Coastal Financial is a bank that has found a way to get pricing power.

A few months ago I asked a colleague about Coastal Financial (http://www.coastalbank.com), a community bank outside Seattle. The stock was rising but the company generated mediocre returns – what was the catch?

With some independent study and a few conversations closer to the business it became apparent Coastal was generating very strong returns under the surface. The issue was the company’s investment in its “Banking as a Service” (BaaS) platform. In other words, while the core banking business was generating elevated ROE, an annual investment in compliance and data management for BaaS was costing up to $6 million against little revenues and the combined ROE ended up a mediocre 8-11%.

Banking as a Service is the name woke bankers use for lending their balance sheet to apps getting into “banking”. Some of these apps / neobanks / challenger banks you may have heard of are Chime, Current, Rho, Aspiration, and MoneyLion. It is a perfect time for them to grow, because Bank of America et al generally want to get rid of deposits, and particularly small checking accounts.

Why invest so much in this business? There are two ways to answer:

  1. The numbers: Management believes BaaS ROA may be double that of traditional spread banking.
  2. The competitive backdrop: Banking is usually a price taking business – there are 20 different banks in a given major US metro area willing to compete for a quality $10 million commercial credit. BaaS is a price-making business – there are abut 20 BaaS banks in the entire country vs countless App Banks in development or growth mode looking to partner. BaaS is expensive to develop, labor intensive, and assumes risk – a trifecta of things most bankers want to avoid.

Those of you who know Colarion know we like to study the banking sector’s hundreds of overlooked but growing, high margin recurring revenue businesses. Spread lending is often a low multiple smokescreen. It shields the market from the money-printing taking place in payments, fintech, trust, loan brokerage, crypto custody, swaps or similar. While it has not (yet?) captured the market’s imagination in a way that Triump (TBK) or Silvergate (SI) have, Coastal is sailing in similar waters.

What’s the upside? “Aren’t the apps taking the wheat, leaving the banks with the chaff?”

Over the course of 2020, Coastal grew its fintech partners, the companies that share revenue in exchange for using Coastal’s banking license, from 5 to 15. It’s a reasonable assumption that Coastal will announce further grow with 1Q results on April 25. What’s unique about Coastal’s relationship with these partners is that Coastal negotiates not just shared debit card revenue but also spread revenue from partner loans and deposits. At the moment, there is a strong secondary market for many of these partner credits.

In other words, Coastal has built a data management company picking and choosing the partner loans and deposits it wishes to keep or sell. Second, unlike most banks it is not a slave to market demand – it is increasingly becoming a bank product clearinghouse.

CCB currently trades under 15x 2022 earnings estimates. Those (two) estimates are arguably conservative if the company’s BaaS business shows traction in 1Q/2Q results. In addition, as mentioned, if the company gets the perception of being a clearinghouse rather than a spread lender, comparisons could begin with “fintech banks” trading over 20x earnings.

This means that if CCB executes, it stands to generate multiple expansion on raised estimates.

It is worth noting that banks are still enough out of favor that the most innovative in the sector come at a lower multiple than the average consumer, healthcare or industrial member of the Russell 3000.

How do we learn more?

It’s not easy yet. The company’s BaaS line is currently a small portion of fee revenue, so discussions with those in the industry are helpful. The company has no conference call and its BaaS pipeline from 4Q is buried in the press release. If you are one of a handful of people who still reads 10Ks, the company’s disclosure appears more focused on keeping information from competitors than sharing with investors:

It’s hard to say if 1Q or 2Q will be the quarter when disclosure and perception evolve and the market re-evaluates Coastal. New customer growth may be irregular. What seems likely is that investors beyond the bank investor community will look more closely as 2021 progresses.

What about competitor TBBK’s multiple, the Google partnership, the yield curve / asset sensitivity, or whether Coastal will sell the legacy physical bank?

We can take up the company’s broad set of other opportunities in a different communication as I prefer to write simple posts rather than “subscribe to my substack” 20 minute reads. Feel free to drop me a line if you would like to discuss – as a regulated entity it’s appropriate we educate in public forums vs hand out price targets. The punchline is, do your own work and you may conclude Coastal is preferable to the broader market.