Webster Financial Looks Undervalued, But With Elevated Integration Risk

Banks in general are out of favor during this tightening cycle, and banks that have recently engaged in large-scale M&A are even more so, which puts Webster Financial (NYSE:WBS) in a tougher position. Down about 18% since my last update, Webster exceeded initial sell-side expectations for 2022, but it hasn’t meant much in terms of relative outperform compared to regional banks in general or more local peers in particular (M&T Bank (MTB) has done a little better, Citizens (CFG) a little worse, and Signature (SBNY) much worse).

I continue to believe that these shares are undervalued, and perhaps meaningfully so. Integrating Sterling isn’t going to be easy, and deals like this typically fail to live up to initial management targets, but I do believe there are other positives working for Webster, including a diverse collection of businesses that generate attractively-priced deposits and/or interest income. If 4% long-term core earnings growth remains a reasonable target, Webster looks undervalued below $60.

A Mixed Fourth Quarter, With A Modest Pre-Provision Beat

Before discussing Webster’s earnings, I’ll offer the cautionary statement that there are a lot of adjustable items in the earnings report and not all analysts/investors make the same adjustments. I believe, for instance, that amortization should not be excluded from operating expenses, but others disagree. So there may be some variance here between your preferred analyst’s numbers or your own calculations. I’m also generally not going to discuss year-ago results, as pre-Sterling numbers are of limited comparability.

Revenue rose more than 6% from the prior quarter, beating by close to $0.04/share versus sell-side expectations. Net interest income rose more than 9%, beating by close to $0.05/share, with net interest margin up 20bp qoq to 3.74% and earning assets up almost 3%. Fee-based income declined about 8%, missing by about $0.01/share.

Operating expenses rose more than 6% qoq by my calculations, missing by about $0.02/share, but still good enough for a low-40%’s efficiency ratio (41.2%). Pre-provision profits rose nearly 10% sequentially, beating by a modest $0.02/share versus sell-side expectations. Provisioning largely took that back, and Webster’s core results were basically in line with expectations.

A Better Balance Sheet Than Most

I was impressed with the loan growth that Webster managed in this quarter, as well as the overall cost of funding for that loan growth.

Loans rose about 4% sequentially on an end-of-period basis, with healthy 4.5% growth in C&I lending (including almost 5% growth in core C&I), as well as 4% growth in the CRE portfolio. Overall loan yields improved 73bp qoq to 5.25%, which isn’t bad next to peer banks (M&T saw 67bp qoq improvement to 5.12%), though Webster is more skewed to commercial lending (about 80% versus around two-thirds), so you’d expect better loan yield improvement.

Deposits rose very slightly on a sequential basis, with non-interest-bearing deposits down a little more than 6%, which was better than the average for comparable banks. Deposit costs rose 44bp yoy and 26bp qoq to 0.48%, while interest-bearing deposit costs rose 55bp yoy and 32bp qoq to 0.60%. Not only are these costs comparatively low, Webster’s adjusted cumulative beta of 15% is comfortably on the lower side of average.

One of the things I like about the Webster story is the bank’s sustainable access to lower-cost deposits. Webster operates one of the largest health savings account businesses in the country, and while this business requires constant reinvestment into IT, it generates substantial lower-cost deposits (an average cost of 0.15% this quarter, versus 0.06% in the prior quarter and 0.06% a year ago). Webster further diversified this theme with the recent acquisition of interLINK, a cash sweep administrator for broker/dealers that further expands the company’s access to low-cost deposits.

For now, credit looks okay. While Webster does a fair amount of CRE lending, it’s office exposure looks manageable at $1.5B (around 3% of total loans), split between Class A and Class B/C, and with the ratio of criticized and classified loans improving sequentially (to 6.6%). The non-performing loan ratio has been stable, and while I expect charge-offs to increase, I don’t think it will go much past the 0.4% level on an annualized basis (and may not even get there).

The Outlook

Perhaps recognizing the challenges of the Sterling integration, and the importance of getting it right, Webster management is taking a slow and methodical approach to the integration. At this point, full systems integration isn’t even targeted until mid-year (presumably the Fourth of July holiday, as these integrations are usually done over a holiday), and while that does delay some of the cost synergies from the merger, this is a case where I’d rather see it done right than done right now.

I continue to see generally attractive drivers for the business, including more commercial lending overall and more lending in specialty verticals/markets where returns should be incrementally higher. I also see an opportunity for Webster to benefit from what has been a somewhat rocky integration of People’s at M&T, though it’s certainly true that Webster could have similar problems of its own, driving customers away and toward rivals like Citizens, Signature, and smaller community banks.

Helped by merger savings, healthy trends in commercial lending, and attractive low-cost deposit flows, I think Webster could generate mid-teens annualized pre-provision profit growth over the next two years, which should compare well to most of its peers, and I don’t expect provisioning/credit losses to be disproportionately higher here. I’m a little below Street-average estimates for ’23 and ’24 on an EPS basis, and I’m looking for long-term core earnings growth of around 4% to 4.5%.

Discounting those core earnings back, I believe Webster should trade above $60 even factoring in some added risk (a higher discount rate) for the Sterling integration. I likewise see undervaluation on an ROTCE-driven P/TBV approach and P/E approach. In the latter case, using the same 10x multiple I use for M&T on ’23 EPS would give me a target fair value of over $67.50 and even a meaningful discount (9x) to account for integration and CRE credit risk would drive a low-$60’s fair value… assuming, of course, that 2023 earnings come in as I expect.

The Bottom Line

Unlike most banks, I don’t think Webster’s net interest margin has peaked, nor do I believe the company has largely exhausted opportunities to meaningfully improve operating leverage from here. I think I understand why the shares have underperformed, and while a hawkish Fed won’t help in the short term, I think there’s enough value here to merit a closer look from investors looking to add some banking exposure in the Northeast U.S.