Bank OZK Should Reverse Some Recent Underperformance As Loan Growth Accelerates

Given the prospect for numerous rate hikes over the next two years, not to mention improving loan growth, the over growth prospects for banks are looking better than they have in some time. Keys for this next part of the cycle will be the ability to grow loans, manage costs, and keep deposit costs low, and I think Bank OZK (NASDAQ:OZK) is well-placed to achieve two of the three, making it an above-average prospect at this point.

When I last wrote about Bank OZK a year or so ago, I thought the bank’s near-term prospects were more modest than for other banks I preferred at the time, and the shares have modestly underperformed since then. At this phase of the cycle, though, I’m more bullish on Bank OZK, and I think this is a name worth considering again.

 

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Bank OZK Should Reverse Some Recent Underperformance As Loan Growth Accelerates

Bank OZK Proving Out Its Credit Quality, But Loan Growth Concerns Loom

Wall Street is an “it’s always something” kind of place, and I wouldn’t expect sell-side analysts who were bearish on Bank OZK (OZK) to simply abandon that position just because the credit story is shaping up far better than the bear-case scenarios bandied about in mid-2020. Given where we’re at in terms of the pandemic and the impact it has had (is having, and will have) on real estate categories like hospitality and offices, it is fair to wonder whether loan growth will be the next focus of more bearish theses.

With these shares up more than 60% from when I last wrote about them, making Bank OZK a relative stand-out, I certainly don’t see the upside I once did. Credit is holding up better than I expected (I wasn’t bearish, but I was cautious), and that helps future earnings growth, but I think a near-term fair value around $40 with longer-term annualized total return potential close to 10% is a reasonable assessment of the opportunity here. I would note, though, that Bank OZK has meaningful under-used capital, and effectively deploying that could meaningfully improve the outlook.

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Bank OZK Proving Out Its Credit Quality, But Loan Growth Concerns Loom

In An Odd Twist, The Market Seems Relatively Calmer About Bank OZK's Credit Situation

I was positive on Bank OZK (OZK) after its last quarterly earnings report, my thinking being that the Street was letting its worst-case scenario thinking get a little too far in front of Bank OZK’s demonstrated historical underwriting excellence. Yes, every cycle is different, but not many banks change as dramatically as the valuation implied with Bank OZK.

Since then, the shares are down about 25%, which is hardly a performance to celebrate, but the stock has outperformed its peer group by about 10%, with most of that coming since earnings. In an odd twist, it seems like the Street is more comfortable with OZK’s reserving assumptions than with other banks. While these shares do still offer an attractive long-term prospective return, there are other banks with even more upside potential and more traditional risk exposures (i.e., not so much concentration in construction and CRE lending).

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In An Odd Twist, The Market Seems Relatively Calmer About Bank OZK's Credit Situation

Bank OZK Beats, But Investors Are Focusing On Any Sign Of Credit Issues

I’ve been cautious on Bank OZK (OZK) for a while now, and I don’t feel as though I’ve missed much – the shares are down about 10% since my January 2019 article on the stock and up less than 2% since my last article – lagging the broader bank sector by about 10% and 3%, respectively, to say nothing of banks I’ve preferred like First Horizon (FHN). I believe there are multiple issues weighing on Bank OZK – a slowing non-residential construction market, growing competition from nontraditional lenders, adverse asset/liability betas, and concern over credit quality.

I’m more and more interested in the valuation opportunity, though, and the risk-adjusted return potential. Credit losses are certainly an ongoing risk, and given Bank OZK’s willingness to write larger loans, the headline risk is not small. Still, the bank should be able to more than handle some losses, and I think a lot of the rate/NIM risk is already in place. If mid-single-digit core earnings growth is still a valid long-term expectation, I believe these shares are starting to show some real appeal.

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Bank OZK Beats, But Investors Are Focusing On Any Sign Of Credit Issues

Lower Rates Taking A Bite Out Of Bank OZK

Although I thought Bank OZK (OZK) looked undervalued a quarter ago, I also thought that the weak short-term outlook, driven by spread compression risk, was likely to weigh on the shares. And so it has been, with the shares down another 7% and underperforming the broader regional bank group over the last three months.

Credit quality remains very good, but spread compression was worse than the Street (and I) expected, and although I think Bank OZK has some underappreciated opportunities to offset spread compression, I do worry that just as deposit betas didn't rise as far/as quickly as expected in the up-cycle (leading to better NIMs), the reverse might be true in this part of the cycle (leading to worse NIMs). I do think expectations are quite low now and I think there is appealing long-term upside here, if, and this is a VERY big if, credit quality stays strong.

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Lower Rates Taking A Bite Out Of Bank OZK

Winter Is Coming For Banks, But Bank OZK May Have A Trick Or Two Left

I’ve been fairly bearish on Bank OZK (OZK) for some time, as I thought the bank’s heavy exposure to variable-rate construction and CRE lending was the wrong mix for this point in the cycle. With the shares down another 8% since my last update and down about 30% over the past year, that thesis has largely been playing out, and over the past quarter new concerns about spread compression have built up.

Oddly enough, I think Bank OZK may be better-positioned to resist spread compression than many investors might think. A high loan/deposit ratio (though far from the worst) and high-beta asset book are risk factors, but Bank OZK’s high-cost deposit base actually may give the bank more maneuvering room than banks like Commerce Bancshares (CBSH), Comerica (CMA), and M&T Bank (MTB) with low-cost deposit bases that probably can’t/won’t go too much lower.

I’m a little concerned there’s a future shoe to drop with respect to credit, but Bank OZK’s strong underwriting history should earn management more of a benefit of the doubt than they’re getting. Likewise, loan growth may not be spectacular in the near term, but management is working hard to diversify the loan business. I’m still worried about sentiment over the next couple of quarters, but the valuation is getting harder to ignore, and more patient (or aggressive) contrarian investors may want to sharpen up their due diligence.

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Winter Is Coming For Banks, But Bank OZK May Have A Trick Or Two Left

A 'Boring' Quarter At Bank OZK Is Just Fine

Bank OZK (OZK) has had a rough 12-24 months relative to the “average” bank stock, as investors have grown increasingly worried about OZK’s heavy exposure to riskier construction lending, and particularly in markets like New York City and Miami, as well as its high beta funding structure. While the shares have continued to underperform over the last three months, operating performance has at least settled down.

If a significant recession is right around the corner (or just a rough period in commercial real estate), Bank OZK will have problems – the bank’s underwriting has always been sound, but it’s tough to thrive if and when your neighborhood is on fire. If the bank can navigate this cycle without significant losses and maintain a long-term core earnings growth rate in the high-single digits, though, the valuation on these shares is pretty interesting today.

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A 'Boring' Quarter At Bank OZK Is Just Fine

Bank OZK Looking For A Little Stability In 2019

It’s been a wild ride for Bank OZK (OZK) (formerly Bank of the Ozarks), as this CRE and construction lending specialist has seen two quarters were almost everything went wrong (the third quarter) and then almost everything went right (the fourth quarter). The exceptionally strong fourth quarter results, and the quick about-face on the Street the sent the shares shooting higher, has largely closed the gap created by the third quarter sell-off, but the shares have still significantly lagged the major regional bank indices over the last six and 12 months.

Looking into 2019, Bank OZK’s heavy exposure to riskier lending (construction and commercial real estate, focused on NYC and Miami) and higher deposit beta will likely lead to higher volatility, but management has taken noticeable steps to diversify the portfolio and improve its deposit-gathering. I do still have worries about Bank OZK’s overweighted exposure to some overheated real estate markets, but in the low $30’s, it’s hard not to like the valuation for long-term holders provided there isn’t a bad recession on the way.

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Bank OZK Looking For A Little Stability In 2019

Quality And Conservatism At People's United Comes At A Cost

There’s a lot to like about People’s United Financial (PBCT). A leading bank in New England (#4 in deposit share), People’s United services a client base with well above-average household income and has maintained excellent full-cycle credit quality versus its peers. The bank has also had solid success in expanding its lending franchise into the New York and Boston metro markets and has produced some good long-term C&I loan growth numbers. I’d also note that the bank pays a fairly attractive dividend and operates with a conservative financial structure.

There are also things that aren’t so good about People’s United, though, including the company’s persistent below-peer profitability and more limited growth prospects. Loan growth is looking more challenging in 2018 and the bank’s asset sensitivity may not be worth as much if we’re closer to the end of the rate cycle. People’s United has long underperformed regional banks as a group, and while I do see some value here, this is a tougher call given the more diminished growth prospects that I see.

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Quality And Conservatism At People's United Comes At A Cost

Exceptional Rate Leverage Continues To Drive Comerica

With one of the strongest net betas (loan beta minus deposit beta) in the banking sector, Comerica (CMA) has continued to outperform, with the shares beating regional peers over the last year and on a year-to-date basis, though lagging more recently. Although Comerica isn’t posting particularly strong loan growth, that’s actually not such a bad thing right now, as loan growth isn’t really what the market is prioritizing or valuing (EPS revisions/growth are stronger drivers at the moment).

Comerica continues to look like a good name to consider for investors who want to play above-average near-term earnings growth, but aren’t as worried about valuation relative to long-term benchmarks. Rising deposit costs do remain a worry, but between regulatory relief, spread leverage, operating leverage, and perhaps some M&A options, Comerica still offers a lot of what the Street currently wants in a bank stock.

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Exceptional Rate Leverage Continues To Drive Comerica

Bank Of The Ozarks Squeezed By Growing Commercial Real Estate Concerns

I've been concerned about the heavy weighting of some banks toward commercial real estate and construction lending given where we are in the CRE cycle. Apparently, I'm not the only one, as more than a few banks with high ratios of commercial real estate loans to capital have underperformed their regional banking peers so far this year.

This brings me to Bank of the Ozarks (OZRK-OLD) (soon to be "Bank OZK" (NASDAQ:OZK)); this isn't the first time I've been concerned about the combination of OZRK's aggressive construction/CRE lending growth, its aggressive expansion into new markets, and its funding situation, not to mention its valuation, but it does seem like the market is now paying closer attention. The shares do now look undervalued if double-digit long-term growth remains a reasonable expectation, but investors should note the elevated risks that accompany that undervaluation.

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Bank Of The Ozarks Squeezed By Growing Commercial Real Estate Concerns