marchmeena29
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.
Rates Continue To Rise, And First Republic Will Be Paying A Higher Price For Growth
I started off this phase of the cycle writing (in reference to First Republic and others) that deposit betas were likely to surprise as the cycle developed, with banks ultimately having to pay more for deposits than sell-side analysts or bank managements expected. That’s happening now, and it’s happening faster than even my relatively bearish expectations.
Since the Fed began hiking rates, the top CD rates have increased by around 260bp, with a beta of close to 70% that is now above the prior cycle’s beta (around 65% between November 2015 and December 2018). There’s relatively little cash on bank balance sheets now (around 4% or so of assets), and loan/deposit ratios are likewise growing as strong lending growth has soaked up surplus liquidity on the balance sheets.
This is a challenge for most banks, and particularly those that lack strong core deposit franchises and/or wish to continue to fund exceptional loan growth. First Republic actually has a high-quality deposit franchise, with non-interest-bearing deposits making up over 40% of deposits (versus a peer average closer to 30%), but the loan/deposit ratio is now above 90% (versus peers in the 70%s and 80%s), and there’s simply no way that the bank can grow regular core deposits at anything close to the rate needed to fund the targeted double-digit loan growth.
First Republic will be increasingly forced to turn to higher-cost sources of funding to support that loan growth. While many banks are increasing their use of FHLB advances, management has stated its preference to grow CD balances over FHLB advances – while CDs are getting increasingly expensive (the bank is now paying around 3.75% for some CDs versus an average of 1.26% in the third quarter), management wants the relationships that go with those CDs.
This is really the crux of what First Republic is doing now – paying today for deposits (and customer relationships) to fund future growth and future customer relationships. To a large extent, this makes sense. Historically, once somebody becomes a First Republic customer, they remain a customer (an annual attrition rate of less than 1%), and they tend to do more business with First Republic over time – the relationship may start with a mortgage or student loan, but then grows into mortgages for vacation homes, business loans, loans for children’s educations and so on.
Higher Costs, With More Limited Loan Rate And Operating Leverage
Having to pay more for deposits is one thing, and First Republic’s 28% cumulative interest-bearing deposit beta was on the upper end of the range of banks I follow in Q3’22, but First Republic’s near-term earnings challenges are magnified by the impact that these higher deposit costs are having (and will have) on overall net spreads.
Loan yields improved only 26bp yoy and qoq to 3%, about half the rate of improvement for a swath of comparable banks, and this issue is going to linger. Relative to many peers, First Republic has a much larger residential mortgage lending business and a much smaller business (C&I) lending operation, and that’s hurting the bank as it leads to a larger fixed-rate exposure and less leverage to rapidly-repricing C&I loans. With that, First Republic is looking at around 25bp of NIM contraction in Q4’22 when most peers will show 10bp-20bp of expansion, and that will continue into the first half of 2023 (albeit not at the same pace).
At the same time, there are not a lot of levers the company can pull to offset spread pressure. The wealth management business is growing well enough but isn’t large enough to offset the spread income challenges. Likewise, while First Republic’s efficiency ratio isn’t bad, there’s not much the company can do on costs apart from around $100M in expenses it considers deferrable.
An Opportunity To Gain Share
Management is still looking to grow loans at a mid-teens rate in 2023, and that’s a notable difference for a bank of this size relative to its peers. Many banks are now tapping the brakes on loan growth, not just in response to more cautious customers, but in view of a worsening macro environment and increasing credit risks.
This approach strikes me as roughly analogous to Buffett’s often-repeated exhortation to “be greedy when others are fearful”. Many banks will claim that they’re still looking to lend money to high-quality clients, but the reality is that many banks lack the granularity and visibility into credit trends that they’d like to claim and are responding to this weakening macro environment by curtailing lending on a larger scale. As this plays out, First Republic stands ready to cherry-pick attractive lending/long-term business opportunities from among those customers that can’t get their current bank to answer the phone.
Stepping up to lend when other banks don’t want to will strike many readers as aggressive and risky. I’d point to First Republic’s long-standing credit history – a cumulative loss of about 8bp on $439B in cumulative lending, including 3bp of losses on $234B of cumulative lending in the residential loan business.
Here’s how I think this all breaks down. In short, First Republic is taking a near-term hit to spreads, earnings, and returns (ROTCE, et al.) as the cost of establishing and growing long-term relationships with high net worth individuals who will most likely do more business with the bank over time. The hit that First Republic will take to spreads isn’t unique, they’re just taking more of it upfront (and faster), but over time as funding costs decline again those fixed-rate loans won’t look so bad.
The Outlook
Management bragged at its recent investor day that it had posted a double-digit return on tangible common equity every year since 2010. That’s a nice record, but I expect it will be broken in 2023 and possibly in 2024 as well. With the intense pressure on spreads and the bank’s commitment to continue growing the loan book, my 2023 core earnings estimate is now almost 30% lower than before, though I do see growth reaccelerating in FY’23, and I’m still expecting double-digit long-term core earnings growth that compares very well with its peers.
Long-term core earnings growth in that 10% to 11% range can support a low double-digit total annualized expected return and a near-term share price around $140. Valuing the stock on ROTCE-driven P/TBV has never been all that useful, as that approach doesn’t work well with faster-growing banks, and that’s still the case. A P/E-based approach is likewise challenging or at least subject to debate – if you still think that First Republic can support its historical 16-18x forward P/E multiple, I can make a case for a fair value in the $130s by assigning a 17x multiple to my ’24 estimate and discounting back a year at a 10% discount rate. In this case, I use the ’24 number because I think the ’23 EPS figure is not really representative of the real core earnings power of the business, but that’s a subjective call.
The Bottom Line
My “buy the pullback” call on First Republic has been absolutely wrong thus far, and I underestimated management’s willingness to pay a high price today to maintain (or perhaps accelerate) long-term growth. I agree with the strategic rationale, but there’s no question that the near-term consequences have been significant. I still think there’s an argument for buying and owning these shares, but I believe the Street may continue to stay away until at least mid-2023, by which point deposit cost pressures should have peaked and the next phase of the cycle should be coming into view.
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