First Republic: A High Quality But Overpriced Bank (NYSE:FRC)

While the bank earnings season isn’t over yet, we’ve gotten a large chunk of the sector’s results already. And those earnings have varied dramatically between banks. Some, like Wells Fargo (WFC), have aggressively built up their loss reserves to deal with potential problems in future quarters. Some banks are even reporting operating losses due to significant deterioration in the loan books. However. other banks have gotten through the first quarter of the coronavirus crisis almost entirely without blemish.

Take First Republic (FRC) for example. First Republic is the nation’s largest regional bank (as judged by the holdings of the KRE regional banking ETF). It used to be part of Merrill Lynch and then Bank of America (BAC). However, BofA spun it off in 2010, and First Republic has been an absolute rock star since then, outperforming its sector peers three-to-one:

Data by YCharts

As you can see, First Republic shares have already recovered most of their March recent losses.

The earnings report earlier this month helped matters – they hardly took any loan loss reserves, and with their huge EPS beat, the stock rallied 7% on the numbers.

The bank claims its unique business model protects it. First Republic primarily lends to high net worth individuals in a few super-wealthy metro areas such as Boston, San Francisco, and New York. The thinking is that these clients, who tend to work in venture capital, biotech, and other highly-remunerated fields, are going to be good for their loans regardless of broader economic struggles.

This quarter, for example, the bank took just $202,000 in net loan charge-offs. Yes, $202k. That’s an absurdly low number, as First Republic is a huge bank in its own right. Since its IPO in 2010, First Republic has taken less than $40 million in cumulative loan losses, which is incredible for a bank with a $16 billion market cap today.

Still, it’s worth keeping a watchful eye of their loans in coming quarters. I’m skeptical that upper class people – as a group – won’t see at least a bit of economic setback from current conditions. And that’s before you get to the subset of wealthy people that own real estate where tenants have stopped paying rent. This is a different sort of economic shock than 2008, and I wouldn’t be surprised if even the safest of banks – like First Republic – see a meaningful uptick in non-performing assets.

Some Slight Blemishes In The Growth Story

There are a few issues with First Republic – none of them are especially pressing, but they’re enough to make you question the valuation a bit. FRC stock is trading at 20x 2019 earnings after all, which was expensive for a bank in a good economy, let alone a recession of uncertain depth. FRC stock is still selling for more than 2x book value as well.

These are simply extravagant figures given the current economic climate and massive selloffs in other banking stocks:

ChartData by YCharts

In fact, First Republic stock is up since last summer, while financials (XLF) are down 19% and regional banks are down 30%. That’s a wide disparity.

As to what might cause First Republic’s valuation to come in a bit, here are a few factors to watch. For one, First Republic’s Return on Equity has steadily come down over the past decade, falling from 15% in 2010 to 10% last year:

Source: QuickFS

What’s caused the sharp decline in ROE? Just look up at the Net Interest Margin line. First Republic’s NIM has slumped from 4.5% to just 2.7% over the same span. It is highly affected by interest rate cuts, as it has an excellent consumer franchise which offers it low-cost deposits. This is a benefit of working with a wealthy clientele, as First Republic does. However, as interest rates go down, this doesn’t help First Republic much since it was already paying next to nothing to depositors.

Given that ROE and NIM were already trending lower even before the Fed’s emergency rate cuts, things weren’t looking great for near-term earnings growth. Throw in Covid-19, and now analysts expect earnings to be down for the next two years as compared to last year’s results:

Source: Seeking Alpha

Again, this would not be a big deal if you were paying a price closer to book value. But at 2x book value and 20x earnings, there’s a ton of expectations baked into the stock price. Two years of flat to declining earnings on a 20x P/E bank stock is not a great look.

There will be little support from the dividend either, FRC stock yields just 0.8%. Its 5-year dividend growth rate of 7% compounded is respectable, but it’s nothing remarkable given the starting sub-1% yield.

It’s not buying back stock, on net, either. In fact, First Republic has been a substantial issuer of stock over the years, creating a significant amount of dilution:

ChartData by YCharts

There’s nothing wrong with issuing stock when you trade over book value. But do be aware of this drag when you make future models of potential earnings and growth. In any case, you’re not getting much cash back via dividends, and you aren’t getting any capital return via share repurchases.

That leaves just organic growth. And First Republic has had this in spades; it’s aggressively seized market share since splitting off from Bank of America to become the country’s largest regional bank. The coronavirus may dampen those growth ambitions however; loan growth will slump nationally for at least a few quarters. First Republic may be able to grab a bigger piece of the shrinking pie as national lenders pull back. But it’s a more difficult market nonetheless. Additionally, First Republic has invested heavily in wealth management services. These will face headwinds with a weaker stock market.

Great Company, Wrong Price

None of this is a major criticism of First Republic. It has an absolutely tremendous client base and excellent loan underwriting, and it deserves a solid premium for that. Additionally, its growth record is exemplary. I get why so many hedge funds love the bank and its stock. That said, particularly after the crash in other bank stocks, FRC stock is really expensive at more than 2x book:

ChartData by YCharts

With profits set to drop through the next two years, the odds of getting back to 2017-type peak valuation ratios is pretty low. And you don’t get paid to wait with the measly dividend yield either.

I’d love to be an owner at the right price. It’d take a much steeper dip than this though for me to get involved. The question is, can we can find other banks that will similarly skate through the current situation while largely avoiding meaningful loan losses?

Look For Smaller High-Quality Banks

The great thing about the American banking industry is that we have hundreds of listed banks to choose from. That means that you don’t have to get too attached to any one bank, you can always find more worthy candidates.

As it turns out, there are plenty of quality regional banks in wealthy parts of the country. Look at something like a Washington Trust (WASH), which is big in the Boston suburbs and states adjacent to Massachusetts. It is cast somewhat in the First Republic mold, serving many of the nation’s wealthiest zip codes while offering extensive wealth management services. Washington Trust – while not exclusively aiming at elites – tends to have very well-off clients in aggregate and had fantastic loan performance during 2008-9.

Something like a Maine’s Bar Harbor (BHB), which has gotten smashed recently, could make for a great dividend play here as well. This sort of sell-off gives us the chance to buy some above-average quality banks at the same price or even cheaper than the sector as a whole. And soon, I’ll share a feature article on Hingham Institution For Savings (HIFS), another Northeastern bank that is arguably a small-cap version of First Republic, yet which has gotten pounded far more:

ChartData by YCharts

If you looked at First Republic after its last sensational earnings report and found yourself wanting to buy into the stock, you are on the right track. There’s a ton to like about the bank. But at 20x trailing earnings and at more than 2x book value, it’s simply too expensive for comfort given the current economy. Instead, take a look at other banks serving wealthy customers and which have excellent risk management track records.

This is an updated excerpt of an Ian’s Insider Corner report published April 14th for our service’s subscribers. If you enjoyed this, consider our service to enjoy access to similar initiation reports for all the new stocks that we buy. Membership also includes an active chat room, weekly updates, and my responses to your questions.

Disclosure: I am/we are long HIFS,WASH,WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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