Butterfield Bank (NTB): Underfollowed, Undervalued, Perhaps Capped On Growth

Despite rising rates, healthy results, uncertainty around the U.S. banking sector, Bank of N.T. Butterfield & Son (NYSE:NTB) (“Butterfield”) really hasn’t been able to catch investor attention. Down about 13% over the past year, underperforming U.S. regional banks, Butterfield’s underperformance seems unusual other than perhaps in the context of limited sell-side support and perceptions that the bank’s growth could be capped by its conservative management approach and very limited geographic footprint in the tax havens of Bermuda, Cayman Islands, and Channel Islands.

It’s been quite a while since I last covered Butterfield, and since that last article the shares have more or less performed in line with the regional bank index. Low-to-mid single-digit core earnings growth should be enough to support a fair value above $40 today, but growth investors may regard this bank as too limited in its growth prospects to merit interest and more conservative value-oriented investors may be put off by the perception of elevated operating and regulatory risk, putting it in a sort-of investment twilight zone.

Healthy Growth Relative To Expectations And Other Regionals

Butterfield managed a respectable opex-driven beat in the third quarter, though balance sheet trends may well have investors questioning the growth profile heading into 2023.

Revenue rose 13% year over year and 6% quarter over quarter in the third quarter, matching expectations and basically keeping pace with U.S. regional banks. Net interest income rose 20% yoy and 11%, outgrowing U.S. comps, and coming in a little light of expectations. Net interest margin rose 62bp yoy and 33bp qoq to 2.59%, weaker than expected, but showing slightly better momentum than peers. Earning assets declined more than 8% yoy and 4% qoq, an unusually weak result for the quarter.

Fee-based earnings rose 2% yoy and declined 4% qoq, largely matching expectations and helped by the addition of wealth management earnings. Fee income remains a significant part of the business at Butterfield (35% of third quarter earnings), and management continues to look for opportunities to grow the trust business.

Operating expenses were down 3% and flat sequentially, outperforming peers and expectations and driving around half of the EPS beat. At around 58%, Butterfield’s efficiency ratio is still comparatively high next to many regional banks. Pre-provision profits rose 46% yoy and 14% qoq, beating expectations by more than $0.02/share and outperforming the broader regional bank group.

Curious Trends With The Balance Sheet Suggest More Limited Growth

One of the most notable standouts about Butterfield’s third quarter results was the balance sheet shrinkage that the company saw this quarter. As I mentioned above, NTB was unusual in the extent of its earning asset shrinkage, and that was largely true of other balance sheet items as well. Loans did rise about 1% qoq on an average balance basis, but that was only about one-third the growth seen by U.S. regional banks, and end-of-period balances were down about 3%. While there was some respectable growth in the commercial loan book (up 5% qoq), the residential book was down slightly and this is over 70% of the loan book. Loan yields improved nicely, growing 83bp yoy and 57bp qoq to 5.05%, solidly higher than U.S. regional banks. Yields improved nicely for both commercial (up 65bp qoq to 5.41%) and consumer (up 54bp qoq to 4.9%) lending.

Securities are a significant part of Butterfield’s earnings base (around 40% of earning assets), and securities balances shrank 3% qoq, with yield up 5bp qoq to 1.94% (below the 2%-plus average of the peer group).

Deposit trends were likewise curious. Total deposits shrank 5% qoq, considerably worse than the average for regionals (around 1% shrinkage), but non-interest-bearing deposits rose almost 4% (much better than the slight decline at mainland peers) and grew to almost 24% of total deposits – still below average, but improving.

Deposit costs rose 18bp qoq to 34b, pretty much spot-on with peers, with interest-bearing deposit costs up 24bp to 44bp, driven mostly by the much more competitive Channel Islands business. At a point of rising deposit betas, Butterfield’s cumulative interest-bearing deposit beta is still very attractive at 14%, as is the 10% overall deposit cost beta.

As mentioned, Butterfield is primarily a mortgage lender in its island footprint, and that does limit growth opportunities. While the housing market in the Cayman Islands has been strong (prices up 18% annualized over the last four years), and authorities are making some moves to expand housing (allowing taller buildings), the reality is that these are small islands with limited capacity to support significant population growth. What’s more, having been burned years ago by bad commercial loans, Butterfield is run much more conservatively now with respect to underwriting risk.

Recently Butterfield was able to offset that with its above-average rate sensitivity. Butterfield has historically been more rate-sensitive than its comparables, and that helped drive earnings growth, but management is laying off the throttle now. About 40% of the loan portfolio is fixed now (it’s not uncommon for mortgage loans outside the U.S. to be floating-rate) and the rate sensitivity has dropped to below-average, with another 100bp in rates only expected to drive around 2% net interest income growth.

Limited prospects for loan growth and limited rate leverage argue to me for more limited spread income growth – the company will still benefit from higher rates on loan repricing, but I do think loan growth will likely be in the low single-digit range unless management decides to alter their approach (say, for instance, participating in syndicated loans), but I really don’t expect that.

The Outlook

M&A could offer some growth potential, but management remains very strict and disciplined on their acquisition standards and criteria. The company is in the process of acquiring trust assets from Credit Suisse (CS) in Singapore, Guernsey, and the Bahamas, but it’s not a large enough deal to really move the needle.

With less rate-sensitivity (and less likelihood of multiple significant rate hikes from here) and more moderate loan growth prospects, my growth outlook has moderated. I still expect good momentum next year from rate tailwinds and further opex leverage, but I think longer-term growth is likely to be more on the border of low/mid-single-digits, with a long-term core earnings growth rate around 4%.

Capital returns to shareholders could, and arguably should, accelerate from here. Management is being a little careful with capital right now, but there should be sufficient capacity for more meaningful dividends and buybacks in the future, as I don’t think the company will be able to deploy all of that surplus capital into loans or acquisitions.

Discounting those core earnings back, I believe Butterfield shares are priced for a mid-teens total annualized long-term return. ROTCE-driven P/TBV, and P/E approaches give me a nearer-term fair value in the low-to-mid $40’s, with the bank’s ROTCE (25%-plus) supporting a 3.25x P/TBV multiple (even using a 10% discount for the different regulatory exposures) and a fair value of almost $45, while a 9x multiple on my ’23 EPS estimate gets me to about $43.

The Bottom Line

It’s possible that I’m too bullish on NTB’s earnings growth prospects, but I don’t see any meaningful trend away from businesses domiciling their funds and their captive insurance operations in the geographies NTB serves, and I don’t see anything changing meaningfully on the competitive front. I do have some concerns that a lack of sell-side interest could limit investor interest, but for patient investors content to collect dividends and wait for the Street to come around to the value here, I think there is definitely something worth checking out.