South State Bank: Not Cheap On The Multiples, But The GARP Case Is Interesting

Last year, two of my preferred smaller banks, South State Bank (SSB) and CenterState, got together in a merger of equals that combined two active acquirers with attractive footprints in growing Southeast U.S. markets into a much larger bank with an excellent growth footprint, a strong core deposit base, good fee-generating businesses, and a lot of options to deploy capital. While credit was a risk going into this down-cycle, the combined entity has acquitted itself well so far.

Valuation for South State isn't as straightforward as you might like. It's not cheap on conventional multiple-based approaches, and the growth expectations are not conservative. Still, given the opportunity to leverage a low-cost deposit base, outmaneuver larger rivals, squeeze out smaller sub-scale players, and deploy more capital toward M&A, I think South State could generate high single-digit to low double-digit core growth and drive double-digit annualized long-term total returns from here.

 

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South State Bank: Not Cheap On The Multiples, But The GARP Case Is Interesting

A Recent Rally Has Soaked Up South State Bank's Undervaluation As It Repositions

I was a little surprised to see South State Bank (SSB) outperform so well since my last article – up more than 25%, beating regional banks by about 5% overall and a more direct set of peers by about 10%. While I thought the shares were undervalued on a longer-term basis, the Street isn’t famous for taking a longer-term perspective, particularly when near-term earnings growth potential is more limited by the bank’s ongoing restructuring efforts. Still, with many large regional banks announcing plans to expand into the U.S. Southeast, and the bank close to the end of that repositioning process, I suspect this outperformance could be due in part to expectations that a regional bank may look to M&A to accelerate its expansion plans.

I do think South State could make an attractive buyout candidate; while the loan-to-deposit rate isn’t perfect, the bank has an attractive core deposit franchise in attractive growth markets like Charleston, SC, and Charlotte and Raleigh, NC. While a bank like U.S. Bancorp (USB) could offer as much as a 20% premium in a cash deal and still see some accretion, South State’s valuation isn’t exactly cheap on a stand-alone basis. Much as I like the long-term story at South State, with a lot of smaller banks offering 10%-20%-plus discounts to fair value today, it’s hard to call this a must-buy at this price.

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A Recent Rally Has Soaked Up South State Bank's Undervaluation As It Repositions

South State Bank Still Grinding Through Some Repositioning

“Ground and pound” may be effective, even necessary, as a strategy, but it’s not a lot of fun to watch, and I believe the sluggish near-term results (and expectations) for South State Bank (SSB) continue to explain this bank’s relative underperformance to broader bank indices, as well as regional peers/rivals like BB&T (BBT), Bank of America (BAC), First Citizens (FCNCA), SunTrust (STI), and Wells Fargo (WFC). Although loan growth has perked up a bit and deposit costs remain low, real earnings acceleration is probably more of a 2H’19 event and the shares aren’t comparatively all that cheap now.

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South State Bank Still Grinding Through Some Repositioning

South State Bank Should Be Near The End Of A Painful Reset

In a poor year for bank stocks, South State (SSB) stands out as an especially weak name, particularly since midyear as successive quarterly misses have led to double-digit downward revisions in earnings expectations for 2019 and 2020. Although South State had advised investors and analysts that there would be an adjustment process as it shifted the mix of loans and funding in its Park Sterling acquisition, the process has led to weaker than expected revenues, margins, and loan growth.

I significantly underestimated just how disruptive this transition would be to South State’s reported earnings, and the shift in sentiment away from banks due to rate and recession worries certainly made a tough situation worse. With South State highly likely to continue with M&A in the future, the challenges with the Park Sterling integration raise valid questions about how tumultuous future earnings may be after other buy-and-restructure deals. I do believe that the current share price undervalues a well-capitalized bank with strong share in some attractive growth markets, but between weak sector sentiment and company-specific investor concerns, it will take some time for this stock to claw its way back.

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South State Bank Should Be Near The End Of A Painful Reset

South State Bank Underperforming As It Digests Its Latest Deal

Whole bank acquisitions are a time-tested strategy for growth and value creation, but it takes time to realize the value and the shares of acquirers can underperform during the integration process. Such would seem to be the case with South State Bank (SSB), which has lagged the regional bank ETF so far this year and lagged most of its similarly-sized peers. Although there’s nothing fundamentally wrong with the bank, unpredictable expenses and weak loan growth during the integration process have led to lackluster reported results.

I still believe that South State’s acquisition of Park Sterling will look like a good move in the future, but it’s clear that the market isn’t inclined to show much patience as South State restructures the acquired loan book and the deposit base. I’ve trimmed back my fair value slightly on lower near-term earnings, but I continue to believe that South State can generate double-digit long-term earnings growth and that the shares should trade closer to $100.

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South State Bank Underperforming As It Digests Its Latest Deal

Carolina Financial Committed To Ambitious Growth

Unless you're a momentum investor, I'm not sure there's any U.S. bank stock left out there that looks like a good prospect. Frustrating as that may be, it doesn't mean that it's not a good time to do due diligence and build a prospective shopping list for when the inevitable pull-back comes. With that in mind, I think Carolina Financial (NASDAQ:CARO) is a small bank with big growth ambitions that is worth a closer look.

To be sure, ambition is no guarantee of success. Carolina Financial's deposit mix is not ideal (though it's not bad) and the company's growth plans are going to put it head-to-head with banks like BB&T (NYSE:BBT), Wells Fargo (NYSE:WFC), SunTrust (NYSE:STI), South State (NASDAQ:SSB), and Synovus (NYSE:SNV) when it comes to growing low-cost deposits and loans. Likewise, management's ambitious asset growth targets will require more M&A, a process that carries its own set of risks including overpayment and buying into problematic loan books.

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Carolina Financial Committed To Ambitious Growth

South State Bank Pairing Organic Growth With A Growing Focus On M&A

I'm confident that South State Bank (NASDAQ:SSB) is going to be a meaningfully larger bank in three to five years' time, and I'm reasonably confident that it will not compromise its quality to get there. While management already has a credible plan in place to drive above-average growth by organic means, they have also made it clear that M&A is going to continue to be a meaningful factor in the company's long-term growth plans.

South State is at an interesting point in its growth story. The bank is about to break through the $10 billion threshold in assets and that's going to increase its regulatory/compliance costs, but I expect additional deals in growth markets along the I-85 corridor and southeastern coast will be coming and will help offset some of those costs with further growth. While South State Bank doesn't look cheap today, it's closer to its fair value than most and this would be a name I'd watch in the hopes of taking advantage of an eventual normalization in bank valuations.

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South State Bank Pairing Organic Growth With A Growing Focus On M&A