First Republic Paying A Steep Cost For Growth

Using pullbacks to pick up shares of well-run companies is usually a good strategy over the long term, but it has absolutely not been working with First Republic Bank (NYSE:FRC) here of late. This bank is choosing to prioritize long-term growth over short-term profits, steering into rapidly-rising funding costs to continue acquiring customers and grow the loan book. While I believe this will prove to be a sound decision over the long term, it has hammered the near-term earnings prospects and valuation.

The shares have fallen another 25% since my last update (and over 40% since I flipped from neutral to positive in mid-2021), dramatically underperforming its peer group. I've underestimated just how willing this bank would be to pay the short-term costs for long-term growth, but I do still believe in the longer-term story here. I think the shares remain undervalued, but I could see sentiment and near-term earnings pressure weighing on the stock at least through mid-2023, given where we are in the rate cycle.

 

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First Republic Paying A Steep Cost For Growth

First Republic's Strong Execution Shows Its Premium Is Not Just About Growth

Higher premiums typically mean higher expectations, and those expectations aren’t always just about pure growth. First Republic’s (FRC) third quarter growth wasn’t amazing (PPOP up about 6% yoy), but the extent to which the bank’s management did much better than expected in offsetting spread pressure is noteworthy to me and makes me feel better about paying more for these shares.

When I last wrote about First Republic, I thought there would be an opportunity to buy shares at a better price, and the stock did drop below $90 (briefly) about a month later. Even with the better performance shown this quarter, I’m not that comfortable paying more than $100/share for First Republic, and I’d prefer to wait in the hopes of getting another chance below $95, though I fully accept the risk that I might not get that chance.

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First Republic's Strong Execution Shows Its Premium Is Not Just About Growth

First Republic Facing A Tighter Squeeze On Spreads

Private banking-focused First Republic (FRC) remains one of the best bank growth stories in its size bracket, but even high-quality growth stories aren’t immune to cyclical pressures. While First Republic is confident that they can maintain mid-teens loan growth, higher competition for loans is limiting yields while deposit costs continue to rise, and expected rate cuts aren’t likely to help the situation. On top of that, the departure of a significant wealth management team is yet another reminder that companies don’t grow in smooth, uninterpreted arcs very often.

I’m concerned that First Republic management is underestimating the impact of spread pressure in the second half of the year, and I think the company’s model limits their ability to offset these challenges with further expense reductions. Although I think the current valuation is still high relative to the risks of a couple more miss-and-lower quarters, I’d keep this name on a watchlist.

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First Republic Facing A Tighter Squeeze On Spreads

First Republic: Okay Quarter, But Valuation And Conditions Are More Demanding

Benchmarking companies and stocks against peers is a time-tested strategy, but what do you do when a company doesn’t really have many true peers? That’s one of the challenges with First Republic (FRC) and its differentiated high-service model focused on providing banking and wealth management services to high net-worth individuals and select lending clients like equity investors, non-profits, and schools. While “it’s different this time” are some of the most dangerous words in investing, it is a relevant to First Republic at least insofar as this model really is different.

These shares have modestly outperformed regional bank indices since my last write-up (when I thought the shares offered a relatively rare entry point at a reasonable price). I don’t think the shares are expensive now, per se, but I do think the valuation is fair and I think First Republic faces some increasing near-term headwinds that could dampen growth and raise a few more pointed questions about how much of a premium the shares really deserve.

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First Republic: Okay Quarter, But Valuation And Conditions Are More Demanding

Strong Growth In Niche Commercial Lending Taking PacWest Into 2019

Loan growth has been relatively disappointing across the banking sector during this rate cycle, but several banks have reported improving momentum in the fourth quarter, and with better than 20% growth in originations in the fourth quarter, I’d say PacWest (PACW) certainly qualifies. Rising deposit costs are going to be an issue in 2019, but PacWest’s low expense ratio and niche commercial lending franchises should offer some cover.

The attempted acquisition of El Dorado Savings didn’t work out, but I fully expect this highly acquisitive bank to remain on the hunt for opportunities to grow its core deposit base and/or expand its footprint beyond its Southern California base. PacWest isn’t wildly undervalued, but I like the risk/reward/quality combination and the company’s position in niche commercial lending.

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Strong Growth In Niche Commercial Lending Taking PacWest Into 2019

Encouraging, If Choppy, Progress At Umpqua

Orgeon’s Umpqua Holdings (UMPQ) has generally been well-liked by investors, which has often meant a less-appealing valuation compared to many peers. Between that popularity, a less asset-sensitive balance sheet than many peers, and general optimism on the company’s efficiency initiative, the shares really haven’t lagged its regional banking peers all that much over the last six or 12 months.

Looking at fourth quarter results, Umpqua seems to be going into 2019 with some decent momentum and attractive prospects for spread improvement on delayed repricings, as well as further cost-reduction benefits from the NextGen process. Although I believe Umpqua is undervalued on both a long-term earnings basis (assuming high single-digit growth) and near-term ROTE, the degree of undervaluation is less than for many banks in its peer group.

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Encouraging, If Choppy, Progress At Umpqua

Continued Excellence Driving First Republic, And The Valuation Is Reasonable

First Republic’s (FRC) high-quality growth continues to be recognized by the Street; the shares noticeably outperformed the major regional banking indices in 2018 (by around 20%). Even so, the minimal share price appreciation has allowed the underlying quality of the business to catch up a bit with the valuation, and I think the risk/reward balance is more attractive now early in 2019.

First Republic continues to generate exceptional loan growth, and I think the quality of the franchise – focusing on high net worth individuals, and what I’d call “high potential” younger clients, and a strong focus on customer service – can take the bank further. While a full-blown recession would certainly be a risk factor from here (and credit costs almost have to increase from here), I think this is an opportunity to buy into an attractive business at a reasonable valuation.

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Continued Excellence Driving First Republic, And The Valuation Is Reasonable

First Republic Putting Some Worries To Rest

There aren’t many truly unique business models in banking, but First Republic (FRC) comes pretty close. Specializing in high net worth (or NHW) clients, First Republic combines a “regular” bank focused largely on jumbo mortgages with a fast-growing business bank focused on private equity, venture capital, and non-profit organizations (including private schools) and a fast-growing asset and wealth management business. First Republic is consistent across its businesses in using a “high-touch” service model that prioritizes outstanding customer service, and the concentration of HNW households means that First Republic doesn’t need many branches to operate its business.

The only downside is that First Republic’s qualities are well-known on the Street. Second-quarter results were pretty solid across the board, but the shares already price in mid-teens long-term earnings growth and meaningful improvements in returns on capital. Accordingly, while this is definitely a name I’d look to reconsider on a pullback, the risk/reward balance doesn’t look so interesting to me now.

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First Republic Putting Some Worries To Rest

With Weak Asset Beta And Rising Deposit Beta, Signature Bank Must Drive Loan Growth

Deposit beta is getting more and more attention these days with bank stocks, but asset betas are also important, and in the case of Signature Bank (SBNY), I’m worried about the company’s net-negative leverage to further rate increases. With little-to-no juice on the NIM line and no real fee income-generating business to speak of, Signature Bank’s growth is tied to its ability to grow the loan book. Luckily for investors, there are a lot of small(ish) privately-owned businesses that feel underserved by larger banks, and Signature is taking its show on the road and looking to open private banking offices on the West Coast.

Signature Bank is a different sort of bank, but there’s only so far “different” goes in terms of valuation. I’d pay a little more for a bank that is likely to earn 14% ROTCE in 2018 and generate double-digit earnings growth over the long term, but I worry that Signature may remain out of favor a little while longer as taxi medallion credit issues and asset sensitivity weigh on sentiment.

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With Weak Asset Beta And Rising Deposit Beta, Signature Bank Must Drive Loan Growth

Investopedia: First Republic Looks To Be A Very Different Kind Of Bank

Costs have become something of a grand obsession with commercial banks recently, as regulatory changes have cut off formerly lucrative revenue sources. First Republic (NYSE:FRC) is a different sort of bank, though. This bank focuses on growing its share of the lucrative high net worth (HNW) market, and it's using a "high-touch" model that has thus far generated solid high-quality growth.

Hunting the Elephants and Whales
Whereas other California banks like Wells Fargo (NYSE:WFC) and City National (NYSE:CYN) generally try to get as many depositors as they can with a minimum of expense, First Republic has targeted HNW individuals as its clientele. This has enabled the company to become the No.10 bank in California (by deposit share) and the No.26 bank in New York with only 56 deposit-taking branches in eight cities.

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http://www.investopedia.com/stock-analysis/2013/First-Republic-Looks-To-Be-A-Very-Different-Kind-Of-Bank-FRC-WFC-CYN-USB0111.aspx

Investopedia: Bank Of The Ozarks Making The Best Of Things

No bank has gone through the housing crash and credit crisis totally unscathed, but it clearly has not harmed all banks to the same degree. Although government-mandated changes to key aspects of the banking industry like capital requirements, lending standards and fee income will alter the profitability of banks going forward, some banks have been able to use the crisis to expand and gather assets. (To read more about how banking has changed, see The Evolution Of Banking.)

Bank of the Ozarks (Nasdaq:OZRK) was a very interesting small-cap bank before the crisis, but a combination of savvy management and FDIC-assisted acquisitions have left the company in good shape for the coming years.

Solid-Looking Numbers for Q1
Bank of the Ozarks has profited from the oxymoronic policy of aggressive conservatism. That in turn has led to unusually low credit losses and non-performing assets, as well as surprisingly high net interest margin. At the same time, it is hard to ignore that the bank's performance has been boosted by the contributions of acquired businesses.

For the first quarter, OZRK saw fully-taxed net interest income rise about 33% on an annual basis (to $36.1 million). On that basis, net interest margin rose to 5.61% from 4.99% - a level that is well above the norm and even high-end performers like Westamerica Bancorp (Nasdaq:WABC), BankUnited (NYSE:BKU) and First Republic Bank (NYSE:FRU).


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http://stocks.investopedia.com/stock-analysis/2011/Bank-Of-The-Ozarks-Making-The-Best-Of-Things-OZRK-RF-BXS-BAC-WABC0418.aspx