserved communities. This injection provided crucial growth capital without diluting common shareholders. More recently, the bank purchased a multi-tenant property in Q1 2025 for a future full-service branch, signaling confidence in physical expansion despite industry-wide branch consolidation. Simultaneously, management has actively managed liquidity—repaying $50 million in FRB borrowings by September 2025 and redeeming $16.5 million in 10-year notes in November 2024—demonstrating disciplined balance sheet optimization in a shifting rate environment.

Technology, Products, and Strategic Differentiation

Security Federal's competitive positioning rests not on proprietary technology but on integrated service delivery and local market penetration. The bank's insurance agency subsidiary generates $643,000 in quarterly commissions, representing roughly 8% of non-interest income. While immaterial in absolute dollars, this cross-selling capability creates customer stickiness that pure-play banks cannot replicate. When a small business owner obtains both a commercial real estate loan and property insurance from the same local banker, switching costs increase meaningfully. This integration supports deposit retention and provides a modest pricing advantage on loan originations, as bundled relationships command premium pricing in tight-knit communities.

The trust division, generating $1.4 million in quarterly income, serves a similar function. In rural markets where wealth management options are limited, Security Federal's trust services capture high-net-worth depositors who might otherwise migrate to regional competitors. These relationships tend to be multi-generational, providing stable core deposits that fund loan growth without reliance on rate-sensitive certificates of deposit. However, this advantage has limits. The bank's digital banking capabilities, while functional, lag materially behind peers. Data processing expenses rose 18.1% in the first nine months of 2025, reflecting expanded digital services and vendor cost increases, yet the bank still lacks the mobile-first platforms that attract younger customers. This technological gap creates a demographic headwind, as checking account balances declined in 2025 while customers sought higher-yield alternatives elsewhere.

The branch network itself represents a double-edged sword. Nineteen locations in underserved areas provide regulatory licenses and physical presence that deter new entrants, but they also burden the bank with fixed costs that digital-native competitors avoid. Occupancy and equipment expenses increased in 2025 due to branch improvements, while larger peers like SouthState leverage scale to spread similar costs across 250+ locations. Security Federal's strategy of maintaining full-service branches in small towns like Ridge Spring, South Carolina, preserves market share but constrains efficiency, as evidenced by its operating margin of 31.7% versus SouthState's 54.7%.

Financial Performance & Segment Dynamics: Evidence of a Working Model

Security Federal's third-quarter results provide compelling evidence that its relationship banking model remains viable despite scale disadvantages. Net income available to common shareholders surged 59.1% to $3.2 million, or $1.01 per share, driven by a $1.7 million increase in net interest income and a $585,000 reversal in credit loss provisions. The net interest margin expanded 30 basis points to 3.17%, a meaningful improvement in a competitive deposit market. This margin expansion resulted from two factors: an 18 basis point rise in loan yields as adjustable-rate mortgages repriced higher, and a significant reduction in funding costs after repaying FRB borrowings. The bank's decision to eliminate $50 million in discount window debt by September 2025, funded by excess liquidity, reduced interest expense on borrowings by $2.9 million year-over-year.

Loan growth of 10.3% year-over-year demonstrates successful origination in a competitive market. The average loan portfolio increased $36.1 million while yields improved 28 basis points, showing the bank's ability to originate new business at market rates without sacrificing credit quality. Commercial real estate and consumer HELOCs drove this expansion, offsetting declines in construction lending where larger competitors like Ameris Bancorp and Synovus have greater risk appetite. The loan portfolio's performance validates the bank's conservative underwriting approach: past-due balances fell to 1.0% of total loans from 1.8% at year-end, with no modified troubled debt restructurings in either 2024 or 2025.

The securities portfolio tells a different story. Available-for-sale securities grew 28.3% to $674.3 million as management reinvested maturing held-to-maturity securities into higher-yielding instruments, capitalizing on a favorable rate environment. This shift increased interest income from securities but also introduced mark-to-market risk, with unrealized losses reflecting rate volatility rather than credit impairment. The bank's stated intent to hold these securities to maturity mitigates immediate earnings impact, but it limits flexibility to redeploy capital into higher-yielding loans. This trade-off—choosing securities yield over loan growth—reveals the bank's cautious posture in an uncertain economic environment.

Non-interest income grew a modest 3.7% to $7.7 million. Rental income on the newly purchased multi-tenant property contributed $365,000, and a $62,000 land sale gain further supplemented income, demonstrating management's willingness to deploy capital into non-banking assets to supplement spread income. Service fees and insurance commissions remained flat, suggesting limited pricing power in transactional services where digital competitors offer lower-cost alternatives.

Expense control remains a challenge. Compensation and benefits rose 12.1% in the quarter, reflecting higher staffing levels to support growth and regulatory compliance. Debit card expenses jumped 24.4% due to increased transaction volumes and network fees, while data processing costs rose 18.1% as the bank expanded digital capabilities. These increases outpaced revenue growth, indicating that scale inefficiencies persist. SouthState's operating margin of 54.7% and Ameris Bancorp's 48.3% demonstrate the cost advantages that size confers, making Security Federal's 31.7% margin a structural handicap rather than a temporary condition.

Outlook, Management Guidance, and Execution Risk

Management's commentary suggests confidence in the bank's trajectory while acknowledging competitive pressures. The company repurchased 60,898 shares for $1.9 million in Q3 2025, leaving 63,143 shares available under its existing program. This buyback, combined with a maintained quarterly dividend of $0.15 per share, signals that capital returns remain a priority. However, the modest repurchase pace relative to the bank's $98.7 million market capitalization indicates capital preservation concerns, particularly given the $82.9 million in outstanding ECIP preferred stock that carries dividend obligations.

The bank's liquidity position appears robust. With no outstanding FRB borrowings, a $467.5 million unused capacity at the Federal Home Loan Bank, and a $50 million Fed Funds facility, Security Federal has multiple funding sources to support loan growth. Management stated that current liquidity and forecasted operating results are sufficient to fund all existing commitments, suggesting no immediate need for external capital. This flexibility provides a buffer against deposit outflows, though the 24.5% of uninsured deposits represents a potential vulnerability in a confidence crisis.

The most significant near-term catalyst is CDFI recertification. The December 31, 2025 deadline requires the bank to demonstrate community development impact to maintain access to ECIP capital and potential CDFI Fund grants. While the $82.9 million in preferred stock provides a stable capital base, the recent Executive Order directing the CDFI Fund to limit operations introduces policy risk. If certification is denied or funding curtailed, the bank would lose a key strategic advantage in serving low-income communities, potentially impairing its growth narrative in those markets. Management is evaluating revised application requirements but has not provided guidance on the likelihood of success.

Strategic investments in technology and branch expansion will likely continue pressuring expenses. The multi-tenant property purchase indicates physical expansion plans, while rising data processing costs reflect necessary digital upgrades. These investments are essential to compete with regional peers who have already deployed advanced mobile banking and treasury management platforms. The question is whether Security Federal can achieve sufficient customer adoption to justify the expense, given its older demographic base and rural market focus.

Risks and Asymmetries: What Could Break the Thesis

The investment thesis faces three primary threats that could materially impair earnings power. First, scale disadvantages create a permanent cost structure gap. The bank's 0.80% ROA and 6.74% ROE compare unfavorably to SouthState's 1.24% ROA and 9.32% ROE, and Synovus's 1.33% ROA and 14.23% ROE. This gap reflects not operational inefficiency but structural reality: spreading compliance, technology, and overhead costs across $1.6 billion in assets versus $60 billion at Synovus creates a 15-20 basis point drag on net interest margin that cannot be eliminated through better management alone. If larger competitors aggressively price loans and deposits in Security Federal's markets, the bank must either accept lower margins or lose market share, creating a no-win scenario.

Second, digital transformation failure poses existential risk. The 18.1% increase in data processing expenses shows management is investing, but the bank's modest scale limits its ability to build best-in-class digital experiences. Fintechs and national banks offer mobile deposit, instant payments, and integrated financial planning that attract younger customers. If Security Federal cannot match these capabilities, its deposit base will age and shrink as wealth transfers to digital-native generations. The 3.1% deposit growth in 2025, driven entirely by higher-cost CDs and money market accounts while checking accounts declined, already signals this pressure. A continued shift toward rate-sensitive funding would compress margins and increase liquidity risk.

Third, geographic concentration amplifies credit risk. With operations focused on South Carolina and Georgia, a regional economic downturn or natural disaster could devastate loan quality in ways diversified peers could absorb. The bank's conservative underwriting has kept past-due loans low, but a severe recession in the Southeast would test this approach more severely than at regionally diversified banks. The $154.5 million in unused commitments represents additional exposure that could materialize as losses in a downturn.

On the positive side, successful CDFI recertification would unlock significant value. Access to additional ECIP capital at discounted rates, potential New Markets Tax Credits , and enhanced federal funding could accelerate loan growth in underserved communities while improving the bank's cost of capital. If management can leverage these programs effectively, ROE could improve 200-300 basis points, justifying a valuation re-rating toward peer levels. The bank's strong capital position (CET1 ratio of 18.70% versus regulatory minimum of 7.00%) provides ample capacity to absorb losses and fund growth if opportunities arise.

Valuation Context: Discounted for Scale

At $31.60 per share, Security Federal trades at 9.0 times trailing earnings, 0.88 times book value, and 8.62 times free cash flow. These multiples represent a significant discount to regional peers. SouthState Corporation (SSB) commands 13.2 times earnings and 1.08 times book, United Community Banks (UCBI) trades at 12.5 times earnings and 1.10 times book, and Ameris Bancorp (ABCB) fetches 13.5 times earnings and 1.33 times book. Only Synovus (SNV), at 9.8 times earnings, approaches Security Federal's valuation, and Synovus's pending merger with Pinnacle Financial (PNFP) suggests its discount reflects integration risk rather than structural issues.

The valuation gap reflects the market's assessment of Security Federal's growth prospects and profitability constraints. The bank's 1.90% dividend yield, while respectable, trails SouthState's 2.50% yield, indicating lower payout capacity. More telling, the bank's return on assets of 0.80% sits well below the 1.24% to 1.49% range of its regional competitors, suggesting each dollar of assets generates materially less profit. This efficiency deficit justifies a lower price-to-book multiple, as book value growth will be slower.

Free cash flow generation provides a brighter picture. The bank generated $25.7 million in free cash flow over the trailing twelve months, representing a 26% free cash flow margin. At 8.62 times free cash flow, the stock trades in line with slower-growing regional peers, suggesting the market recognizes the bank's cash-generating ability even as it discounts earnings quality. The modest share repurchase activity—$1.9 million in Q3—indicates management believes capital is better deployed in the business than in retiring shares at current valuations.

The $82.9 million in ECIP preferred stock, while treated as Tier 1 capital, carries dividend obligations that reduce income available to common shareholders. Management has the option to repurchase this stock at a significant discount to face value based on current market conditions, which would be accretive to earnings per share. However, doing so would consume liquidity that might otherwise fund loan growth, creating a capital allocation dilemma that larger peers with excess capital do not face.

Conclusion: A Stable Franchise at a Fair Price

Security Federal Corporation represents a well-managed community bank that has successfully navigated recent rate volatility while maintaining pristine credit quality and strong capital ratios. The 59% earnings growth in Q3 and margin expansion to 3.17% demonstrate that its relationship banking model remains viable, while the elimination of FRB borrowings shows disciplined balance sheet management. The bank's deep local roots, integrated insurance and trust services, and CDFI-eligible focus provide defensive moats that protect market share in its core rural markets.

However, the valuation discount to regional peers appropriately reflects structural headwinds. Scale disadvantages create a permanent cost gap that technology investments alone cannot close, while geographic concentration and an aging deposit base limit growth options. The bank's sub-1% ROA and mid-single-digit ROE trail industry benchmarks, suggesting that even efficient execution cannot overcome the profitability constraints of a sub-$2 billion asset base.

For investors, the thesis hinges on two variables: successful CDFI recertification to unlock low-cost growth capital, and the bank's ability to accelerate digital adoption without eroding its cost structure. If management can execute on these fronts, the stock's discount to book value and peer multiples could narrow, generating 15-20% upside. If CDFI funding is curtailed or digital transformation stalls, the bank will likely continue generating steady but uninspiring returns, making it a bond-proxy rather than a growth investment. The current valuation appears fair, pricing in the bank's stability while acknowledging its limitations in an increasingly scale-driven industry.