2502 N. Rocky Point Drive, Suite 665
Tampa, Florida 33607
2502 N. Rocky Point Drive, Suite 665
Tampa, Florida 33607
Jonathan Bale:
Good morning everyone, and welcome to the Gator Capital Management Q4 2020 webinar. And thank you for joining us. Our Q4 2020 webinar will be presented by portfolio manager, Derek Pilecki. The webinar will last approximately 30 minutes, after which, we will open the floor for a question and answer session. If you have any questions you can submit any time during this session by clicking the Q&A icon on your screen. Due to time restraints, if your question is not answered, we will follow up with you individually after the webinar to answer your question. And as always, if you have any questions about Gator Capital Management, please do not hesitate to reach out.
For those who read our Q3 letter, you will know that Derek, highlighted the opportunity he sees in regional bank stocks. Today, Derek, will review his investment thesis on regional banks, and then drill down specifically into ConnectOne Bank call. And as I mentioned, we will then conclude with a question and answer session. Very quickly for compliance purposes, the views and opinions in this presentation are solely those of Gator Capital Management. Gator Capital Management has made every attempt to assure that the accuracy and reliability of this information provided, but it can not be guaranteed. And past performance is not a guarantee of future results. With that being said, I would now like to hand it over to Derek Pilecki, portfolio manager at Gator Capital Management.
Derek Pilecki:
Hey Jonathan. Thanks everyone for joining us today. I wanted to highlight what I think is a once in a decade opportunity in regional bank stocks. As you know, regional bank stocks have lags in definitely this year. Even with the rally over the last six weeks of upwards of 40%, the regional bank Index is still down 13% for the year, compared to the S&P 500 rising 14% year to date. This poor 2020 performance comes after regional banks of Arthur Hill lag the broader market over the previous three years. From 2017 through the end of 2019, regional banks returned only 11% total versus that the S&P 500 Index is return of 52%. This long-term underperformance regional bank stocks has created the opportunity that we see.
So I’m going to go through several parts of our investment thesis today. And first I wanted to start with valuation. This graph shows the median price, the tangible book value of all publicly traded banks for the past 30 years. As you can see, recently, the regional banks have been trading in a medium price, the tangible book value slightly above one times tangible book. This was as of the end of September. This has risen to about 1.25 times tangible book currently, that is still at the very low end of the range. In fact, the only time this index is traded at a more inexpensive level was in the six months after Saddam Hussein invaded Kuwait in the fall of 1990. This occurred at the time of the SNL crisis when commercial real state was crashing and banks were poorly managed. So these valuations were near all time cheapness of regional banks, even though the industry is in much, much better shape than it was in 1990.
We can see from this graph, the range has been 0.9% in tangible book up to three times tangible book. Three times tangible book occurred in a very different time frame. It occurred twice in 1997 at the height of the bank M&A wave. And then again, from late 2005 to mid 2006 at the height of the value returns in the mid two thousands. I would argue that it’s unlikely with the current interest rate environment that we ever returned to three times tangible book. But I think getting more to the center of this range, specifically getting to 1.6 to two times tangible book, is definitely reasonable given the return profiles of banks, the credit quality that they’re seeing, the profitability of the banks and the stability of their capital base. So I’m not arguing that we returned to all time highs evaluation, I’m just arguing that we’ll return to more of a median valuation in regional banks.
Another way to look at regional banks is to devalue them on a price to deposit premium. So most bank investors view the deposit franchise of individual banks as the most valuable aspect of the bank. There’s customer relationship and the sticky deposits of people who are willing to accept below-market returns to have the safety and the relationship with the bank. And on average, bank M&A occurs the average price that banks have been acquired for as a deposit premium of 14%. So the way you hack-related deposit premium is you look at the price, the premium above tangible book that the banks trading at divided by its deposits. So if bank was traded below tangible book, you say there is zero or a negative deposit premium. Of course, we know deposits have value. So it makes sense for them to trade above tangible book since the average price of banks been acquired is 14%.
Obviously with the pandemic and the economic shutdown, the regional banks sold off heavily in March. Until recently, they hadn’t rallied much because there’s been fears about credit. Credit picture has been murky over the past six months for two main reasons. First, the bank regulators and the banks were very generous with granting deferrals for borrowers who needed more flexibility due to the pandemic. And so, the banks were liberal with granting loan deferrals. Loan deferrals guide as high as 30% for some banks, if they just granted deferrals to any customer who wanted them. Other banks only granted deferrals after talking to customers why they needed the deferrals.
Also with the economic situation, it was hard to predict in March how the economy would play out. There was a huge shift in spending away from discretionary leisure travel towards home improvement and fitness. And so, there was some businesses, like any home improvement business, like the local tile store that have done very well, but wouldn’t have predicted that in March. So they took a loan deferral and it turned out they didn’t need them. Then there are other businesses like hotels that needed the loan deferrals and are still struggling.
The second issue with credit was the change in accounting methods that FASBI wanted to implement for several years called CECL, which in the past banks had put aside loan loss reserves for the next year’s estimated loan losses. Where CECL forces the banks to put out aside loan loss reserves for the entire lifetime of a loan. So for example, on a credit card loan which on average last seven years, you have to… When you make the loan, you have to make open the credit card account. You have to estimate how many losses you’re going to have from that account over a seven year timeframe. And so, the banks effectively front loads credit losses for the banks. And the banks also have to change the amount of loan losses they have for changes in economic environment. So Q1 was the first quarter that we had this new loan accounting standard, and it was also a huge degradation in their outlooks for the economy. So they had to massively increase their loan loss reserves in Q1 and Q2. So made it uncertain what their loan loss provisioning would be in Q3 and Q4. And since the economic forecast didn’t go down in Q3, loan provisions came way down. And so, the deferrals and the change in loan loss accounting really confused investors.
And so, bank stocks didn’t rally with the rest of the market through the summertime. Capital reserves are an interesting topic because capital is as strong as it’s been for the industry in many decades. The changes in the way that banks have held capital and their capital requirements have forced them to hold more capital. This has lowered returns, but has also increased the stability of the banks. Similarly, loan loss reserves are extremely high right now relative to charge off levels. And so, we think the banking industries is in good shape as far as the amount of capital reserves to get through whatever economic environment we were facing due to the pandemic.
The other thing that we’re encouraged about, most banks have increased their tangible book value through this time. So we’re viewing 2020 as more of an earnings event for the banks rather than the capital event. There are some headwinds that we’re not ignoring, mainly interest rates. So interest rates have come down sharply this year, and that’s a headwind for banks mainly because, their deposit costs have not declined as much as their loan declined. Mainly because of the zero bound, you can’t charge negative interest rates for checking an account. So the headwinds to the banks, and I think that’s one of the reasons…
Just to continue, I want to move on to cost cutting. Cost cutting is a huge opportunity for banks. We’ve had some announcements from several banks that they’re cutting 20% of their branches. Branch utilization has declined drastically with the pandemic, and we think the real estate footprints of almost every bank are too high. And so, we think there’s a massive opportunity for cost cutting. There also be cost cutting in the back office staff with the banks seamlessly transitioning to work from home. I think there’s massive opportunity to cut the real estate cost. The election and regulatory issues, I think there’s some fear that the Biden administration will increase regulation of the bank, one of the benefits of a Republican administration that there was a little bit of easing on the banks as far as the regulators and some regulations.
I don’t think that the first priority of the Biden administration is the focus on banking. I think it’ll be more on foreign policy. It’ll be on getting economic health to people and it might be around healthcare. I think doing anything to the banking system is way down on the list. So we think that is a less of a risk than the market does. We would say that the one outstanding regulatory issue is how the treat delinquent loans due to the pandemic. The current regulatory framework has been very generous to the banks. We think one day that’ll end and the banks won’t have advanced notice. But we think for now the regulatory risk is relatively low. And then one other thing I want to touch on was the low valuations banks. The decline of banks in March was so severe that it torched a lot of the bank specific investors.
And I think when I look around at my peers, we all know the bank stocks are cheap. But bank specific investors don’t have enough capital to invest in banks. And so, that has kept valuations lower. And I think it’ll take some time for the generalist to buy up the banks and get more clarity. We’re seeing it in recent weeks. So that’s my general thesis on the banks. Mainly, low returns for the past four years has created a low valuation mainly due to credit. Credit’s not going to be as bad as the market’s feared and banks haven’t rallied mainly because investors have been having trouble seeing through credit and also had redemptions from their investors.
Jonathan Bale:
Thank you Derek. And again, everyone I apologize for the technical difficulty. I think we’re good now. But again Derek, thank you. We’d love to get your thoughts on what you see are the biggest opportunities in regional bank stocks.
Derek Pilecki:
Yes. I think there’s four pretty interesting opportunities within regional banks. I think generally regional banks are going to do well. But there’s four specific areas where I’ve been focused. First one’s been the Puerto Rico banks. Puerto Rico consists of U.S. territory. Maybe doesn’t get as much attention from US-based investors. But Puerto Rico banks are regulated by the FDIC, under the same U.S. banking regulations. Puerto Rico has changed drastically in the last 15 years, as far as banking has gone. They’ve gone from 12 banks to three banks on islands. So there’s been massive consolidation. We’ve seen margin widen now on the Island.
And the other big change is the Puerto Rico economy is about to turn, could possibly turn to a growth mode. It’s been in recession for 15 years. There’s some… With all the hurricane damage and the rebuilding and money coming onto the Island from the CARES Act that we could have population growth level off or even grow. There could be some re-migration back to Puerto Rico from Florida and New York City. We also could benefit… Puerto Rico could also benefit from onshoring of healthcare production. They have a big footprint of pharmaceutical and medical device manufacturing on the Island. And so, to the extent that we onshore pharmaceutical and medical device manufacturing from China back to the U.S. Puerto Rico should get its fair share of a business.
And so, when I look at the Puerto Rico banks, the three of them are all trading below tangible book value. Two of them have recently done acquisitions that are massively creative to their earnings. And then, when I compare Puerto Rico to Hawaii, which is another island market. Hawaii’s market is consolidated like Puerto Rico has just become, and those banks traded premiums to the banking industry. I don’t expect Puerto Rico banks will trade at a premium because Puerto Rico is not a state. And I think that some investors will just always shy away from Puerto Rico, but I think they can trade at a median valuation within the banking industry.
The second area that we see of opportunities is growth regional banks. So if you go back to 2017, early 2018, there’s a group of regional banks that traded at a premium. And these tended to be good organic growers. They just grew faster than the rest of the banking market mainly because they were very disciplined about their hiring and they were taking market share by hiring loan officers from bigger banks. And these banks traded their premium to the group in late 2018, 2019. All these growth banks lost their premium to the group. And so, you can buy these banks. And I’m talking about like Western Alliance, Wintrust Financial, Access Financial, Signature Bank in New York. They’ve lost their premium valuation, but they’re still growing organically. And so, I think that’s an interesting area where you can get some growth banks for median bank prices.
The third area we look at is New York City area banks. So there’s been investors who have avoided or even shorted New York City banks because New York City was hard hit by the pandemic. And there’s also a thought that because New York City is so dependent on public transportation, it’d be slower to come back. And so, there’s some investors who are avoiding credit risk with New York City. I would say… I think there’s a difference in… New York is a pretty diverse region. I think the outer boroughs are very vibrant still. I think if you go to Midtown Manhattan, the office occupancy is still in the low double digits. But I don’t think a lot of the New York City area banks have loans against the skyscrapers in Midtown. I think most of those buildings, loans, mortgages find their way into commercial mortgage backed securities, and they’re not held by the New York area banks.
Also, when I look at the LTV, loan-to-value ratios of the loan portfolios of banks around New York City, they tend to be very conservative here. Most of the lending to multifamily owners in the outer boroughs. And so, we think there’s just an opportunity there. People have avoided New York City area banks and New York is going to come back and it’s not that dead by any means. And then the fourth area of banks that I would focus on are banks with repurchase programs. So there’s… Quickly, when the pandemic hit in March, the big banks agreed with regulators to turn off their repurchase programs, and most of the small banks followed suit. But as we’ve gone through Q3 and now there’s Q4, there has been a number of banks and a couple of dozen banks have announced that they’re restarting their repurchase programs.
Most of them are small couples, mid midcap banks have announced the resumptions too. But I think having that natural bid under the stock with the repurchase programs will help those stocks outperform. So those are the growth banks that we are…. Those are the little niches within regional banks that we would focus on.
Jonathan Bale:
Awesome. Thank you, Derek. And then can you drill down into an example of a regional bank that you like for us?
Derek Pilecki:
Yeah. So I want to talk about ConnectOne. So this ConnectOne is located in Northern New Jersey. It’s one of the New York… We’d classify it as a New York City area bank. It’s been a great organic growth story as well. And so, the bank was started in 2004. They grew organically. They’ve made some smart acquisitions along the way. We think they have a very dynamic CEO. His name is Frank Sorrentino. He started the bank and he’s run it since he started it. The acquisitions he’s made have been very interesting to expand the bank in a low cost manner. The credit is stable. ConnectOne deferrals have come down drastically. We’re assuming that credit losses will be minimal. They there’s a little bit of exposure and some hotel portfolios, but we think there’ll be able to work them out with minimal losses.
Last year, they made an acquisition of Bank of New Jersey, which had nine branches right inside ConnectOne’s footprint, and they closed their other branches and kept all the customers. So basically, it eliminated almost all the expenses of that acquisition. It’s going to be massively creative, and we haven’t been able to see the accretion because the pandemic hit before they could report the first quarter. So because of that, we think that their earnings estimates for 2021 for ConnectOne Lennar are way too low. I think the streets had 211. I think they can do 245. And so, at $17, they are in 245 next year. It’s trading at seven times earnings. I think a fair multiple for ConnectOne given its growth profile is 12 times, so that mean that’s 60% upside.
One of the benefits… Actually, the low interest rates are helping ConnectOne because they’re able to get rid of some of their higher costs funding. Unfortunately, ConnectOne has a lot more loans than deposits. Usually, we like banks that have 90% loan to deposit ratios. The big banks run crazy low loan deposit ratios because they’re just a wash in deposits. But with the amount of liquidity in the system right now, ConnectOne’s able to raise the posits and replace some high-cost borrowing. So that’s actually helping their interest margin, which is different from the typical bank in this environment.
And then, the other issue that we’ve mentioned is commercial real estate concentration. So the regulators are a little on edge about how much commercial real estate loans a bank has. I think ConnectOne is right at the edge there, although the regulators have not made a big push recently about this. And they’ve backed off a little bit by looking at what the credit experience has been of individual banks rather than just looking at the percentage of their loan portfolios in commercial real estate. So we just raised that as a potential issue. It’s not a current issue. It could become an issue if their credit experience doesn’t stay as strong as it’s been. So we like ConnectOne Bank. We think there’s some pretty good upside with a well ran organic grower.
Jonathan Bale:
Thank you, Derek. I do want to remind our listeners too that if you have a specific question, you can submit it in the Q&A icon at the bottom of your screen. You can do that at any time during this webinar. While you’re doing that, I do have a couple of questions for you Derek, that have been submitted already. The first one, are you worried about credit losses at banks if we have a second shutdown like we did in March?
Derek Pilecki:
Yeah. So that’s an interesting question. So if we have a second shutdown, I think it will be a targeted shutdown and it would be for a defined time period. I think it’ll be for a four to six week time frame. I think that the problem with what happened in March was we were uncertain of how long the shutdown would be. I think with the vaccine on the horizon and targeted shutdowns, I think that it’ll be easier for bank investors to get comfortable with the banks to be able to manage through things. I think the other thing that this experience this year has shown is that, a lot of the marginal businesses don’t qualify for bank loans already. So like the nail salon or the restaurant in the strip center, they don’t have bank loans necessarily. They might have some equipment rentals under a lease or something, but they’re not funding working capital through a bank loan. The retail shopping center does have a bank loan that they’ve been able to show they can fill that space relatively easily with a new nail salon or new restaurant.
So I think the regulators have pushed a lot of riskier credits out of the banking system since the great financial crisis. And that’s been the rise of private debt funds. And so, I think that the banks have shown that credit quality is pretty high. And if we go through a second shutdown, I think it’ll create some minor issues, but I don’t think it will be game-changing for the banks.
Jonathan Bale:
Perfect. Thank you, Derek. The next question is on ConnectOne specifically. Do you think ConnectOne trades at the lower multiple because it has changed from an organic growth store to more of a growth through acquisition story?
Derek Pilecki:
Yeah. So that’s interesting. I think their acquisitions have been smart. They acquired Center Bank in 2014, which was a larger bank, but the smaller bank management ran the combined company. And so, I thought that was a very good deal. And then obviously, the bank in New Jersey deals, a great cost cutting deal. So I think the acquisitions have been value-enhancing for ConnectOne. And I think they actually might disguise the underlying organic growth at ConnectOne. And so, I go back and forth in my own mind about whether I refer them to start making acquisitions and just grow organically. But so far, the acquisitions they’ve made have been positive and BV acquisitions. So it’s hard to turn those down.
Jonathan Bale:
Awesome. Thank you. We have a couple more submissions. Derek, why are you not more optimistic on the bank M&A aspect of your thesis?
Derek Pilecki:
Well, I think we definitely need more consolidation in the industry. I think right now, we’re on pause. We’ve had some announcements of bank M&A. Obviously, PNC made a big announcement yesterday. But I think typical M&A or broader M&A is going to wait until there’s even more clarity on credit. So I think that is one issue. And then, I think the second issue is banks are sold and not bought. So we have to have a place where management teams want to give up their paychecks to consolidate. I think we could get to the point with lower interest rates where the banks aren’t hitting their return targets and boards force them to do value improving moves.
I also think another roadblock to more M&A is stock price. So everybody wants to sell for their all time high stock price. And we’re so far below the stock prices of early 2018 that how many management teams or boards are willing to say, “Hey bro, we’re going to sell at this lower stock price so that we can ride up with the acquirers stock.” I just think there’s… Some of those social issues are hard to work through. But that being said, we’re definitely going to have an M&A. And there’s too much capacity in the banking industry. There’s too much benefits from scale. We are going to have M&A. I just think you can own the organic growers or the well-run banks and make just as much money as you do by fishing around for the people who are going to sell.
Jonathan Bale:
Awesome. Another one is here. How do you think about the threat fintechs when evaluating traditional banks?
Derek Pilecki:
Fintech? The fintech issue is a big deal. So there’s a big effort to try to disintermediate the intermediate banks. So a lot of the efforts are on the consumer side, and I think of that more of a big bank problem than a small bank problem. And most consumers bank at a big bank, even bigger branch coverage, bigger ATM network better, better apps. The small banks are really business banks. They’re really small business lending and small business deposit gathering. So I don’t see fintech disintermediating that and small businesses as much as they disintermediate the consumers.
On the consumer side, the big deposits… We’ve seen some consolidation… Well, not consolidation. More competition from the brokers. And so, Schwab and Fidelity are obvious competitors. They both offer bill pay and ATM’s. And Schwab offers mortgages. The wirehouses now offer check-in. And so, the high-end consumer have been competed away for less 15 or 20 years. In the middle or the low-end, we see some of the fintechs going after the very small deposit customers or balances. I don’t think that’s such a big deal. I think the real big deal is the big balance customers are the most profitable for the banks. And I just don’t see the fintechs getting to that customer.
We’ve seen a little bit with the online banks. Online banking has really grown and taking share from the industry. So we’ve seen it with Ally and Capital One and Synchrony and Sallie Mae and Goldman and Discover. All have very strong online banking presences. So I worry about the online threat more than I do the fintech threat.
Jonathan Bale:
Perfect. Thank you. We’ll just try and squeeze in one more here. Is there any update available on Ambac?
Derek Pilecki:
Yeah. So Ambac still has its lawsuit with Countrywide. It’s slated to go to trial in February. Bank of America has done its controlled. Bank of America, of course, owns Countrywide. So Bank of America has done its best to try to keep the lane that trial. There was a hearing on Friday, another effort to try to delay the February trial. Of course, we also have the pandemic to deal with. The trial was supposed to scheduled for July this year. That delayed due to the pandemic. So I think that the start of that trial is the real big catalyst for Ambac. So as long as that date holds, I think Ambac’s interest is here.
Jonathan Bale:
Perfect. Thank you. Well, we’ve gone over the 30 minute mark here. So I’m going to wrap this up. But Derek, thank you again for your time. And thank you everyone for taking the time to join us here. There’ll be a replay of this webinar and the presentation. So that will be accessible in the next couple of days. But as always, if anybody needs any additional information from us or would like to discuss a specific questions in more detail, please do not hesitate to reach out. Thank you again, Derek, and everyone for joining us. And have a great day. Thank you.
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.