Guido Mieth
Washington Federal (NASDAQ:WAFD) (“WaFed”) has done well since my last update, rising almost 7% (and beating regional banks by around 12%), with the stock getting a big boost on strong fiscal fourth quarter results, including excellent operating leverage and credit quality. The bank likewise posted healthy loan growth and decent deposit performance at a time when these metrics are getting closer scrutiny by the Street.
I still like WaFed, but operating conditions are going to get more challenging from here. The bank is going to have to rely more heavily on more expensive sources of funding for its loan growth, and that’s going to impact profitability. At the same time, I don’t see how credit can get much better for the bank. On the flip side, there are still opportunities to drive attractive loan growth in markets like Texas, Arizona, Nevada, and Utah, and I believe the shares do still offer some upside from here.
Strong Operating Leverage And Strong Spread Income Growth
WaFed benefited from better-than-expected rate sensitivity in the fiscal fourth quarter (the October quarter), and that played a significant role in driving a strong earnings result.
Revenue rose 25% year over year and 11% quarter over quarter, with net interest income up almost 32% yoy and 14% qoq. Spread income was driven principally by stronger loan yields, as net interest margin improved 76bp yoy and 42bp qoq to 3.64%, and earning assets were basically flat sequentially, as the bank ran down securities and cash balances to fund loan growth.
Fee-based income declined 24% yoy and 17% qoq, with the declines in the catch-all “Other Income”; mortgage banking is not a significant business here and fee income is less than 10% of total revenue.
Operating expenses rose 9% yoy and 7% qoq, with the efficiency ratio improving from almost 57% a year ago to 49.5% this quarter. That strong operating leverage shows up in the pre-provision earnings, which grew 45% yoy and 16% qoq.
Unlike many banks, the negative impact to tangible book value of mark-to-market adjustments on security portfolios isn’t present here. WaFed has benefited from a shorter-duration portfolio, as well as rate hedges, and securities aren’t as large of a portion of WaFed’s holdings. With all that, tangible book value per share rose 10% yoy and 3% qoq in a quarter where many banks have reported steep declines.
Loans Are Growing, But Funding Is A Growing Concern
WaFed posted over 16% year-over-year growth in period-end loans, as well as 3.5% sequential growth that was a bit better than the average for “smaller” commercial banks in the U.S. during the third quarter. Management continues to shift the loan mix more and more toward commercial lending, with commercial real estate loans up 8% qoq and multifamily loans up 6%. While construction loans didn’t grow much on a sequential basis, the bank is seeing meaningful originations here.
WaFed is benefitting from both higher rates and a shift toward a lending mix that includes more variable-rate lending, including construction lending. That has helped drive loan yields strongly higher, rising 91bp yoy and 48bp qoq to 4.38%. At the same time, current credit quality remains quite good and WaFed has an enviable track record since the Global Financial Crisis where credit costs are concerned.
The bank reported 3% yoy growth in deposits, with a slight improvement in the sequential balances. Non-interest-bearing deposit balances were flat, which is actually better than average for banks this quarter, but is still rather low at 20% of total deposits.
One of my concerns about WaFed back in August was its relatively thin funding cushion, and that remains one of my main concerns today. WaFed has run down its cash balance from $2.1 billion last year to $0.7 billion this quarter, and to fill the gap FHLB borrowings increased by more than 23%. While FHLB advances are a reliable source of funding, they’re also more costly, with the average rate moving to 2.02% from 1.51% a year ago while deposit costs have jumped from around 22bp to 43bp.
Given a loan/deposit ratio above 100% on an end-of-period basis, expect WaFed to have to keep relying on more expensive sources of funding, as I don’t see especially strong prospects for organic core deposit growth over the next year. To that end, I wonder if WaFed might consider a select in-footprint acquisition or two of a smaller community bank that has surplus deposits.
The Outlook
I do think this is a challenging time in the banking cycle. Deposit betas are likely to exceed earlier industry expectations, and while banks continue to benefit from higher rates on new loan originations, I do have some concerns that the current Fed rate cycle will overshoot and do a little more damage to loan demand and credit quality. While I don’t have credit quality concerns here, I do see some risk that WaFed sees more of a revenue slowdown than is currently in sell-side models.
Moving the model out a year reduces my long-term core earnings growth rate into the mid-single-digits (5% to 6%) versus a growth rate closer to 8% previously. My FY’23 earnings estimate is quite a bit higher now, though, as the bank has seen a much bigger step up in spread and operating leverage than I’d expected. I’ve tempered my FY’24 and FY’25 expectations some in response.
The Bottom Line
Between discounted core earnings and shorter-term valuation approaches like ROTCE-driven P/TBV and P/E, I believe WaFed is still undervalued. I see double-digit long-term annualized return potential from here on core earnings, while a 10x multiple to my FY’23 EPS estimate supports a fair value in the low $40s.
Sentiment remains a key risk here, and I don’t think the Street is going to get especially excited about the banking sector until there’s more confidence that the rate hike cycle is closer to an end and more visibility on how much these hikes will impact employment and business growth plans. I still like WaFed’s leverage to “Main Street banking”, though, and I think there’s still an argument for buying and holding these shares today.
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