Banks with “cost save leap” potential

Centerstate Bank’s correspondent group recently published a recommendation that banks who wanted to confirm their independence should be running 50% efficiency ratios with a goal to reach 40% in the years to come, in part by cutting branches:

Taking this to heart, and joining the list of banks closing in aggregate 50-100 branches a month across the US, Northwest Bank in Pennsylvania last Friday announced a reduction of 20% (!) of its branch network: As you can see below they are joining a party that’s been going on for some time:

Branch closures are generally boring to investors because they are incremental – the stock of Northwest’s parent rose about 3% post event and the cost saves should run $13 million on a bank earning a bit over $100 million annually. They are boring but they are essential, because low cost wins over time if doing the commodity banking that so many banks do. It’s also a waste of money to run a $30-$40 million deposit branch when wholesale funding may be 25bp or less for the next 2-3 years. Finally, branch traffic tends to decline 1-3%+ each year (per FMSI and S&P) with that number accelerating dramatically now that Covid lockdowns forced millions to figure out how to work online technology.

The issue is some banks can close branches more easily and profitably than others. Beyond standard roadblocks such as lease terms, location and local demographics, the biggest variable is technology. While banks like PNC spend heavily to develop solutions in house, most smaller banks are dependent on the core processor oligopoly. (FIS, Jack Henry and Fiserv). These processors know they have the banks under contract and a 30% EBITDA margin to uphold so with this unfortunate incentive set, banks are notoriously frustrated with their responsiveness to technology initiatives. This podcast: provides more detail.

So how to get to 40% efficiency with a legacy network? Increasingly, providers will move to startup cloud-based processors or other means to get to “open API”, meaning the ability to easily bolt on software solutions to offset the “inconvenience” of a closed branch.

For example, Live Oak Bank likes to point out that they ran 1/3 more PPP loans than they would have otherwise because of the flexibility of a cloud platform. Live Oak only has one branch, but increasingly other banks are making the same conclusion. This is why we tend to focus on technology right behind credit and capital management when speaking to banks to determine long-term return potential.

Perhaps this is also why Live Oak, part owner of one such cloud processor, has outperformed its peer group by 50% this year:

Is your bank board willing to do the math?

One topic that typically comes up in recent bank management discussions is capital plans. A proactive and well thought out capital plan is among the best determinants of “management quality.”

Some banks have been increasing dividends. Some just hope to maintain dividends; some are issuing subordinated debt and some are repurchasing common stock.

Very few are issuing common stock, because common equity levels in US banks are the highest in the developed world, and should remain so after 3Q and 4Q increases in charge-offs at hospitality and retail etc.

But how do management teams optimize their capital in a changing backdrop? Many are lost. They need a helping hand, and here it is: if you are not issuing subordinated debt or preferred at 4-6% to get regulatory support, and using it to buy in stock at 9-15% earnings yield on forward estimates, you need to revisit your math.

It is very likely your bank has enough common equity. Regulators approve of sub debt as capital too, so use the system to your advantage. Sell the 5% capital and buy the 10% capital. Regulators will know their bases are covered assuming your risk exposure is at or better than industry average.

One other note – if you want to pay a 3-5%+ dividend, trade well under tangible book, and are not repurchasing, you are sending a message that the market has it right, you are worth under tangible book, and the company should, by extension, be liquidated. That’s what trading under tangible book value means – you are worth more being wound down than you are as a going concern. If you disagree on liquidation, you can buy the stock in, grow your tangible book per share, and engender shareholder goodwill assuming credit metrics are in check.

Do you love your bank as much as I do?

Many bank managements are surprisingly upbeat on the direction of credit. Given ample capital levels, forward thinking managements are beginning to repurchase deeply discounted shares.

Managing a bank is tough, because CEO’s have to be mindful of customers, employees, shareholders, regulators, and sometimes even politicians. JP Morgan CEO Jamie Dimon has stayed CEO for so long because he manages all these in balance, even giving a nod to the Democrat postal banking idea by offering to set up ATMs at post offices.

As of August 2020, however, many management teams are seeking the warm cocoon of regulators first, everyone else later. It seems right, but think in terms of Big 10 college football vs. SEC / ACC – sometimes you have to look forward to take calculated risks. Specifically, we want to own Alabama and LSU – banks taking advantage of cheap shares – and sell Ohio State – banks sitting on their hands waiting to buy more expensive stock later.

We see bank shares underperforming the broader markets while most bank management teams are quietly very optimistic. Directors prove this by having consistently purchasing bank shares since March, while more popular technology companies have been the source of a wave of selling (last week was a continuation of this trend, from below)

But while directors buy their own shares and give upbeat reports on credit (vs expectations), only a handful of banks have been buying shares back, despite massive accretion from purchasing at 7-9x 2022 earnings and less than tangible book. They would rather make loans at 4%, and avoid explaining their decisions to regulators.

But a few management teams have the guts to act on what they are seeing. Community banks in Texas, Georgia, and Wisconsin are a few we have found from recent months.

Let Apple buy back stock at a 3% earnings yield. Several small, forgotten banks are getting a 12% earnings yield + tangible book accretion buying back stock from forced and fatigued sellers. Many will be raising a trophy on 2021 earnings…