First Citizens Bancshares (NASDAQ: FCNCA)

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October 31, 2023

The Fund’s largest position is First Citizens Bancshares (“First Citizens” or “FCNCA”). We acquired our stake over the past three years. Initially, we owned and traded around a small position in CIT Group Inc. (“CIT”) during the summer of 2020. We felt CIT was undervalued and management was making progress in reducing risk during the Covid-19 pandemic. In late 2020, CIT agreed to be acquired by First Citizens. We added to our CIT stake the morning of the acquisition announcement because we thought the acquisition was so financially attractive that First Citizens’ shares would rally and pull CIT’s shares higher. Our CIT shares were exchanged for First Citizens shares when the merger completed. We held onto our First Citizens shares because we admired the management team, we felt the bank was undervalued, and we projected the bank would benefit from higher interest rates. Then, earlier this year, First Citizens was the winning bidder in the FDIC’s auction of the failed Silicon Valley Bank (“SVB”). We added significantly to the Fund’s First Citizens position on the following Monday morning because the deal was unbelievably favorable for First Citizens.

First Citizens’s stock price rose more than 50% that day and has risen another 40% in the months since the SVB acquisition. We have not sold any shares. We believe the stock still has the potential to double over the next three years. Despite this attractive upside, we think the downside is minimal. Our downside scenario is an unchanged stock price in three years.

Here is our detailed investment thesis for First Citizens:

FCNCA trades at a discount to other large regional banks on a Price-to-Tangible Book value (“P/TBV”) basis. It also trades at a slight discount on a Price-to-Earnings (“P/E”) basis looking at sell-side 2024 earnings estimates (see chart below).

Usually when a bank trades at a discount to peers on a P/TBV basis, it is because it has lower returns than peers. At first glance this appears to be the case with First Citizens. It is projected to earn a 14% Return on Equity (“ROE”) in 2024 where its peers are projected to earn higher ROEs. However, when we adjust for the excess capital that First Citizens is holding, we believe it has a ROE similar to its peers and does not deserve to trade at a discount.

We believe there are other possible reasons why First Citizens trades at a discount to its peers. The main reason is it is not a member of the S&P 500 Index, so it does not have the demand from passive index investors. Other minor reasons for First Citizens’ valuation discount are a lack of familiarity within the investment community due to limited but growing sell-side coverage, not hosting quarterly earnings conferences calls until recently, not attending brokerage investment conferences, high nominal stock price and limited trading volume, and a low dividend compared to peers.

One additional unusual reason for the valuation discount is the dual-class share structure of First Citizens Bank. The Holding family controls the Class B voting shares. This dual-class structure may discourage some investors from owning the stock. We disagree with this thinking. First, the Holding family has demonstrated an extraordinary commitment to shareholder returns. First Citizens is the best performing stock of its peer group over the last 30 years. We view the Holding family as owner-operators. We note that many of the best performing stocks have had owner-operators: Berkshire, Microsoft, Amazon, etc. There is data that proves companies with owner-operators outperform because management is able to focus on long-term value creation. We think this applies to the Holding family controlling First Citizens.

Another criticism of the dual-class share structure is the difficulty in applying outside pressure to gain voting control and/or board seats. I believe this is a non-issue for banks. The difficulty of a hostile takeover in banking is high. There hasn’t been a successful hostile takeover of a bank since Bank of New York acquired Irving Trust in 1988. Plus, the regulators limit ownership levels of banks before an investor has to register as a Financial Holding Company. Overall, we see the First Citizens dual-class share structure as a non-issue.

First Citizens’ stock outperformance in 2023 may be distracting some investors from the potential returns still offered by the stock. First Citizens’ stock has returned 78% this year. Its peers have had negative returns between 20% and 35% this year. We know it is natural for investors to say, “We missed it,” when a stock has performed like First Citizens’ stock has. The last thing these investors want is to buy First Citizens after the run and have it underperform once they buy it. In other words, they don’t want to be wrong twice on the stock. As we will discuss below, we believe there is significant downside protection in First Citizens because of the defensive nature of its balance sheet.

First Citizens has a very liquid balance sheet, which is perfect for the current environment. For example, First Citizens has 17.6% of its assets in cash compared to Truist at 5.6%. This liquid balance sheet gives First Citizens plenty of opportunity to take advantage of the wider loan spreads available in the current environment. The extra liquidity also reduces pressure to pay up for deposits. The high cash balance is the best indication that shareholders have a measure of protection from First Citizens’ balance sheet.

First Citizens’ balance sheet is defensive and well-positioned for growth.  The bank has almost no borrowings beyond the $35 billion FDIC note that has a five year term. First Citizens’ management did not invest in long-dated fixed rate securities, so unlike many other banks, it is not carrying a portfolio of underwater bonds. Also, First Citizens loan book is balanced between floating-rate and fixed-rate loans. This balance was created through the strategic acquisitions of CIT and SVB. The CIT franchise produced excess loans and the legacy SVB franchise produced excess deposits. We believe First Citizens is positioned well for the current consensus outlook for rates of “Higher for Longer”.

Investors are not assuming any growth at First Citizens based on its stock price trading just above tangible book value. Based on sell-side models, expectations are for minimal growth in First Citizens’s legacy banking operations and that SVB will shrink going forward.  We think this is wrong because we think prospects for the former SVB operations are strong. Certainly, the SVB franchise is diminished as several business development personnel have been poached by competitors. We think multiple competitors are targeting the venture capital community.

The current environment in the venture capital community is not ideal, but SVB was a powerful growth franchise. To offset these concerns, we note that the current deposit balances at SVB are already down close to 80% from year-end levels. So, we believe customers who want to leave SVB have already left. Also, we believe there is substantial goodwill within the venture capital community for SVB. SVB is intertwined with the venture community and continues to have strong relationships with the community. Lastly, we believe venture capital as an industry will grow faster than the overall economy. We think there is a good chance that SVB will continue to grow under First Citizens ownership. At the current valuation, we view this growth potential as a free option.

Regional banks as a group may re-rate higher. In addition to First Citizens trading at a discount to peer large regional banks, we believe regional banks trade at the low end of their historical valuations. Large regional banks trade for about 7.4x 2024 EPS estimates, we believe the normal valuation for this group is between 10x and 14x. We understand that at this point in the cycle banks should trade cheap, but time marches on and cycles can change quickly. We expect the group multiple to re-rate higher as the industry works through higher interest rates and the credit cycle peaks.

We do see some risks to our First Citizens investment thesis:

Aggressive rate cuts by the Fed.  First Citizens is among the most asset-sensitive of the large regional banks. If the Federal Reserve were to aggressively cut short-term interest rates in response to weak economic conditions, this would hurt First Citizens’s earnings. We think this scenario is unlikely given the recent bout of inflation that the Federal Reserve has been battling and the Fed’s “Higher For Longer” mantra.

Continued calls for increase capital requirements for banks. Bank regulators continue to make statements that banks need higher capital requirements. While we disagree with this sentiment, we acknowledge the potential reduction in returns for bank investors with higher capital requirements. We do believe First Citizens is well-positioned to comply with higher capital requirements due its excess capital position. We would expect First Citizens’ management to operate the bank with a significant capital cushion.

First Citizens may be over-earning in the near-term. First Citizens is experiencing two temporary benefits to earnings. One, as part of the SVB acquisition, First Citizens issued a 5-year note to the FDIC for a below market interest rate of 3.5%. Two, First Citizens marked-to-market the SVB loan portfolio at a discount to account for credit risk. As the old SVB loans payoff, First Citizens recognizes the discount into income. Both of these factors are causing First Citizens to over-earn in the near-term.

First Citizens is facing significant integration risks with the SVB deal. The SVB acquisition was a large deal. SVB was a complex bank in a new business line. Multiple competitors are poaching SVB personnel. The SVB customer base went through a traumatic event in March as it was uncertainwhether they would lose their deposits in the SVB failure. We worry about the integration risks that First Citizens faces with SVB. But, we are reassured that First Citizens has significant experience integrating complex and geographically disperse acquisitions.

Future M&A deals are unlikely to create as much value for First Citizens as the SVB deal did. Going forward the opportunity for value creating acquisitions is less likely now that the bank is much bigger than it was 15 years ago or even earlier this year. First Citizens has a successful M&A track record that includes a number of FDIC deals as well as the heavily discounted acquisition of CIT Group. The SVB acquisition was a monster deal that doubled First Citizens’ capital. While the opportunity for future FDIC deals is diminished, we believe the FDIC is happy to have another bidder besides JP Morgan Chase for large deals. We have been surprised about the lack of outcry over the extraordinary deal First Citizens got in buying SVB. We think the SVB deal clearly shows the FDIC executives are comfortable with First Citizens management team.

 Quantitative Tightening effect on banking industry deposit balances. Even though Federal Reserve’s Federal Open Market Committee seems close to the end of this interest rate tightening cycle, they continue to implement Quantitative Tightening by allowing the Fed’s portfolio of securities holdings to mature with limited reinvestment. Just as Quantitative Easing by the Fed accelerated deposit growth in the banking system, Quantitative Tightening is a strong headwind for deposit growth. SVB had some of the strongest deposit growth during Quantitative Easing, so we expect it will have deposit pressures with continued Quantitative Tightening. Of course, there are other factors that will influence legacy SVB’s deposit base such as: the strength of the venture capital cycle, competitive intensity from other banks attacking SVB’s old franchise, and SVB’s customer’s willingness to return to SVB under First Citizens’ ownership.

Legacy SVB’s business is dependent on the venture capital cycle and it does not look great in the short-term. Venture capital goes through cycles and it seems like late-2021 represented the peak of the latest cycle. The amount of venture capital raised in 2022 and 2023 is down significantly. There are many start-ups who have had to cut expenses and conserve capital. Venture capital exits are few and far between. Given the strength of the stock market in 2023, we are surprised the IPO market has not recovered. There is potential upside from excitement about artificial intelligence.

We think First Citizens is still an attractive holding despite its outperformance to date in 2023. We estimate First Citizens’ tangible book value will be $1,800 at the end of 2026. We think FCNCA can trade at 1.5x tangible book value at the end of 2026 or $2,700, which is double the current share price.

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Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.

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