First Republic Planting The Seeds For A Later Harvest (NYSE:FRC)

It may be an exaggeration to say that 2023 is a lost year for First Republic (NYSE:FRC), particularly in mid January, but I don’t think it’s an exaggeration to say that the results this bank will post this year will not be representative of the real long-term earnings power of the business. First Republic is going to take a hit from much higher funding costs, but the bank is willing to pay that short-term cost to reap the long-term benefits of continuing to build a base of high net-worth customers that can continue to support above-average loan growth and profitability over the longer term.

First Republic shares have done pretty well in the brief time since my last update, climbing more than 12% in the last six weeks and outperforming peers (particularly smaller regional banks). The call on this stock is a fair bit more challenging today – while I think the shares are undervalued for investors looking for a long-term buy-and-hold name, I do think there’s a better-than-average chance of another chance to buy at more attractive levels this year, particularly if the Fed maintains a harder line on rates through the end of the year.

A Low-Quality Beat To End The Year

Technically First Republic did beat Street expectations for the quarter, but it was a low-quality beat driven by lower provisioning and a lower-than-expected effective tax rate. At the core pre-provision earnings line, the company posted a small miss, but I believe many institutional buyers were prepared for an even worse miss-and-lower performance.

Revenue rose about 5% year over year and fell more than 5% sequentially, missing by less than 1% or about $0.02/share. Net interest income (FTE basis) fell 5% yoy and more than 7% qoq, missing by about 2% ($0.06/share), with net interest margin down 23bp yoy and 26bp yoy (to 2.45%), but only missing by 1bp. Earning assets grew almost 3% qoq in the period.

Non-interest income rose more than 6% yoy and more than 3% qoq, beating by more than 3% and adding back almost $0.04/share. The wealth management business was a bit sluggish sequentially, but continues to add assets under management.

Operating expenses rose 6% yoy and were flat sequentially, coming in a bit better than expected in absolute terms, but almost exactly in line with expectations on an efficiency ratio basis. Pre-provision profits rose more than 3% yoy but fell more than 13% qoq, missing by less than 1% (and about $0.01/share). Provisioning expense actually declined annually and sequentially, and both provisioning and taxes were better than the Street had expected.

Beta Bites

As I discussed at greater length in that December article, First Republic is seeing meaningful earnings headwinds from higher funding costs as Fed rate hikes send costs higher (deposit beta). The issue isn’t so much that First Republic has a poor-quality deposit franchise (it doesn’t), but rather that it simply cannot grow low-cost deposits at the rate needed to find the bank’s exceptional loan growth.

Although loan originations fell more than 7% yoy and about 13% qoq (with sizable drops in single-family mortgages and capital call loans), loans did still grow almost 24% yoy and around 5% qoq, well above the average for the U.S. banking system in the quarter (closer to 12% yoy and 3% qoq). Even with loan demand moderating, “moderating” at First Republic means that loan growth is likely to slow from 20%-plus to something more in the mid-teens.

Deposit growth simply isn’t keeping up, with non-interest-bearing deposits down about 12% year over year (and 11% qoq) and core interest-bearing deposits up around 11% yoy and around 2.5% qoq. More expensive funding, CDs in particular, are having to fill the gap, with CD balances up 114% qoq, with rates up 143bp (from 1.26% to 2.69%) against an overall deposit cost increase of 59bp (to 0.99%).

Management acknowledged these ongoing pressures with a lower NIM target for 2023 (2.15% to 2.20% versus 2.30% to 2.35% previously), but I believe many investors were braced for worse. Moreover, management has shown no inclination of letting up on its client acquisition initiatives – between the bank’s excellent service reputation (it increased its Net Promoter Score lead on the industry in 2022) and many banks pulling back due to higher costs (and worries about credit), First Republic views this environment as an attractive one for client acquisition, and I don’t disagree.

First Republic management did throw a bone to the Street in the form of deferring around $150M of opex spending (to boost near-term profitability), but the reality is that management is willing to withstand weaker short-term profitability to build a larger, more profitable bank for the long term. I have no problem with this, but do acknowledge that it flies in the face of Wall Street’s typical Veruca Salt-like “but I want it now!” attitude regarding margins and profits.

The Outlook

I’ve taken another whack to my FY’23 core earnings expectations at First Republic, and I now believe core earnings could fall by around 25% or so. I’m somewhat more bearish than the Street, and there could be upside if the Fed takes a more accommodating stand on rates before the end of 2023. Longer term, though, I still expect 10%-plus core earnings growth from First Republic, as I continue to see the bank adding high net worth customers and leveraging loan growth opportunities in areas like multifamily lending and specialty finance lending (covered call lending, et al).

Between discounted core earnings, ROTCE-driven P/TBV, and P/E, I believe First Republic should trade somewhere in the mid-$130s to mid-$140s in the near term (< 12 months). Longer term, I do think investors can reasonably expect a total annualized return above 10%, but I also still see risk to the outlook and multiple in the short term.

The Bottom Line

With management’s commitment to growth, I do think First Republic is among the more vulnerable banks to higher deposit costs, though I don’t see increased credit costs as a substantial risk here (First Republic has an excellent underwriting track record). The issue, then, is whether the Street will remain patient with management’s decision to forego near-term margins for longer-term returns, and whether the Fed signals that it’s ready to ease up on rates before the end of 2023. I see risk on both counts, which is why I’m not as bullish on the shares in the short term, but I still see this as an attractive bank stock for long-term investors.