Valley National Bank Trying To Turn Over A New Leaf (NASDAQ:VLY)

Valley National Bank (NASDAQ:VLY) is still trying to put a lackluster performance and total return history behind it. Since a CEO change at the end of 2017, the company has made meaningful progress on operating efficiency and has seen some acceleration in tangible book value growth, but challenges remain. Despite a fairly strong return on tangible common equity, the bank’s acquisitive behavior continues to sit poorly with many analysts and investors, and the company’s efforts to drive a more balanced mix of organic and acquired growth are still relatively new and unproven.

I like the strategy Valley National is following now, and I think the Bank Leumi deal may be a better long-term opportunity for the company than is reflected in the share price, as I think a larger private banking operation (somewhat similar to First Republic (FRC)) and a larger national specialty commercial lending franchise (somewhat similar to First Citizens (FCNCA)) can both create value. Still, I’m worried about the short-term profit outlook given the bank’s need to raise higher-cost deposits and the Street’s penchant for short-term thinking. Valuation is interesting at today’s level but there are a lot of banks trading at “interesting” valuations, and sentiment remains a concern for me.

Funding Costs Likely To Accelerate From Here

Funding costs have always been a bit of a challenge for this bank. The bank has a decent enough non-interest-bearing deposit base, but during the prior cycle (2014-2018) the bank had a cumulative deposit beta of 37% versus a peer group in the mid-20%’s. While today’s cumulative deposit beta actually isn’t bad at all (a little below 20% and below peers), I think costs are likely to rise more substantially from here.

Right off the bat, the company ended the third quarter with a loan/deposit ratio of basically 100%, which is a fair bit higher than the mid-80%’s average of comparable banks. Non-interest-bearing deposits declined 1.4% qoq on an average basis, which was a little worse than average, and period-end balances declined more than 4%, and the bank doesn’t have all that much in securities and cash (around $6 billion against a loan book of $45B).

With the bank expecting above-average loan growth in the fourth quarter (8% to 10% annualized) and looking to continue that growth in 2023 by leveraging the Leumi acquisition as well as organic commercial lending expansion into markets like Philly, Atlanta, and Nashville (as well as its cannabis business), funding is getting tight. Valley’s CD balances grew 44% qoq (average balances) and this is going to head higher still in the coming quarters. On top of that, Valley is showing that it’s willing to pay to fund its growth – the bank has recently been advertising CDs at 4.5% (13-month), which is one of the highest CD rates I’ve seen.

I agree with management that NIM spreads will probably flatten out in the mid-3%’s next year (around 3.55% to 3.65%), but this is going to weigh on spread income growth, and I expect very low single-digit sequential net interest income growth in 2023 as a result. At the same time, I don’t see much expense leverage opportunity, so I’m worried that Valley National will screen out with rather lackluster pre-provision profit growth.

Building A Better Mix Of Organic And Acquired Opportunities

Simply put, the Street typically applies a valuation discount for highly acquisitive banks, and Valley National is inarguably one of them, with a dozen deals since 2005. While some banks can leverage M&A to build value, Valley National’s long-term tangible book value per share growth rate of less than 4% doesn’t argue the case that they’re one of those.

Perhaps recognizing that, management has been putting more emphasis on organic growth opportunities more recently. The company has entered the home owner association business (which can generate attractive, sticky, low-cost deposits), as well as the cannabis business.

While the bank hasn’t made a lot of loans to cannabis companies so far, the bank has started collecting deposits and developed a secure payment solutions product called “Valley Pay” that it launched last year. Because many banks and card companies refuse to do business in the cannabis space (because it is still a Schedule I drug), there is a significant level of cash transactions, which not only increases the risk of theft, but creates more costs and complications for businesses. As a secure cashless option that can be rolled out across many states (27, I believe), I believe this could see a meaningful adoption rate.

Valley National has also been investing in organic commercial lending growth, hiring away productive loan officers from other banks to build out operations in Philly, Atlanta, and Nashville to complement branch-based operations in Florida, Alabama, and the New York/New Jersey metro area. While not strictly organic, I also expect the bank to leverage the national niche lending capabilities it acquired with the Leumi transaction; the latter of which has national operations in middle-market, construction, healthcare, and multifamily lending, as well as a significant private banking operation.

The Outlook

I do think that Valley National’s vulnerability to higher deposit costs will weigh on results in 2023 and 2024, and while the company has done a great job of driving out costs (taking the efficiency ratio from the low-to-mid 60%’s in the second half of 2016 to the high-40%’s more recently), I don’t see a tremendous amount of operating leverage from here. This means that building/growing the business in the short term is going to come at a higher cost.

Longer term, though, I think those costs could well prove worth paying. The cannabis industry is still relatively small (particularly in terms of business done with banks), and by offering loans and products like Valley Pay, Valley National may be planting the seeds for a more lucrative long-term franchise. Likewise, the company’s HOA, national deposit, and specialty commercial lending operations are young and subscale, but investing in those operations today (by underwriting loan growth despite high deposit costs) could pay off in leverageable market share down the road.

If Valley National can generate long-term core adjusted earnings growth in the neighborhood of 6%, I see a low-to-mid teens total potential annualized return. Using short-term approaches like ROTCE-driven P/TBV and P/E (with a forward multiple of 9x on ’23 EPS), I likewise get fair values in the $13-$14 range.

The Bottom Line

Banks are often a bit like ocean liners – it takes time to turn them around and the progress isn’t always immediately evident. I do believe Valley National is making progress, and I like the company’s strategy of pursuing attractive niche commercial lending opportunities. I do think further M&A remains a risk, though I get the sense from management that they appreciate the Street’s skepticism on this subject and will be more discerning with future deals.

I do think Valley National is undervalued today, and while the 10-year and 15-year performance track record is relatively poor next to the larger regional banking group, I think past may not be prologue in this case. I do see elevated near-term risk, though, both to deposit costs (and reported financial results) and sentiment. This may be a name that is better suited for a watch list with an eye toward a 2023 purchase than a full-position purchase today, but I am finding this a more interesting name.