First Republic: Target Common

Background

I have owned First Republic Bank (NYSE:FRC) for nearly a decade in my long-term buy-and-hold bank portfolio which is diversified by geography, business model, and asset size. First Republic is a niche holding, providing exposure to the High Net Worth Segment.

First Republic is currently the second smallest holding among 12 banks and unlikely to become a large percentage of the portfolio given interest rate risk exposure.

First Republic Key Statistics at a Glance

Source: YCharts, Seeking Alpha, Company 4Q 2022 Press Release

• January 13 closing price: $128.78
• Price range past year: $106.86 – $199.91
• All-time high: $222.86
• Market Cap: $23.56 billion
• Share count: 184 million.
• One month price: 4.72%
• One year price: -32.5%
• P/E: 15.6x
• Forward P/E: 19.7x
• Total Assets: $212 billion
• Loan/Deposit Ratio: 95%
• Return on Equity Q4: 10.05%. 2022: 11.6%.
• Return on Assets Q4: 0.74%. 2022: 0.86%.
• Cost of Deposits Q4: 99 basis points. Cost of Funds: 112 bp.
• Net Interest Margin Q4: 245 basis points, -26 BP Q/Q
• Noninterest Income 2022/2021: +12.1%
• Noninterest Expense 2022/2021: +14.9%
• Efficiency Ratio Q4: 63.9% (63.3% Q4 2021)
• Wealth Management Assets: +8.7% 2022/2021, -2.9% Q4 2022/Q4 2021
• Dividend yield: 0.84%
• Payout Ratio: 19.6%. (9/30)
• Beta (5-year): 1.07

Investment Opinions

Consensus: BUY.

• Steet Analyst one-year price target $143. Range: $102-$200
• Consensus: 1.96 (24 analysts: 11 Buy, 5 Outperform, 7 Holds, 0 Underperform, 1 Sell)
• Seeking Alpha Consensus: Buy (1 analyst past 30 days)
• Merrill Lynch: Buy $140
• Morningstar: 4 Star Buy $149
• CFRA S&P Global: Buy $145
• CFRA S&P Global Quality Rating: A+

Seeking Alpha Grades

Seeking Alpha Grade: LOW.

Four Reasons FRC is in My Long-Term Buy-and-Hold Portfolio

1. Management: Jim Herbert is On the Job

Founder and executive chairman, 77-year-old Jim Herbert, kicked off the 4Q earnings call. His presence on the earnings call was especially gratifying since he took an extended medical leave one year ago.

In my book, Herbert is an industry icon. He has done a masterful job building First Republic from scratch in 1985. Today he is beneficial owner of 800,000 FRC shares (~0.5% of bank’s shares outstanding).

Investors may not recall that Merrill Lynch bought First Republic in January 2007 for $1.8 billion (3.6x P/TBV, 23.7x earnings) when bank stock prices peaked prior to the Financial Panic of 2008-2009. Herbert structured the deal 50% cash, 50% Merrill stock.

Merrill then went off the rails when the Financial Panic struck with full force in September 2008 in the immediate aftermath of the government’s gross mishandling of Lehman. Hours after Lehman’s failure, Merrill was left with no choice but to be bought/rescued by Bank of America.

Facing regulatory pressures, Bank of America Corporation (BAC) turned around and sold First Republic back to a Herbert-led investment group in late 2009 for $1 billion.

For more details about this absolutely brilliant purchase by Herbert, see my 2016 “Investing in Banks” book.

Note that the $1 billion paid for First Republic in 2009 is now worth $23.56 billion.

2. Credit Performance Safety: A+

It is no secret that I own only High-Quality banks. And as a reminder, I define High-Quality as banks that earn returns (net income/equity) consistently greater than the bank’s cost of capital (today ~10% for the average bank).

One key to being a High-Quality bank is to avoid credit losses. In September 2020, when bank stock prices hit Covid lows, I provided Seeking Alpha readers with a list of ten Dividend Champion banks that show the best credit performance historically among all U.S. banks.

Here is a chart from the article. These A+ credit performance banks have had average net annual credit losses over the past 19 years of about 15 cents per $100 in loans. As a percentage of assets, losses are even lower: a dime per $100 in assets. These are spectacular numbers.

First Republic did not make the 2020 list because the bank only went public (again) in 2010 and did not start paying dividends until 2012. There is no question that FRC is among the elite banks in the country based on credit performance.

Since going public in 2012, per FDIC call reports, the bank’s aggregate net credit losses are $39 million. As a percentage of average loans since 2010, FRC has net losses of only six cents per $100 and, as a percentage of average assets, a little less than five cents.

To put these miniscule losses in perspective, FRC’s credit performance history runs about half of that of the nation’s best lenders.

Here is what management had to say about credit performance during the 4Q earnings call:

“Credit quality remains excellent. Net charge offs for the fourth quarter were less than $1 million. For the entire year, net charge offs were less than $3 million or less than 1/5 of a single basis point of average loans. Non-performing assets ended the year at only five basis points of total assets. As Jim mentioned, this is one of our best levels ever. We do not stretch on credit quality to deliver loan growth. Our growth is driven by consistent execution of exceptional client service, one client at a time each and every day.”

The January 13 8-K includes six fabulous slides overviewing First Republic’s superior credit performance since 1985.

3. Narrow Moat: Net Promoter Score is Evidence

Much of banking is a commodity. Differentiation is difficult to achieve. Evidence can be seen by the massive consolidation within the industry since 1980 when the number of banks shrank from 18,000 to the 4,500 we have today in the U.S.

There can be businesses or services within a bank that are wide moat, but rare is the bank that can achieve wide moat across the enterprise. To do so, it must be, in my view, a low-cost producer (e.g., deposits, operational expenses enabled by scale), or a specialty bank focused on a niche.

First Republic falls into the niche category.

During First Republic’s January 13 earnings call, Founder Jim Herbert, called out the bank’s industry-leading “Net Promoter Score.” (See Bain Net Promoter Score background and methodology here.)

“It was a very strong year for First Republic, our time-tested business model and service culture continued to perform really well. In fact, it was our best year ever in many ways. Our new 2022 Net Promoter Score, which was announced this morning, is our highest ever client satisfaction level is actually extraordinarily strong.”

CEO Roffler added:

“Today, we released the results of our 2022 Net Promoter Score survey, our client satisfaction scorecard. We’re pleased to have achieved a record high score of 80. This is an increase from last year’s score, which was also a record at the time. At the same time, client satisfaction is declined for the overall banking industry. In 2022, the net promoter score for the U.S. banking industry declined to only 31. Our service focused model is truly differentiated, even more so during challenging and disruptive environments.”

I had dinner about a decade ago with the CEO of a bank in up-state New York. We talked for several hours about our favorite topic: Banking. Midway through our conversation, I thought to ask him about how he did his own personal banking. In response, I got a ten-minute recital of why he loves his bank, First Republic.

Since then, I’ve heard similar stories from many other First Republic clients.

Customer loyalty is the core reason First Republic has established a Narrow Moat. Customer loyalty means growing wallet share. It also means lower marketing expenses as “word of mouth” testimonials from existing customers attract new ones.

On that topic, here is another comment from the bank’s CEO during the call:

“For clients who identify us as lead bank, our net promoter score is 87 even higher than our overall score. And importantly, nearly two thirds of our clients now consider us as lead bank. Remarkably, our net promoter score increased in each of the past three years, as we have dealt with a pandemic, and rising levels of economic uncertainty.”

4. Safe Organic Growth

The word “growth” appears 49 times during First Republic’s 4Q earnings call. Here are a few of those:

Herbert: “Exceptional client service, and our strong focus lending led to safe organic growth during the year.”

CEO Roffler: “2022 was a terrific year with record loan growth, record loan origination volume, record revenue and record earnings per share... Total loans outstanding were up 24%, total deposits have grown 13%, wealth management assets were down only 3%, while the S&P 500 was down more than 19% over the same period. This strong growth in turn has led to strong financial performance. Year-over-year, total revenues have grown 17%, net interest income has grown 17%, earnings per share has grown 7%. And importantly, tangible book value per share has increased 11% during the year.

CEO Roffler: “We do not stretch on credit quality to deliver loan growth. Our growth is driven by consistent execution of exceptional client service, one client at a time each and every day.”

Bank investors learn over and over again how easy it is for a bank to grow when a bank trades risk for growth. Can you say Silvergate Capital Corporation (SI)?

Nearly 3,500 U.S. banks have failed over the past four decades. The bank graveyard is littered with banks that grew too fast by taking short cuts to growth.

Real and safe organic growth for a bank can only be accomplished by banks that execute flawlessly, and that means in practice, not losing money through bad loans when the business cycle turns south. As a rule, the banking industry can only grow, in aggregate, as fast as the overall economy grows. However, some banks can grow faster than the overall economy and gain market share over time.

First Republic is a textbook case of how a bank can grow market share.

What makes First Republic so unique is its laser focus on one segment of clients: High Net Worth. Founder Herbert built the bank years ago on the strategy of offering high-touch service to deep wallet clientele. First Republic’s value proposition is simple: Highly responsive, initiative-taking service provided to clients with deep wallets and often complex financial needs.

One last comment regarding growth: The bank reported that at the end of 2022, assets under management fell 3% year-over-year. This is a remarkable accomplishment given the S&P 500 fell 19.5%. First Republic’s relative decline is best among the major banks. Clearly, the relatively superior performance is because of a growth in clients, not necessarily superior portfolio returns.

Valuation: Reasonably Attractive

Price/Tangible Book Value

As of 12/31/22, First Republic reports that its tangible book value per share is $74.19, up from $67.10 YE 2022. At its current price (1/13) of $128.78, the P/TBV is 1.73x, a 23% discount to the average of 2.28x since 2017.

At my target Buy price (<$120), the discount to tangible book value is 28%, a number I believe provides a reasonable margin of safety.

Relative Valuation and ROE to Peers

The scatterplot below is taken from my January 9 article on 4Q bank earnings estimates. The scatterplot below shows two data points: X-axis the Risk-Adjusted ROE calculated as the average rolling four-quarter ROE by quarter since 2012 minus the standard deviation; the Y-axis is the January 2023 Z-score which is calculated as the product of the quarterly Price/Earnings ratio and Price/TBV since 2012.

Note that as of January 7, First Republic shares ($126.53) were selling about one standard deviation lower than its average valuation since 2012. As I point out in the January 9 article, I prefer owning High-Quality banks (i.e., superior RAROE) and prefer accumulating their shares when they are “on sale,” which I generally define as having a valuation at least one standard deviation less than its history.

Based on this knowledge, I added FRC shares in December (at $119.53).

While First Republic’s valuation appears relatively attractive to both history and peer banks, risks have arisen that concern me.

Risks

Net Interest Margin Squeeze

4Q NIM was 2.45%, a drop from 2.71% in 3Q 2022. This is a meaningful one quarter drop and evidence that First Republic is not one of the “Have” banks I wrote about in September 2022.

“Have” banks are characterized by having low cost of deposit funding as well as low loan-to-deposit rations. First Republic has neither. While the decline in NIM is not a surprise, the magnitude of the drop is greater than I expected.

Per the bank’s recent press release, deposits had an average rate paid of 99 basis points during the quarter, and average total funding costs were 112 basis points during the quarter.

The main reason First Republic shares today sell about 39% lower than their all-time high is because of the margin squeeze which is a function of the bank’s funding costs as well as loan mix (see next risk).

Over-reliance on Home Mortgage Lending

This is not a new risk. It is the principal reason First Republic has remained one of my smaller bank holdings.

Jumbo 1-4 Family lending (home mortgages) is the bread-and-butter loan product for First Republic. At the end of Q3, 59% of the bank’s total loans were 1-4 Family per FDIC call report.

Here is the problem: Home mortgage lending is the ultimate commodity business. My data show that it is nearly impossible for a bank to develop a lasting wide moat in this business. Even more important, my data also show that it is extremely difficult for active 1-4 family lending banks to consistently earn returns greater than their cost of capital. As a result, the least profitable and lowest shareholder return banks are ones that mostly engaged in 1-4 family lending.

First Republic enjoyed a wonderful decade since going public in 2010, in part, because interest rates remained low and High Net Worth clients actively bought and mortgaged homes. The bank, to its credit, has concurrently developed other services critical to their affluent segment while successfully capturing home mortgage loans. It is this growth in wallet share that is key to First Republic’s continued long-term success.

Succession Planning

The bank’s 2021 Proxy addressed Succession Planning in considerable detail. Founder Jim Herbert is synonymous with First Republic. He has been the indispensable linchpin of the bank’s success. That said, the board has recognized that this strength is also a weakness.

Talent War

As the adage goes, live by the sword, die by the sword.

A considerable measure of First Republic’s success gaining assets under management is because of the bank’s aggressive hiring of investment advisors. As recently as January 9, First Republic touted its ability to bring on yet another investment team.

Teams of investment advisors change firms for a variety of reasons, not the least of which is money. First Republic has not been timid in paying up for high producers. Make no mistake, this fact is not lost on competitors. As a result, there is a war for talent, and therefore, employee expenses are at risk of growing faster than revenue.

Not only is there a war for talent on the production side, but also in key risk and operational roles that are critical to the bank operating safely.

First Republic addressed this risk in its January 13 8-K, noting the bank’s low turnover of bankers over the past nearly 40 years. Currently, 74% of the bank’s loan production is associated with bankers having ten or more years of experience with FRC. In contrast, less than 1% of loan production comes from bankers with 2.5 years or less of experience.

Closing Thoughts

FRC common shares remain an anchor holding in my long-term buy-and-hold bank portfolio.

The interest rate challenge facing First Republic shareholders creates a nice opportunity to acquire common and preferred shares at prices attractive relative to historical valuations.

To reiterate, despite industry-leading attributes (credit performance, management experience, customer loyalty, revenue growth), First Republic faces two material risks.

1. Funding Costs/Margin Squeeze/Liquidity Risk

The 99-basis point cost of deposits is a tough pill to swallow for this investor who prefers “Have” banks over “Have-Nots.”

I am monitoring Liquidity risk given the high loan-to-deposit ratio. Since I do not believe the Fed will steer Fed Fund rates much higher than, worst case, 7%, I remain confident that First Republic can navigate Liquidity concerns.

2. Home Mortgage Lending Concentration

I have long viewed First Republic’s Achilles Heel as being its over-reliance on commodity home mortgage lending. As a Jumbo lender, this risk is exacerbated by the fact that Jumbos do not enjoy the same liquidity as conventional mortgages. As a result, Jumbos often end up on the balance sheet as fixed rate loans funded by variable rate deposits.

This formula is problematic in a rising interest rate world. Investors may recall that in the second half of the 1970s, when interest rates skyrocketed, the U.S. savings and loan industry imploded.

If I thought inflation worries were so high as to prompt the Fed to drive rates to 10%+, I would be a seller of First Republic shares. I do not see that happening.

Buying the Common <$120

Prior to the 4Q earnings announcement, my accumulate price on First Republic was <$120. In light of insights drawn from the 4Q earnings report, I will maintain that entry point.

The best scenario for FRC common: Declining interest rates which will bring relief to NIM squeeze and resurgence of the home lending business.

Prefer the Preferred: 6% Target Yield

First Republic has a number of perpetual preferred shares (FRC.PH) (FRC.PI) (FRC.PJ) (FRC.PK) (FRC.PM) (FRC.PN) that have been dinged up badly (one-year declines of 11% to 25%).

Given my high confidence in First Republic’s ability to navigate this current interest rate cycle and my view that First Republic represents minimal Solvency risk, I find the Preferred shares of particular interest at this time.

My entry point is a 6% yield.

Caveat

The foregoing is my opinion which I share for the purpose of getting feedback and questions that challenge my ideas and assumptions.

Every investor needs to do his/her own due diligence before investing as well as determine their risk profile. I am risk-averse, preferring to invest in the nation’s best banks which reliably earn returns exceeding cost of capital.