3.5 Reasons Why I Just Bought Bank OZK (And A Caveat) (NASDAQ:OZK)

Introduction

It has been more than a year since the fall of Silicon Valley Bank (OTC:SIVBQ) sparked fears of nationwide bank runs with the potential to jeopardize the stability of the nation’s financial backbone. However, to those who dared to take a closer look and weighed the reasons for the fall of SIVBQ against the quickly announced Bank Term Funding Program (BTFP), several very solid value opportunities presented themselves. Two examples that I started covering here on Seeking Alpha in March 2023 are Truist Financial Corp. (TFC) and U.S. Bancorp (USB).

There was a massive spike in “emergency” lending in late 2023 and going into 2024, but as I explained in this article, this was simply due to a likely unintended arbitrage opportunity. Borrowing under the BTFP is no longer possible, and other indicators (see e.g. this article) also suggest that the risks associated with the 2023 banking crisis are well contained.

However, concerns around commercial real estate (CRE) loans remain high, and I would say that the risk should not be underestimated, especially for smaller banks that are heavily involved in this sector. Assuming the market deteriorates further, a bank would have to reclassify such loans, which would weaken capital ratios. But even if the hit to the capital does not necessarily jeopardize the bank’s survival, the news could still cause depositors to lose confidence and exacerbate the problem by withdrawing their savings. This can be an extremely dangerous and self-reinforcing cycle.

Why OZK Is Not Your Typical CRE-Focused Bank

While I previously ruled out investing in banks with significant CRE exposure, there is one particular CRE-focused bank that, I think, has an extremely compelling risk/reward proposition: Bank OZK (NASDAQ:OZK)

In my view, it’s important not to lump OZK in with other banks with material CRE exposure. OZK began specializing in construction, land, and development loans in 2003 and has become one of the domestic market leaders in this area. The bank focuses on short-term loans and newly developed projects. This approach significantly limits the risks associated with duration (e.g. a changing market environment, evolving construction standards). In addition, loans are often granted for projects where the owner has a significant financial interest and therefore cannot easily exit, while OZK’s loans are naturally senior in the capital stack.

So in this article, let me explain the three (and a half) main reasons why I view Bank OZK as a highly compelling value investment, despite its sizable exposure to CRE.

As a side note, I will not address the issues surrounding the double downgrade by Citi analyst Gerlinger in this article. I have looked carefully at the available information and have come to the conclusion that the risks associated with the two loans mentioned in the report should not be over-interpreted. I believe the issues have been discussed adequately, so I politely refer readers to the comments below the news article on Seeking Alpha, the rebuttal released by OZK management shortly after the downgrade, and the CEO’s response to analyst Matt Olney’s question in the Q2 2024 earnings call Q&A. In addition, I’d like to highlight that the bank recently announced a $200 million share buyback (representing about 30% of 2023 net income) and increased its dividend for the 56th consecutive quarter on July 1 – if the loans were so risky, I would argue that Bank OZK would be doing everything it can to strengthen its capital ratios (its Common Equity Tier 1 ratio is hovering around 11% since Q4 2022) rather than returning cash to shareholders.

Reason 1: OZK Is Owner-Operated And Extremely Profitable

Bank OZK’s roots go back to the early 20th century. It operates mainly in Arkansas (75 branches), Georgia (67 branches), Florida (41 branches), North Carolina (24 branches), and Texas (22 branches). It also has a few lending offices in California, Mississippi and New York. The demographics in the states where OZK primarily operates are, in my view, rather favorable.

Bank OZK in its current form was taken over in 1979 by the current CEO and Chairman of the Board, George Gleason. I can only recommend listening to some of his appearances in videos or earnings calls. Gleason currently owns 6.94 million shares according to his last Form 4 filing, which is about 27% more than 3.5 years ago (5.46 million in January 2021). His stake represents 6.1% of OZK shares outstanding at the end of the second quarter of 2024 and is currently worth $289 million, a sum that I believe aligns him well with other shareholders.

That being said, Mr. Gleason’s growing ownership should not be interpreted as more or less regular open market purchases. I reviewed all of his form 4 filings since 2020 and did not notice a single purchase transaction during that period. So Mr. Gleason must have received these shares as part of his compensation package. At the same time, he has very rarely sold shares (apart from the required code F transactions). Since the beginning of 2020, I have only noticed two transactions – on March 3 and March 8, 2021 – in which Gleason sold 60,000 and 24,731 shares, respectively, for around $3.6 million.

Gleason took OZK (formerly known as Bank of the Ozarks) public in 1997, and the company’s performance under his leadership has been nothing short of spectacular (Figure 1). Over the past 27 years, OZK stock has returned nearly 7,000%, including dividends, compared to 890% for the mighty S&P 500 Index (SPY) (SP500). This corresponds to an annualized return of 16.7% compared to 8.9% for SPY.

Of course, one could argue that OZK’s best days are behind it, as evidenced by its effectively zero performance – but pronounced volatility – since early 2015. An investor who bought into OZK some ten years ago has seen a “return” of zero while watching their investment fall dramatically in 2018 and even further amid the COVID-19 pandemic in 2020. However, I argue that the poor performance of OZK shares over the last ten years is mainly due to a significant overvaluation at the time (Figure 2). For example, OZK shares were trading at a whopping 24 times adjusted earnings per share (EPS) in January 2016, compared to less than 7 times today (more on this later).

One main reason for the previously lofty valuation is OZK’s excellent profitability. But even today, OZK still has a lot going for it. Looking at the performance since Q1 2020, which was (and remains) arguably a challenging environment, I was pleasantly surprised by the average quarterly net interest margin (NIM) of 4.47% (Figure 3). In this environment of rising interest rates, most banks (with the exception of the largest G-SIBs) have to offer increasingly better deals on their deposits in order to remain competitive, which is putting pressure on profitability. For example, Truist and U.S. Bancorp reported a NIM of 3.03% and 2.67% respectively for Q2 2024.

Although OZK’s NIM has declined since the beginning of 2023, the bank is still earning a lot of money at 4.7%. In addition, the management of Bank OZK is tirelessly focusing on a lean cost structure. In 2022, when costs rose significantly at many banks, OZK continued to report a declining efficiency ratio, which currently stands at around 33%:

Taken together, it is no surprise that Bank OZK regularly achieves a strong and stable return on equity of 12% to 15% (Figure 5). The bank recognizes that it currently has around $660 million in goodwill and other intangible assets on its balance sheet (12% of total assets at the end of Q2 2024), so the return on tangible equity is slightly higher (16.1% for Q2 2024).

Reason 2: A Solid Deposit Structure, Good Loan Growth, And High Loan Quality

To come back to the net interest margin: Skeptical investors might argue that a high margin could merely be the result of a weak denominator, namely the bank’s earning assets. In the case of Bank OZK, however, I would argue that the foundation is very solid on both sides of the balance sheet.

Unlike many banks – even larger ones – that have seen a decline in deposits in the current environment, OZK has continued to see healthy growth due to its compelling offerings (Figure 6). Over the last 4.5 years, OZK’s total deposits have increased by more than 50% from under $19 billion to almost $30 billion.

Small banks do not benefit from the “too big to fail” argument, so the risk of depositors withdrawing their savings if there is significant negative news about the sector in general or the bank in particular must be taken into account. However, OZK’s deposit structure does not strike me as potentially unstable – quite the opposite. 66% of deposits at year-end 2023 were so small that they are insured, and a further 16% were collateralized (p. 67, 2023 10-K). Uninsured deposits amounted to around $9.3 billion at the end of the year. The uninsured term deposits amounting to $4.7 billion show an appropriate distribution of maturities:

I should also add that Bank OZK has significantly increased its funding via term deposits over the years (Figure 8), which, I believe, is a smart move as it reduces the bank’s risk in terms of acute bank runs. Since 2017, average time deposits have increased from about $5 billion to $16 billion, which today represent approximately 80% of total interest-bearing deposits. The slightly higher cost of term deposits is an insurance premium well spent, so to speak.

OZK’s loan portfolio has also shown solid growth of more than 10% on an annualized basis since 2020:

At the same time, the quality of the bank’s loans appears to be very solid. Although loan loss allowances have increased in the face of rising interest rates, they are still very healthy at just 1.4% of total loans (Figure 10). A comparison of OZK’s net charge-off rate with the average for all commercial banks in the U.S. also shows how well the bank is managing credit risk in a rather difficult environment (Figure 11). For Q2 2024, OZK reported a net charge-off rate of only 0.17%, compared to the national average of 0.65%. In a direct comparison with e.g. Truist and U.S. Bancorp, Bank OZK looks significantly more conservative, but I would argue that this is not an apples-to-apples comparison as OZK operates a very differentiated business model and is still relatively small. Therefore, I would not regard the slightly higher derecognition rates of TFC and USB as a significant risk, also because they are well within the national average (see my coverage of Truist and U.S. Bancorp).

Reason 3: Strong Dividend Growth With Plenty Of Room For Further Increases

OZK stock currently offers a starting yield of 3.84% based on the annualized quarterly dividend of $0.40 declared on July 1, 2024. Considering a 26% payout ratio based on 2024 expected earnings per share of $6.04, the strong capitalization, and a healthy loan portfolio, I think the income generated by an investment in Bank OZK are pretty safe – despite the obvious cyclicality. Don’t forget that OZK also raised its dividend during the Great Recession and the COVID-19 pandemic. Moreover, with total assets of only about $37 billion at the end of the second quarter of 2024, Bank OZK is below even the lowest regulatory threshold, making it less “vulnerable,” so to speak, to regulatory-mandated dividend and share buyback suspensions.

As shown in Figure 12, Bank OZK is a true dividend growth stock. The average dividend growth rate over 20 years is a whopping 18%, meaning that investors who bought OZK shares six years after the IPO are now sitting on a yield-on-cost of around 30%. Dividend growth has slowed somewhat over the years and decades, averaging 13% over the last ten years and 11% over the last five years.

I think it is only natural to expect a gradual slowdown in dividend growth from this still very solid level. It is of course impossible to predict the future, but given the low payout ratio and the scope for disciplined operational growth (as has been proven over the years and decades), it will probably be a long time before dividend growth declines to a mid to low single digit percentage. However, it should be added that part of the strong earnings growth over the last two decades is due to management’s continuous efforts to improve profitability as measured by the efficiency ratio. As OZK is already managed very efficiently (see above), I do not expect much additional room for improvement in this context.

Reason 3.5: Bank OZK Is A Compelling Value

Although I consider myself a dyed-in-the-wool value investor, I first make sure that the company I want to invest in is of good quality. Only then do I ask the question about the valuation of the asset under consideration. This is a lesson I have learned and internalized over many years. That’s why I consider the convincing valuation of OZK shares to be only half a reason.

As is well known, the Citigroup report published in May triggered a sharp fall in the share price, from which OZK shares recovered well against the backdrop of a broader rotation from growth to value stocks. In recent weeks, however, OZK has given back most of these gains and is now again trading in the low-$40 range.

While I acknowledge that valuing banks based on the price-to-earnings (P/E) ratio is not necessarily standard practice, I still believe that the FAST Graphs chart in Figure 13 should not be hastily dismissed. The regional bank has a surprisingly strong earnings record with low volatility, but unlike many other companies, this is not only the case in terms of adjusted EPS (recall Figure 2), but also in terms of reported EPS. Earnings adjustments are the exception at Bank OZK, which in itself is a strong indication of the quality of the management team. The chart below, therefore, is based on reported EPS.

With a blended price-to-earnings ratio of 6.9, OZK shares are currently trading at a discount of more than 50% to their long-term average valuation. An annualized total return expectation of 45% over the next two years and four months sounds unreal, but considering that OZK’s long-term earnings growth has averaged 14% per year, a 15x earnings multiple is by no means excessive. That said, I doubt Mr. Market will suddenly shed his fear of OZK’s CRE portfolio and look past the difficult macroeconomic environment. Also, Bank OZK’s earnings should only be expected to return to reasonable growth in the next boom cycle. OZK stock requires patience, but given the bank’s strong capitalization and fundamentally conservative foundation, I think it could eventually rerate to a low to mid double-digit P/E (and I’m talking many years, a decade or even longer).

Taking into account the ten-year average price-to-book ratio of 1.66, OZK shares are similarly cheaply valued, trading at a discount of 47%. One can certainly argue that OZK shares went through a period of significant overvaluation, which I attributed largely to the real estate boom fueled by the Federal Reserve’s interest rate policy. To take a slightly more conservative stance, let’s now look at the average valuation of OZK over the last 20 quarters (five years) – a period arguably characterized by “crises.” As Figure 14 shows, even against this much more conservative valuation backdrop, Bank OZK trades at a modest discount of around 10% and 12% to the average price-to-book and price-to-tangible book value, respectively.

Finally, let’s look at the valuation of Bank OZK from a dividend investor’s perspective. As mentioned earlier, the stock currently offers a starting yield of 3.84%, which compares very favorably to the dividend yield at which OZK shares have traded over the past decade (Figure 15). Of course, those who bought into OZK stock at the height of the COVID-19 pandemic with a starting yield of 6% have seen their yield-on-cost rise to around 10% in less than five years thanks to continued solid dividend growth. However, I maintain that buying OZK at a yield of 3.84% today is also a very good deal.

Conclusion – Betting Against The Mainstream With OZK Stock

Buying shares in a small regional bank with a significant CRE exposure against the backdrop of a difficult macroeconomic outlook sounds like a forlorn hope. Add to this the recent double downgrade by Citi analyst Gerlinger, and it seems only logical that Bank OZK’s shares are trading at less than seven times earnings and below book value.

On closer inspection, however, we are looking at an underfollowed and misunderstood bank that was all too quickly lumped together with similarly CRE-exposed institutions. Over the years and decade, Bank OZK has carved out a niche for itself in specialized CRE lending, focusing on short-term loans and newly developed projects. This approach significantly limits the risks associated with duration and allows the bank to pay comparatively high-interest rates on its deposits. The loans are oftentimes made for projects where the owner has significant financial interests and therefore cannot simply back out.

The Chairman and CEO owns a significant stake in the bank, and under his tenure the stock even massively outperformed the mighty S&P 500. Investors praised George Gleason and traded OZK shares at up to 26 times earnings in the 2010s. Since then – OZK peaked at around $56 in early 2017 – the stock has been a volatile underperformer. I don’t want to argue away the risks associated with the bank’s operations, but I do maintain that I believe OZK is run conservatively and with a long-term view. Therefore, I think the gradual contraction in valuation metrics is largely due to the overvaluation mentioned above.

Bank OZK has a strong deposit base, wisely focusing on time deposits and thus limiting the risk of the bank collapsing in the event of an acute bank run. As mentioned above, OZK can afford to pay a healthy interest rate on its deposits, allowing the bank to increase its deposits at a time when other banks – even larger ones – are struggling to offer a competitive proposition. Although its loan portfolio is highly concentrated, it is of solid quality, as evidenced by the still low and only slowly rising loan loss allowances and a net charge-off rate that is well below the domestic average.

CEO Gleason and his team are relentlessly focused on lean operations, and thanks to ongoing savings and profitability measures (despite a difficult environment), the bank’s efficiency ratio is among the lowest I have ever seen. The low efficiency ratio, high net interest margin and solid capitalization allow the bank to return significant amounts of cash to shareholders, even during difficult times. With a starting yield of 3.8% and likely continued dividend growth in the high single to low double digits, I don’t think it’s an exaggeration to say that OZK stock offers the best of both worlds: a solid starting yield paired with good growth.

To end this article on a cautious note, earnings growth will likely be muted in the coming years. However, as interest rates fall and the economic outlook brightens eventually, I believe OZK’s management can play to its strengths and continue to grow thanks to its differentiated business model.

I recently bought a starter position in OZK stock, which makes up about 0.35% of my portfolio. This sounds like a low-conviction investment, but I want to emphasize that OZK is a relatively small bank with significant concentration risk and operates in a difficult macroeconomic environment. The current valuation discounts many of these risks appropriately, in my view, but if the U.S. does slide into a significant recession, I would expect OZK shares to fall sharply. With this in mind, I think it is only prudent to manage the risks associated with such an investment by sizing the position appropriately. Personally, I expect my position in OZK stock to eventually represent about 0.5% of the current value of my portfolio.

Thank you very much for reading my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there’s anything I should improve or expand on in future articles, drop me a line as well. As always, please consider this article only as a first step in your own due diligence.