Home Bancshares: Taking Advantage Of Rising Rates (NYSE:HOMB)

I was going to start this article by talking about Home Bancshares’ (NYSE:HOMB) current strategy, and how it positioned them to take advantage of rising rates. I was going to talk about how HOMB was going to be making more money just by deploying cash and maybe some short-term securities safely at higher rates than many banks are yielding with their loans. But now, while I still think they can make a lot of money as rates increase, I’m not so sure it will be as easy as I thought.

This isn’t a knock on the bank itself. They have traditionally performed very well. They have some of the highest yielding loans of any bank I’ve seen and consistently keep their efficiency ratio below 50%. That combination on its own is enough to put their ROAA at around 2%. They are also safe lenders, and have (out of an abundance of caution) avoided locking in long-term fixed rate loans at low rates over the last several years.

And they have been positioning themselves to take advantage of rising rates. In fact, they’ve been positioning themselves better than maybe any other bank in the country. Before the last quarter, HOMB was holding over $3.5 billion of cash on its balance sheet, ready to deploy it into safe and higher-yielding bonds (bonds that may even be yielding more than most banks’ loan portfolio). They were poised (and may still be) to generate an impressive amount of interest income just from buying safe bonds.

But recently, things have slightly change. First, when rates started to rise significantly in the third quarter of 2022, HOMB lost about a billion of deposits, which directly depleted their cash pile pretty significantly. They also deployed about a billion, buying higher-yielding bonds, but maybe not at the rate they were expecting.

It’s hard to tell what exact interest rate they’re deploying cash at now. But their CEO – Johnny Allison, who, as you’ll find out, is maybe one of the best bank CEOs and capital allocators in the country – said in HOMB’s Q3 earnings call that they’re finding pockets here and there to deploy their cash into securities with high yields.

Overall, though, the bank now only has about $1.5 billion of cash sitting on its balance sheet. Deploying that (even into bonds yielding 6% or so) won’t make as big of an impact. But I think they’re still very well-positioned. They have a pretty sizeable securities portfolio (over $5 billion) that is probably very liquid – i.e., they could sell off lower-yielding bonds (at a discount of course) to deploy the capital at high rates) – and about 70% of their loan portfolio is either rolling over in one year or is floating rate.

I just don’t think redeploying at higher rates will be as easy for them as I thought it would be earlier this year. They won’t be able to just stick their piles of cash into treasuries yielding 6%. It’s going to probably take a little more finesse, precision, and sacrifice in the short term. That being said, if anyone can do it, it’s HOMB.

And, as I’ll detail below, I think they’ll still be able to take advantage of rising rates – maybe even doubling their income. Overall, this is a pretty easy bet to make. Johnny Allison has literally been telling you what he’s going to do all year. He believes that Fed Funds Rate will get to 6%, and while some may disagree, I don’t think it’s a good idea to bet against him. Even without their extremely large cash pile, I think HOMB can take advantage of rising rates better than any other bank in the country.

All of this isn’t even taking into account HOMB as a business, or the current valuation. HOMB has been strategically (and oftentimes on the cheap) acquiring banks throughout the Southeast over the last 10 years. Its strategy has largely paid off, with HOMB growing its diluted EPS (roughly adjusted for a 2-for-1 stock split) at about 15% a year for the last 10 years and compounding its BVPS at roughly the same rate over the last decade. HOMB also has a fortress balance sheet and may be one of the best capitalized banks in the United States – its equity was 14.9% of its assets as of Sept. 30, 2022, and its loan to deposit ratio is currently at 75.1%. As you know from reading above, it also holds a large chunk of its assets in cash and investment securities. In spite of all this, it still generates a strong 2% ROAA. And, on top of all that, it is one of the most efficient banks in the country, sporting an impressive 41.1% efficiency ratio at the end of 2021.

History

Home Bancshares was started in 1999 when Johnny Allison and a group of investors bought a bank in Arkansas. Before that, Allison started, grew, and sold a mobile home manufacturing company. He also has a history of making opportunity out of financial crises. In 1988, he used his knowledge of the mobile home business to buy a bunch of mobile homes that failed banks had taken possession of during the S&L crisis. He bought roughly 8,000 of them and resold them over the next 3 years.

It seems that he was involved in banking throughout his career as well, becoming the chairman of First National Bank of Conway in 1983 as well as being a significant shareholder in First Commercial Bank (the largest bank in Arkansas at the time) when it sold to Regions in 1998.

As mentioned above, HOMB began by acquiring First State Bank in 1999. After that, they acquired Community Bank, Bank of Mountainview, and Centennial Bank in 2003, 2005, and 2008 respectively. Home Bancshares was also involved in the formation of Twin City Bank and Marine Bank, both of which they acquired in 2005. In 2009, HOMB consolidated the bank subsidiaries under one bank charter – Centennial Bank.

As you can see, HOMB is an acquisitive bank. And, consistent with the culture Allison has established, HOMB excels at finding deals and weathering storms better than most everyone else. In 2010, HOMB stepped up its rate of acquisitions, buying six banks in Florida through FDIC assisted transactions. In 2017, the bank made larger inroads into Florida, purchasing a bank with $2 billion in assets, one with close to $400 million in assets, and another (out of a bankruptcy proceeding for practically nothing) with $178 million in assets.

Also, in 2015, HOMB established its national CRE lending presence (think large commercial deals) by acquiring a portfolio of CRE loans. It named this arm of its business Centennial Commercial Finance Group (Centennial CFG) and established a head office in New York, with loan production offices in Dallas, Miami, and Los Angeles.

In 2018, HOMB expanded into a unique area of consumer lending – U.S. Coast Guard (USCG) registered high-end sail boats and power boats. It did this by acquiring Shore Premier Financial (SPF) – basically a high-end marine lending business – from a marine lender. It added to this business in 2020 with the purchase of a LH-Finance. HOMB’s SPF group primarily finances consumer purchases of high-end boats and also offers dealer floor financing for the same kind of boats.

HOMB made a few other acquisitions over this period, the majority of them being in Florida, with some in Arkansas and Alabama. By 2021, HOMB was poised to make its largest acquisition yet, allowing it to enter into the growing Texas market. The transaction, which closed in the second quarter of 2022, was for the acquisition of Happy Bank (headquartered in Dallas, TX). HOMB paid close to $1 billion for it, and the acquisition increased the size of its total assets by roughly 30%.

By the third quarter of 2022, HOMB was a bank with $23 billion in total assets – loans making up $13.9 billion of that, securities $5.3 billion, and cash $1.5 billion – $18.5 billion in deposits, and just under $3.5 billion in equity. The bank currently has a market cap of about $5.2 billion.

Business Model

It’s kind-of difficult to understand what kind of bank Home Bancshares is at first. That is until you realize that it’s just a bank that strives to make good decisions. It doesn’t necessarily try to focus on one niche area, one market, or even one geographic location. And it doesn’t try to force loan growth. HOMB is a bank that is comfortable with growing through acquisitions. And it is always on the lookout for assets it can get cheaply.

But HOMB is also trying to acquire banks that fit within its strategy. And, because of the way HOMB operates, this means that buying a bank for over 2x book value can still be a cheap acquisition. This is because, more than anything, HOMB is an efficient bank. Its efficiency ratio was 41.7% in 2021, and it has stayed at 50% or below for at least the last ten years, if not longer. And its non-interest expense as a % of Earning Assets (a measure I like to use) stays around 2.20%. This kind of efficiency is what generates great returns on assets.

And when you pair this efficiency with another defining feature of HOMB – high yields on loans – you get a fantastic bank. HOMB generates some of the highest yields on its loans in the country. Over the last three years, HOMB’s average interest rate earned on its loans was 5.43%, 5.66%, and 6% respectively. And it has stayed over 5% for much of its history. Pair this with HOMB’s steadily improving deposit base (30% is now non-interest bearing), and you get a very impressive NIM.

HOMB’s NIM was 4.34% in 2021, and it is typically over 4% in normal years. Its spread is also over 4% most years. This is largely the result of HOMB’s very focused lending culture. It really only underwrites loans that are worth the risk. It doesn’t try to grow loans for the sake of growing loans or to keep up with deposit growth. In fact, HOMB actively avoided making too many loans over the last year at rates it thought were too low – that’s why it ended 2021 with a cash balance of ~$3.6 billion and a portfolio of securities worth ~$3.1 billion.

You see, HOMB only seems to make loans at rates where it wins over time. Most other banks are lending to businesses at 3%. They do it because everyone else does and they have to do it to grow. But HOMB makes loans opportunistically and finds other banks making loans at high rates and buys them.

Overall, the company’s loans break down as shown below:

This shows the loan portfolio before and after the Happy acquisition. As you can see, HOMB is tilted pretty heavily towards real estate lending, though it has diversified over the years. Right now, roughly 71.9% of its total loan portfolio is made up of some kind of real estate loans. Roughly 37% of total loans are regular CRE loans and 16.1% are Construction/Land Development loans. And Agriculture (combined real estate and business lending) makes up a little less than 5% of total loans. On the residential side, 1-4 family makes up ~12.3% of total loans. And Multifamily has been growing over the last year (now 3.7% of total loans compared to 2.8% at end of 2021), as Allison and teamed have remarked that they’ve been going after this area as competition pulled back.

HOMB’s C&I loans haven’t really changed too much since the acquisition (though they have grown), now comprising roughly 16.4% compared to 14% in 2021. Overall, C&I has never seemed to be too much of a focus for HOMB. Some banks just focus more on real estate than others, and considering the yields HOMB has been producing and is going after, it makes sense that a lot of their focus is on CRE loans.

As we’ll discuss below, HOMB has also been focused on growing consumer loans over the last few years. They now make up just over 8% of the loan portfolio, compared to under 5% when they first acquired SPF. As you know, these aren’t your normal consumer loans, but are focused on a particular subset of the market (high-end boats).

Overall, the loan portfolio is becoming a little more diversified, but the Happy acquisition also didn’t really change things in terms of the makeup of the loan portfolio. Before the acquisition, real estate loans made up roughly 72% of total loans. The only thing that really changed on the lending side is the geographic location of the loans.

Geographically, HOMB is now more diversified, with Texas now being a much larger part of the loan portfolio (28.79% vs. 4.6%) than before. New York and California have stayed roughly the same, and Florida has slightly decreased to around a third of the total portfolio (compared to over 40% before the acquisition). Arkansas has also stayed roughly the same.

Throughout its history, HOMB has remained a very safe lender. We’ve talked about their low leverage and impressive capital position. But what we haven’t talked about is their lending record. Most banks can’t lend at the rates that HOMB can without having some serious issues with the quality of their loans. HOMB, on the other hand, has never had a real issue.

In fact, HOMB has been bolstering its allowance for loan losses [ALL] over the past few years. As of Dec. 31, 2021, they sat at 2.41% of loans. If you’re not familiar with this measure, this is extremely high. In 2013, HOMB’s ALL was at 0.87% of total loans. Today, HOMB’s ALL is currently 4.1x its non-performing loans [NPLs] – the highest it’s ever been.

The highest charge-offs ever been was in 2010, when they sat at 2.61% of total loans. Charge-offs were actually higher than NPLs in 2010 (which were at 2.01%). This makes sense, considering HOMB was acquiring failed banks throughout Florida in 2010. As a result, it’s clear that the loan book wasn’t going to be pretty, but HOMB turned it around pretty quickly.

Charge-offs immediately dropped to 0.66% of loans in 2011 and have stayed below 0.5% since 2012 (hovering around 0.10% recently). And it’s the same story for NPLs. They dropped to 1.00% in 2012 and haven’t reached 1% since then, staying around 0.5% the last five years.

This is all even more impressive considering HOMB’s average earned interest rate. Its loan portfolio is typically yielding anywhere from 5.5% to 6% most years, and yet it hasn’t had any significant charge-offs or even significant NPLs since 2010. Also, the fact that HOMB hasn’t had any problems given the growth of Centennial CFG shows just how strong its lending culture is. As a national CRE lender, CCFG is designed to make large commercial loans in major metros throughout the U.S. Usually a large book of loans like this could raise the NPL if one or two major loans goes into default or is 90 days past due. But it seems that HOMB has been even more careful with Centennial CFG (as we’ll discuss below).

Today, HOMB’s business is really split into three divisions: (1) the traditional branch banking business, (2) Centennial CFG, and (3) Shore Premier Financial. As of June 30, 2022, HOMB had 222 branches nationwide. Arkansas has 76, Florida has 78, Texas has 62, Alabama has 5, and New York has 1.

Branches And Traditional Lending

HOMB’s branch side of its business (which is by far the largest) is mainly focused on one thing – expanding into growing markets. They have obviously built a culture where lending at the highest rates or not lending at all is the standard. That seems to be the rule across the board. But how they accomplish this while continuing to grow is to keep their focus on growing markets. Just look at the map below.

After the Happy acquisition, HOMB is largely focused in (1) its original state of Arkansas – which isn’t really a high-growth environment, but one where they have a strong position – (2) Texas, (3) the Florida panhandle and Alabama coast, and (4) the Southwest coast of Florida, the Miami area, and the Florida Keys. These are all markets that poised for high growth, both economically and in population.

This has helped HOMB’s deposit base grow, even as it slowed its lending the past few years. For instance, HOMB’s deposits grew at 11.8% and 13.1% in 2021 and 2020 respectively (this is before the Happy Acquisition). The Happy acquisition will likely provide another avenue for loan and deposit growth, especially when HOMB decides to start putting its capital to work making more loans again.

HOMB has also improved the quality of its deposits over the last decade or so. In 2013, HOMB’s non-interest bearing deposits were less than 20% of total deposits. Now they make up 30.8% of overall deposits. This is good for HOMB’s liquidity (it doesn’t have to rely on brokered deposits or anything like that), but the cost of funding hasn’t really changed that much over the last 10 years.

The average interest rate HOMB has paid on its deposits over the last decade is 0.42%, which is pretty much in line with a lot of high-performing banks over this period. Average rates paid on deposits reached their peak in 2019 at 1.03%, and were at 0.75% in 2018 when rates started to rise. Rates stayed consistent around 0.20% before that. So, I’m not too worried about rising rates in the future, considering 30% of HOMB’s deposits are in demand and non-interest bearing compared to 18.4% back in 2013.

Unlike a lot of banks I analyze, though, HOMB isn’t really improving its metrics over time. It’s a pretty mature bank, so it’s unlikely HOMB will be able to wring any more efficiency out of its operations as it grows. Yes, its efficiency ratio has decreased (and this has helped its margins), but overall its expenses as a percentage of earning assets haven’t really decreased over time.

Its non-interest expenses did decrease significantly from 2011 to 2014 (from 3.24% to 2.63% of earning assets), but they have stayed pretty steady since dropping to 2.27% in 2015. This brought its total expenses as a percentage of earning assets down from 4.28% in 2011 to 2.94% in 2014. But, like I said, not much has changed on that front over the past 6-7 years.

This doesn’t really matter though. HOMB’s interest spread – at 4.27% in 2021 – is higher than the yield most banks generate on their actual loan portfolio. Its True Net Yield (my calculation of (interest rate earned on EA + non-interest income) – (interest expense + non-interest expense)) is over 3%, which is among the best I’ve seen. Think about it, HOMB earns 3% on its earning assets after all of its expenses. And its non-interest income only adds about 1% to the total income, so that’s not a huge factor. Some banks are lending at 3% rates.

In the end, yes, it’s true that HOMB’s efficiency isn’t really improving over time. It’s about as efficient as its going to get. But it’s still growing. It strategically and opportunistically acquires banks and brings their efficiency to its level. And that constantly adds value to the bank, allowing it to compound its equity at a high rate over time.

Centennial CFG

As of Q3 2022, Centennial CFG had about $2.1 billion in total loans. It’s experienced some payoffs over the course of the year, so the total loan balance has stayed pretty steady since Q1. The story’s completely different, though, if you look back over the last seven years.

Since HOMB acquired the $289 million pool of commercial real estate loans in 2015 that became Centennial CFG, it’s experienced pretty impressive growth. The growth to $2.1 billion by 2022 puts CCFG’s CAGR at a strong 32%. From Q1 2021 to Q1 2022, the loan book grew from $1.6 billion to $2.1 billion. And, though I’m not sure how reliable this measure is for future growth (especially considering growth seemed to slow in the second half of 2022), HOMB did say that CCFG had around $3.4 billion of total loan commitment back in the Q1 2022 Earnings Call.

For the most part, CCFG’s loan book is made up of high dollar value commercial real estate loans in some of the larger markets across the U.S. And to give you an example of the size of the loans, we can look at the break-down HOMB gave in the Q1 2022 earnings call. In that call, CCFG said it originated 11 new loans in Q1 worth a total of $459 million. That’s an average of ~$41.7 million a loan.

As far as I can tell, this segment of the business hasn’t traditionally been focused on attracting deposits. As I’ve noted before, for most banks, deposits are their real assets. And, as we’ll discuss below, this is especially true during a rising rate environment. Centennial CFG has really, it looks like to me, been a way for HOMB to actually grow its loan book at a time when it was turning down a lot of the loans that were demanded by customers in its regional markets. Deposits weren’t really a part of the CCFG playbook

But, in the Q3 Earnings Call, Allison and his team hinted at trying to bolster deposits by getting what they called the “New York Deposit Machine” going (i.e., deposits where CCFG is headquartered). They noted that they haven’t really done that until now, and it makes sense. I don’t really know how effective this will be, but hopefully they can get some big-time borrowers to park long-term deposits there (at little to no cost).

I think the big upside to HOMB now having CCFG (and it being relatively large now), is that they can really take advantage of this large commercial real estate lending market during a downturn. Unlike a lot of lenders who focus on this market, HOMB has excess liquidity and isn’t highly levered. When lending for these big projects dries up – and Allison has indicated that it already has, saying in the Q3 Earnings Call that big borrowers from California were flying to Arkansas – CCFG can take advantage of it and grow their loan book.

I obviously don’t know for sure if this will happen, but given Allison’s comments, I think this could be what they focus on as rates start to rise. This seems to be especially true considering HOMB’s growing concern about buying entire banks during a rising rate environment. As Allison has explained on earnings calls, you really don’t know what you’re getting when you purchase an entire bank when rates are rising. A lot of these banks have made loans at 3-4% interest rates, and while their balance sheets aren’t currently showing it, they’ll have to write down a large chunk of their loan portfolio when they sell it. So, if you agree to buy a bank at 2x book, you could, in reality, be buying it at 4x book.

The best way for HOMB to take advantage of this environment then (aside from buying banks out of FDIC receivership or something) is to step in and lend to large commercial real estate borrowers when other banks can’t. CCFG would then be able to charge higher rates, with very little or no competition. They could also build their balance sheet by buying large loans at a discount from lenders who need some extra liquidity.

Shore Premier Financial

Shore Premier Financial is definitely operating in an interesting market. It obviously appeals to someone like me who’s always looking for banks that lend in weird and interesting markets. And, considering HOMB’s large presence in Florida, I think it’s a natural progression.

I don’t really know a lot about this kind of lending, though. To me, it seems like a better way to get into consumer loans than credit cards and auto lending, but I don’t really know how the portfolio will hold up in any kind of recession.

HOMB has obviously grown SPF pretty quickly. And it’s made one significant bolt-on acquisition since it started the operation back in 2018. Its marine lending book is now over $1 billion, compared to $386 million when it started. That’s growth of over 2.5x, and, quite frankly, a CAGR that the rest of HOMB’s loan portfolio can’t touch. But, that’s not the end of the story. Loan growth has stalled in 2022. Loan origination was down in Q2 and Q3 2022. And while the team says on earnings calls that it’s mainly a supply chain issue (not as many boats are able to be built and sourced to dealers), I’m not sure how I feel about the cyclicality of this market.

Think about it. High-end boats like this are typically a luxury good, which may be the first kind of spending that falls during a recession. I don’t really think that HOMB has over-extended itself (Non-accrual loans in SPF were only at 0.13% in Q1 2022), but it’s hard to say how things could turn out if the economy really takes a turn for the worst. HOMB has never done this kind of lending in a down cycle, so we’ll see how it plays out.

But, to be honest, I wouldn’t worry too much about the downside. I doubt all of SPF’s $1 billion in loans will have serious problems. And, anyways, $1 billion is a pretty small portion of HOMB’s $13.9 billion in total loans. So, maybe the best thing to do is focus on the potential growth that SPF could deliver over the next decade or so – a sort-of reward/risk viewpoint considering SPF has historically grown fast and the potential losses (which would likely be very small if anything bad did happen) would not make that much of an impact on HOMB’s loan portfolio.

SPF is mainly focused in Florida – but maybe not as much as you think. Roughly 24% of its loans are concentrated in Florida. But even this confuses me a little bit. A larger portion of its customers could own a boat in Florida but not live in Florida. So, is the loan recorded where the boat is or where the individual lives? I would assume that the loans are allocated based on where the collateral is, so the 24% allocation to Florida is probably accurate as far as where the risk is located.

I really don’t know how fast this market can grow, and I can’t really find reliable data on the size and growth of the high-end boat market. One source says the worldwide sail boat market is worth $6 billion. If that’s true, then SPF is a pretty big player in the market – and I don’t know how much more it could grow. But, it is financing both dealers and customers, and I don’t know what that estimate is taking into account – final consumer sales? SPF is financing both dealer inventory and customer purchases, so it’s really getting two bites at the same apple – which is good for a lender in a market like this.

Valuation

On its face, HOMB is a pretty cheap stock. Right now, it trades at ~15x its 2021 earnings (and probably much lower for 2022 expected earnings). And it’s at less than 1.5x the current book value. Getting a bank like HOMB at less than 2x book is a very good deal. No, it doesn’t generate 20% returns on its equity right now, but that’s mainly because of its capital position and the large quantity of cash and bonds that it’s holding. It still generates a ~2% return on its assets, and if it was leveraged like other banks you’d be getting over 20% returns on your equity.

That’s as it stands right now. If HOMB starts buying bonds and lending at much higher interest rates, there’s a very good chance that it will be earning those kinds of returns without increasing leverage.

We can do the math to see what happens here. HOMB earned an average rate of 5.43% on its loan book in 2021. In 2019, a year after rates started increasing, the average loan yield got to 6%. We can assume that this will happen again, though, as you probably now know, this assumption is actually a little too low.

The Effective Fed Funds Rate in 2018-19 only got to 2.42% at its highest. Right now, the Fed is targeting a range of 4.25-4.5% and the Effective Fed Funds Rate is at 4.33%. So, it’s already higher than it was in 2019. Many of the loans on most banks’ balance sheets have not been rerated yet because the raise has been so fast, but they’re getting there, and 2023 will see a definite change.

According to Centennial Bank’s September 30, 2022 FDIC Call Report, HOMB currently has about $6.27 billion in loans that either mature or reprice in 1 year or less (the split between maturing and floating rate is about half and half). That’s roughly 45% of its total loan portfolio. About 39% mature in 1-5 years, 8.2% mature in 5-15 years, and just over 7% mature after 15 years.

Traditionally, deposit rates lag fed fund rates and don’t re-rate as immediately as loans do. But, we also have a flattening yield curve. And since bank assets (loans and bonds) are typically longer in duration than bank liabilities (deposits), we could see increasing deposit rates while loans and other securities don’t re-rate as fast as they traditionally would.

In fact, according to ustreasuryyieldcurve.com, the U.S. Treasury yield curve is currently inverted.

With that in mind, take a look at HOMB’s bond portfolio below.

They’ve only got about $882.7 million in bonds due in the next ten years. Roughly $3.5 billion of their bond portfolio is due after ten years – $1.4 billion in bonds due in ten years and over $2 billion in MBS (which are all due in 15 to 30 years).

Obviously, with the current rate environment, they could deploy the 1-year securities at higher rates (if those aren’t the recently deployed securities that were probably made at high rates). But the current yield for some longer-term bonds may actually be lower.

Using common sense, though, we can say that this isn’t the case for the MBS portfolio. Mortgage rates are now averaging about 6-7%, so it’s unlikely that HOMB won’t be able to find higher-yielding MBS’s if it goes looking. The duration of the securities does mean, though, that HOMB would probably have to sell their lower-yielding MBS portfolio for a loss if it wants to deploy them anytime soon. This doesn’t take into account, however, a possible rush of repayments to lock in a lower rate before rates rise more.

With all that in mind, let’s look at some actual numbers.

Right off the bat, we can say that 45% of HOMB’s loans will be redeployed in 2023. I don’t know what percentage of that is already committed at lower interest rates (we saw that there’s a possibility that $3.4 billion or more of CFFG’s loan portfolio is arranged pretty far in advance).

We can now calculate an expected interest rate on those loans. I think an estimate of 9% is reasonable. I don’t think that’s too much to ask for considering average rates were at 6% in 2019 and 6.39% in 2014. Overall rates weren’t even close to current levels then. In addition, can assume that the non-rerated loans average 6% rates. So, we get: (.09)(.45)+(.06)(.55) = 7.35%.

Overall, I think it’s safe to say that in 2023 and maybe 2024, the average interest rates on HOMB’s loans could be around 7.35% or so, considering they already reached 6% in 2019 with a much lower Fed Funds Rate. Maybe you think this is crazy or unjustified. But keep in mind that HOMB is and always has been making the kind of loans that have rates that are much higher than average. They intentionally go after loans with higher rates, and have been positioning themselves to take advantage of this environment.

With $13.9 billion in loans currently (again assuming they don’t’ grow over the next year or so), 7.35% on that would be $1.021 billion in interest income. With the $1.5 billion in cash deployed at a safe 6%, you can get an extra $90 million. That’s $1.111 billion of interest income. You can add to that also the current bond portfolio of $5 billion. Let’s say it has some longer-duration bonds that are weighing it down, so the yield only gets to 5.5% or so. That’s an extra $275 million. The interest income added from the bond and cash portfolio alone already exceeds 2021’s net income. Added all together, the total interest income amount would be $1.386 billion for 2023 (the hypothetical year). On total earning assets of $19.3 billion, this would be a 7.18% overall yield.

So, we have an overall yield on earning assets of ~7.2%. HOMB’s average non-interest income was at 0.88% of earning assets over the last nine years (not including 2022 – not a full year). The tenth year, 2012, was a bit of an outlier – the rate was much higher (~1.5%) – so I excluded it. Rates tended to stay relatively the same since then. In 2021, non-interest income as a percentage of earning assets was actually at 1.03%. So, I think 0.88% is a reasonable number, considering that in the majority of those years, HOMB did not have the cash balance that it had now, so the earning assets number was a better representation of total capital compared to the last few years.

The average interest expense as a percentage of EA has only exceeded 1.00% one time, and that was in 2019 (it was at 1.22% – this is the cost of deposits and cost of debt averaged together). Non-interest bearing deposits were sitting at about 21% of total deposits then, compared to ~30% now. So, even if deposit rates are rising, HOMB’s larger chunk of free money will help to mitigate the cost. But it won’t stop things completely. As I said earlier, rates on deposits traditionally lag rates on bank assets. So, the deposit rates probably won’t re-rate superfast, though they could, considering these are the fastest interest rate increases we have seen in a long time. Being conservative, I think 1.8% could be a reasonable number. If you don’t think that’s reasonable, keep in mind that HOMB’s non-interest expense doesn’t get much over 2% of earnings assets.

As far as the largest expense – non-interest expense – goes, I think we can use an average of the last few years. Yes, HOMB’s asset base and workforce has grown, but since it has already gotten its efficiency ratio down, I think its non-interest expense will stay pretty close to around 2.18% (average of last 5 years).

Add 2.18% to 1.8% and you get a total expense of 3.98%. Subtract this from the average rate earned plus the non-interest income (7.18% + 0.88% = 8.06%), and you get a True Net Yield on Earning Assets of (8.06% – 3.98% = 4.08%). A 4.08% True Net Yield on $19.3 billion (assuming no growth from 2022) comes out to $787.4 million in pre-tax income.

If this is the outcome, HOMB sounds like a great bet to make. Obviously, there are some risks (which I address below), but it’s pretty obvious to me that HOMB is a safe lender and a bank that takes risk very seriously. Maybe loan demand won’t be as strong in this rising rate environment, so it will be difficult for HOMB to actually deploy its maturing loans? Maybe we will go into a recession and there will be serious problems in the loan portfolio? I don’t know. If you think my projections are too aggressive, then just go back and test my assumptions. I think they’re pretty reasonable, but if anyone thinks something is really out-of-whack please tell me.

Looking at it from the other, side the only real problems I can identify are that my interest rate projections could be too high. Assuming 8% for loans that are rolling over and 5.5% average for the bond portfolio may be too aggressive. Maybe I just don’t know enough about the supply of high-yielding loans out on the market right now. That may be true. I’m trusting that if interest rates go higher, HOMB will be ready to take advantage of it.

While acknowledging that rates are going higher, most people don’t seem to share Johnny Allison’s views on where the Fed Funds Rate will end up. The consensus seems to be 5% or so (maybe not even that), then the Fed will start winding things back down. Yes, that is the consensus. But, looking back, it seems to have been a bad move to bet against Johnny Allison. And isn’t this how you make money in the stock market anyways? You bet against the consensus or you bet on something that isn’t priced in yet.

Plus, what’s really the risk here? These projections are all made without even taking into account the bank’s history of great operations. I still think, at around 15x, the bank is cheap for what it can do when rates are higher. If HOMB doesn’t get to take advantage of rising rates like it wants, it’s just back in the same boat it was before – which is a pretty nice boat (maybe even one of the boats SPF would finance).

Risks

The Happy Acquisition

I really don’t think the Happy acquisition is that big of a risk. More than anything, it’s a predictor of whether HOMB can pull off acquisitions of this size in the future.

First off, the Happy acquisition wasn’t without its problems. HOMB had to write-off roughly $50 million in problem loans on Happy’s balance sheet after the acquisition. If that wasn’t enough, they also had some personnel issues – apparently some relatively senior employees left to join another bank in Texas after the merger.

But, by the third quarter of 2022, things had started to look up. Happy’s efficiency ratio was over 60% when HOMB first made the acquisition. But by Q3 2022, HOMB had gotten the firm’s overall efficiency ratio back down to the low 40s.

In addition, any potential issues between Happy’s team and HOMB’s seem to have stabilized. Things were looking good financially by the third quarter.

More than anything, this acquisition is a pre-curser of what future growth could look like at HOMB. As I said above, HOMB will probably have to grow through larger acquisitions in the years to come. Happy gave it access to a growing Texas market, which is good, but to move the needle, it will probably have to acquire banks that are around Happy’s size or larger.

So, the Happy integration will be a thing to watch over the next few years, and it’ll give a good idea of the risks related to HOMB’s acquisition strategy in the future.

Slowing Growth

The biggest risk facing HOMB in the long term could be its inability to grow. I’m not really worried about HOMB’s lending practices or its acquisitions. Obviously, Happy is still a little bit of a question (with some issues around personnel and high expenses), but I believe all of that is temporary. This is a larger acquisition than normal, so it will take HOMB longer to straighten things out at Happy.

The real issue for HOMB is growth. It’s obvious that growth has slowed over the last four to five years. Equity has grown at around 6% or lower every year since 2018, when it was growing at double digit rates before then. Similarly, earning assets and overall interest income have also slowed to single digit growth rates or have even decreased in recent years. Deposits and non-interest income, however, have been bright spots in recent years, both growing at double digit rates the last couple of years.

It’s no secret that HOMB was intentionally restraining loan growth over the last few years. It’s been more conservative in the competitive, low-rate environment, and loan growth has suffered. But the real question is can HOMB actually continue growing its equity at a CAGR of 15% for the next decade?

I think the answer is difficult. HOMB has traditionally grown through acquisitions. Yes, its loans and deposits have grown organically too, but the big moves have been through acquisitions. And the big moves are what sets the average rate for the long term.

HOMB’s asset base is a lot larger now than a decade ago. Total assets sat at over $23 billion by Q3 2022, compared to $3.76 billion in 2010. It’s just harder to grow $23 billion in assets at the same rate that you can grow $3.76 billion. HOMB will have to make larger and larger acquisitions (like the Happy acquisitions) in order to move the needle.

Part of its strategy seems to be to make acquisitions in high-growth markets. Texas and Florida are some of the highest-growing markets in the U.S. HOMB’s focus on those markets could definitely spur loan and deposit growth. But I doubt loans can grow much faster than the overall economy in those states for extended periods of time.

So, while I do think that HOMB is positioning itself well to grow a higher single-digit rate organically, it’s hard for me to say that it can grow its equity or earnings at the 15% CAGR it did in the past. To do this, it’ll have to make acquisitions. And those acquisitions – as we’ve seen with Happy – will have to get larger and larger to move the needle, which will also make them more difficult.

Deposits

Another risk is HOMB’s deposit base. We know that about 30% of its deposits are non-interest bearing, which is normally great for both interest expenses and stickiness of the deposits. Someone depositing money that gathers no interest at your bank probably won’t leave to chase higher rates at another bank.

We also know that only about 5.5% of HOMB’s deposit base is made up of time deposits. This is also good, considering time deposits are not only the most expensive, but the most likely to leave once their time is up.

The largest portion of deposits that HOMB controls are savings and other interest-bearing deposits (maybe money-market accounts, etc.). These obviously cost something, but are cheaper than time deposits and brokered deposits. They are less likely to leave than time deposits, but may still leave for higher-yielding accounts.

All of this is well and good, but we do know that HOMB lost about a billion dollars of deposits in the third quarter of 2022. This is pretty scary to me honestly. I try to look for banks that have the stickiest deposit base around. They’re usually the most stable and do the best in environments like this one.

It worries me to think what other banks may start experiencing once rates start rising and liquidity dries up. Luckily, HOMB isn’t highly levered and is pretty liquid. Just imagine if it had equity at 8% of assets and had a loan to deposit ratio of 90% or something. It may have been in trouble if $1 billion of deposits pulled out in one quarter. Fortunately, HOMB was holding a lot of cash. Even if that money was in bonds, things wouldn’t have been very pretty.

I would say that I don’t expect HOMB to lose deposits like that again, but I really don’t know. I’ve never invested in an environment like this. But what I will say is that, as far as banks go, HOMB is well-prepared. It does worry me that its loans are mostly longer-duration real estate (though it does have a pretty decent chunk of loans that are due in 1 year or less, as we saw above).

Interest Rates

One of the risks we don’t think much about is opportunity costs. In HOMB’s case, the opportunity cost is how much interest income they gave up over the last few years and are currently giving up now.

They’re making a bet that interest rates will rise a pretty good bit. They (and I) believe that it is a safe bet. It’s definitely safer than using the full amount of your allowable leverage and plowing your entire balance sheet into loans at low rates. But, HOMB’s strategy isn’t without its own risks.

If rates don’t rise as much as they hope, they’ve, to some extent, wasted time and money. There is a scenario where the Fed immediately stops raising rates early in 2023 and instead starts lowering them. If that happens, HOMB will not have had much time to take advantage of the rising rate environment that they were prepared so well for.

Rates will drop back down, and HOMB will go back to generating average or sub-par returns on equity (if they keep the same amount of leverage they’ve been using). Keep in mind that they’re already generating great returns on their assets even with low leverage and a good bit of their balance sheet in cash and securities.

Conclusion

Home Bancshares is an impressive bank, there’s no doubt about it. Even without its current strategy, it’s still probably a good long-term investment. But, given the strategy Allison has been vocal about over the last year and HOMB’s strong operating and lending culture, I think it’s poised to take advantage of rising rates better than most any other bank out there.

Yes, the scenario I outlined above might not play out. Nothing is a certainty, and redeploying loans, securities, and a large cash pile in a rate environment like this can’t be easy. But, it’s a pretty risk-free proposition for investors at this price.

On one hand, HOMB could profit immensely from rising rates (as I’ve outlined above). But if rates don’t rise as much as I say they could, or if HOMB isn’t able to easily redeploy its capital at much higher rates, you still get a bank that (1) lends at extremely high rates, (2) hasn’t ever had any serious issues with its loan book, (3) is positioned in growing markets, (4) has a long history of making value accretive acquisitions, (5) is extremely efficient, and (6) generates around 2% ROAA even in a low-rate environment.

It’s truly a “heads I win, tails I don’t lose much or anything” kind of bet. Yes, you can find statistically cheaper banks out there, but once you dig below the surface it’s hard to beat the value proposition that HOMB presents right now.