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Writing about Texas Capital Bancshares (NASDAQ:TCBI) in February, I said that while I was bullish on the long-term strategic transformation plan put in place by the new CEO, I saw a “better than average” chance that the bank would underperform in the near term given the bank’s high deposit beta and willingness to invest opex into the transformation of the business. That’s largely played out this year as I expected, though I’m honestly a little surprised that the shares are only down a bit more than regional banking peers given the steeper pace of deposit cost growth.
I still see Texas Capital as a short-term/long-term puzzle I do like the CEO’s vision for what the bank should be – focused on commercial lending, with stronger investment banking, trading, and treasury options to drive fee income and stickier relationships – but it will take time to get there. In the meantime, I see elevated operating risk on higher deposit costs and weaker operating leverage. Investors unsure of their ability to time a turn in sentiment for banks may want to consider buying or holding the shares now, but there could be better entry points over the next year.
Deposit Costs Head Skyward…
Deposit costs were always going to be an issue for Texas Capital during this phase of the banking cycle. While the bank has a sizable non-interest-bearing deposit base as a percentage of deposits, the stickiness of those deposits isn’t tremendous, and the bank has long needed to rely upon more expensive sources of funding like brokered and indexed deposits.
In the last cycle (2014-2018), Texas Capital had a deposit beta of around 75%, or close to double its peer group. For readers not intimately familiar with banking terms, deposit beta is a measure of how quickly deposit costs rise relative to the underlying cost of Fed Funds, a high deposit beta means that as rates rise, a bank sees its deposit costs rise more quickly than banks with lower betas.
Part of my thesis on banks since 2021/2022 has been that banks would see a steeper rate cycle and higher deposit betas than expected, as deposit inflows during the pandemic reversed in pursuit of higher yields. That’s happening, with higher-than-expected cycle-to-date betas across the sector and CD deposit betas recently reaching 70% (based upon the highest advertised rates), and already beating the prior cycle high.
For Texas Capital, the total cumulative beta reached 33% in the third quarter and I think there are risks that it could exceed management’s 50% full-cycle target. While management is working down indexed deposits (now 15% of the total versus 18% in Q2’22 and 36% in 2020), the steep 11% sequential decline in non-interest-bearing deposits (the worst result, I think, I saw in Q3) underlines the bank’s funding challenges. With that, deposit costs nearly quintupled on an annual comparison and nearly tripled sequentially (from 20bp a year ago and 33bp a quarter ago to 94bp), and Texas Capital’s total deposit cost is higher than many banks’ total funding costs.
Some of this deposit cost risk is offset by a very high asset yield beta – the rate at which the bank sees loan yields (and other sources of interest income like securities) increase in response to higher rates. At over 80%, Texas Capital’s beta is well ahead of peer averages (closer to 50%), as the bank has about 70% of its book tied to prime or one-month LIBOR. Management is using spreads to reduce asset sensitivity and lock in some protection, but I do think deposit costs remain a risk (albeit a known risk).
Transforming Toward A Higher-Earning Commercial Bank
I remain bullish on management’s transformation plans for the bank. The overarching idea here is to transform the bank into a commercial-focused middle-market lender that can serve the needs of mid-sized and smaller commercial clients not just through lending, but also through complementary services like investment banking, trading, and treasury services.
The bank has only just started building its i-banking/trading capabilities, with FINRA approval coming about a year ago, and management is looking to grow this from around 3% of the business today to 10% in 2025. Likewise, treasury product fees now contribute around 3% of total revenue, and management is looking to grow this to 5% by 2025.
As part of this strategy, management is prioritizing broader and deeper relationships with its clientele and looking to deprioritize transactional relationships. To that end, the bank sold its insurance premium finance business to Truist (TFC) for $3.4 billion in cash. Getting rid of a business that generates approximately 20% full-cycle return on equity is painful in the short term, but it was a transactional business where the company couldn’t really deepen those relationships. What’s more, selling off around $3 billion of loans (around 13.5% of the book) will relieve some of the bank’s funding pressures.
Looking at the core lending part of the business, average loans held for investment were down 2% qoq, while end-of-period loans fell more significantly (down close to 20%). The Mortgage Finance business is unsurprisingly seeing significant weakness (down about 25% qoq), but core C&I lending was strong (up over 6% qoq), and while CRE lending was soft (down 2%) on higher repayments, it wasn’t too bad.
Utilization rates have held steady in the low-50%s; Texas Capital didn’t see the same fall-off as many other banks and isn’t see as much leverage from improved utilization. With that, there’s a greater need here to establish new banking relationships to drive growth – a more challenging prospect given the cost of funding loan growth in this environment (something I also discussed in a recent piece on First Republic (FRC)).
The Outlook
To reiterate, I see a pretty sharp separation between the near-term prospects of this bank and the longer-term prospects. In the short term, I do see meaningful risk to spread income from higher deposit rates and I think the bank will continue to accelerate investments in the business transformation (higher opex) where it can. Underlying core C&I lending growth should remain healthy, and with weaker Mortgage Finance demand and the sale of the insurance premium finance business, there should be a little less funding pressure there.
Longer term, I’m bullish on the company’s plan to build a well-rounded commercial bank capable of doing more than just lending money to business clients. Not many banks of similar size try to offer those investment banking, trading, and treasury services (and fewer of them can do so effectively), and larger banks struggle to serve the smaller businesses that are the core clientele of this bank.
I’ve cut back my 2022-2024 earnings expectations on weaker spread income and higher opex, and that drops my five-year core earnings growth rate to 6%-7% (almost half of my previous expectation. Longer term, though, I still believe low-to-mid-teens core earnings growth is possible. Texas Capital will have to be a share-gainer in the very competitive Texas commercial lending market, but I think management is building out a suite of offerings that can stand out.
On a discounted core earnings approach, I believe Texas Capital is around 10% undervalued today and priced for a low-double-digit long-term annualized return. Shorter-term approaches are less favorable, with a 14x multiple on my ’23 EPS estimate supporting a fair value around $59 today.
The Bottom Line
I’m more negative on Texas Capital’s near-term earnings prospects, but the company is addressing the main drivers of this vulnerability (indexed deposits, et al) and I believe the bank will emerge stronger for it. With Fed easing likely off the table until 2024, sentiment may not improve meaningfully for the sector until mid-2023 or later and I do see Texas Capital’s valuation as still somewhat of a risk factor. Investors who are less confident in their ability to time shifts in sentiment may want to consider this name now on the basis of its long-term transformation potential, but the near-term valuation isn’t so special and I think the near-term risks to earnings are still meaningful.
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