Q4 Market Outlook: Growth Banks Webinar

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November 12, 2019

Hi everyone. This is Derek. We’re going to wait a few minutes to get started to let people dial in.


Okay welcome everyone. This is Derek Pilecki. Welcome to Gator Capital’s Q4 market outlook webinar. To get started, I’d like to read a disclaimer. The views and opinions in this presentation are solely those of Gator Capital Management. Gator Capital Management has made every attempt to ensure the accuracy and reliability of the information provided, but it cannot be guaranteed. Past performance is no guarantee of future returns.


Today we’re going to give you a brief overview of Gator Capital. Then we’ll talk about the banking industry and some of the ways our view of the industry is different from conventional wisdom. We’ll then specifically discuss the subset of banks that we’ve labeled growth banks. We’ll review our investment thesis on Western Alliance Bank Corp, which we profile it in our October letter and then we’ll wrap up by giving you some contact information.


Go onto slide three here. Gator Capital’s an SEC registered investment advisor. I founded the firm in 2008. At the end of September we managed about $97 million. Our investment focuses, we’ve been specializing in the equities in the financial sector since we started. This was driven by me working at Fannie Mae in asset liability strategy early in my career and then I worked at GSAM covering financials for their growth equity team. Within the financial sector I’d say we focus on the deep value part of the sector.


We manage three portfolios with all significant overlap. We manage a long/short financials portfolio for our private hedge fund. We manage our long-only financials portfolio in a mutual fund form in the Gator Series Trust. And then we manage a long short portfolio for another mutual fund in the Caldwell and Orkin Fund Corporation. The firm is 100% employee owned.


Moving on to our view of the banking industry, we hear a lot of things about banking industry and lack of profitability, low growth and I think some of these things are just conventional wisdom that’s wrong. And I wanted to share our different view on some of those things. Want to express some of the positive aspects of banking that I don’t think are discussed enough. And then there are some real threats to banking that I don’t hear people talk about or I don’t think are well known.


Going back to misperceptions of banking, I think banking’s considered a low growth industry. I think it’s actually an okay growing industry. I think it grows a little bit faster than nominal GDP. If GDP grows in real terms 2% and then inflation is 2% we have 4% nominal GDP growth. I think banking grows a little bit faster than that. Mid single digits. I think this is interesting because I see a lot of other industries that are low single digit growers that have very high valuations like consumer packaged good companies, utilities, REITs. I think there’s a misperception that banking is low growth. Another misperception I hear a lot is, oh how can banks make money in a flat yield curve?


A flat yield curve is a headwind, a slight headwind for bank profitability. It takes years for portfolios to turnover. I think there’s also a misperception that banks make money just solely in the shape of the yield curve. When I think of different industries making money off the yield curve, I think of mortgage rates as wholly dependent on the shape of the yield curve. Whereas banks, there’s a lot of banks that make floating rate loans and price their deposits off the short term rate and they don’t even care what the shape of the yield curve is. Sure there are some fixed rate lenders. They lend long and borrow short, but they’re a small subset within banking. I think the shape of the yield curve gets overstated so that you can go through periods like currently where people say, “Oh, banking’s tough because shape of the yield curve is not helpful.” I think that drives valuations to a level that don’t make sense considering the profitability of banking. I think banks are generally regarded as having asymmetric risk profiles.


I think through history, I think this is true. I think there are particular points in time where the risk profiles are not as asymmetric. I think now is one of those times, I don’t think the banks have loaded on a lot of high risk loans onto their balance sheets through this economic cycle. If you’re betting on against the banks because we’re going to head into a recession, I think you’re going to have an unpleasant surprise. I don’t think there’s as much downside risk to the bank loan portfolios as there have been in other cycles.


Another reason why I hear people not wanting to invest in banks is they’re black boxes. Yes, to some extent they are black boxes, but some of the loan portfolios are very granular with, especially the consumer loan portfolios. And you can see long histories of how these credit losses have developed in some of these banks. Another aspect of them being black boxes is they’re regulated and the regulators go in and look at loans at the loan level, especially for the large corporate loans. You have an independent body in there, a government agency looking at the loan portfolios. I think you can overcome some of the issues around the banks being black boxes. I think of other businesses that are black boxes like insurance companies where you don’t have regulators going in and looking at the individual insurance policies and seeing what kind of, what the loss reserves look like. From that standpoint, I think banks are relatively more transparent than insurance, so it’s not as bad an issue, big issue.


Leverage, so banks run with leverage. Leverage is less than it used to be, but it’s still significant. They tend to have 10% equity to assets ratio for the regional banks. I think people misunderstand why they have leverage. Banks tend to make low risk loans. And so if you think of a capital asset pricing model worthy of the market line and risk free rate and then an equity portfolio and there’s different grades of risk and you earn higher return for taking higher risk, I think it’s misunderstood that bank loans actually sit slightly above the capital asset pricing market line. There’s alpha in the loan portfolios that they’re making. And if the risk free rate’s 2% and these loan portfolios are really almost risk free at a 4% level, there’s not enough investment capability in the world that is willing to accept a 4% return, even if it’s very low risk.


And so the banks are able to take advantage of these low risk loans by using leverage to generate equity like returns. And so, I’ve just had long conversations with some other investors why they don’t understand why banks need to use leverage. And it’s just a misunderstanding of these loan portfolios actually have a lot of alpha in them and they’re using leverage to translate the low returns into an equity type return. We see ROEs of the industry in the mid teens.


Another misperception I see about banks, bank investing is M and A will drive stock returns. I think there’ll be consolidation going forward, but we’re not going to have days like in the mid nineties where you had a massive land rush to consolidate the industry. The biggest banks can’t acquire any more because they have higher than 10% deposit market shares. They can’t acquire any more deposits. I think bank stock investors are very savvy and penalize banks that overpay for acquisitions. And we’ve seen a few deals this year where they’ve been low premium merger of equal deals where both the buyers and seller shareholders should benefit from the consolidation, the expense cutting. And so I don’t think we’re in the days of oh and all the banks that are going to sell out. you’ll get paid premiums for them. I think it’s going to be much more muted and it’s going to, the returns will come from individual stories where there’s good expense cutting and organic growth.


And the last misperception about banking that or negative perception about banking that I don’t think is real is FinTech’s about the disintermediate the banks. I don’t think this is going to happen. I think it’s a misunderstanding about the regulatory framework around deposits. You have to get an FDIC charter to raise deposits. I think the banks will continue to get paid for the FDIC insurance, and so they’ll partner with FinTech, but I don’t think it’s the type of issue where somebody can come in and disintermediate the banks. Otherwise they’d have to be labeled a bank holding company. We’ll see it with Apple, they’re not issuing their own credit card, they’re partnered with Goldman Sachs. We’ll see it with other types of products where they’ll partner with banks, but the banks will still earn their fair return.


Positive aspects of banking. Regulatory burdens are easing. Even though the regulators are all over the banks with their loan portfolios, there are some issues where I think compliance costs are going to level out or trend lower. Some of the midsize banks don’t have to submit to the stress test or only submit to the stress test every other year now. I think this will with the election in 2016, saw the pendulum reverse this directions and the banks have an opportunity going forward to benefit from easing regulation going forward. I don’t think it’s going to loosen so much that we’re going to go back to the 06, 07 time period, but it just won’t be the extreme of 15, 16. I think there is an ongoing expense cutting opportunity and mainly this is from branches. We’re way over branched. Banks will shed branches meaningfully going forward and this will be a good expense cutting opportunity for the banks.


Mortgage opportunity, I think there’s a real opportunity for banks to grow residential mortgages on their own balance sheet for portfolio purposes. I think it’s a good low risk asset. I think the rates that Fannie and Freddie are charging are too high. Before the financial crisis, Fannie and Freddie charged 13 basis points to wrap mortgages. Now they’re charging 45 basis points. That 30 basis point difference the banks can retain by owning the mortgages on their own balance sheet. I also think since the agencies haven’t raised the conventional lending limit in a long time, the more of the housing market, more mortgages are pricing in the jumbo market and I think that the GSEs are going to shrink their footprint. With the changes coming to them, I think banks will retain more mortgages on their balance sheet and I actually think that’s a pretty good growth opportunity for the banks.


Some things that are threats to the banks. I think disintermediation from Wall Street has been happening for 30 years. Started with the large corporate loans and then we’ve had the big brokerage firms have cash management counts so people can manage their bill paying, checking from their Merrill Lynch or Charles Schwab accounts. Takes a lot of low cost deposits away from the banks. I think this is an ongoing issue for banks. Bank competitive intensity is increasing. This is really, we’re 25 years past the interstate branching laws being struck down and banks can enter new geographies without buying other institutions. And I think we’re seeing competitive intensity increase going forward for banks. For example, Chase entered DC and Boston earlier this year. They didn’t buy anyone. They’re just opening branches in those markets and taking advantage of their national consumer customer base and starting to attract deposits in those markets.


Capital One is doing the same thing. PNC opened an online bank to cater to people outside their branch footprint. I think competitive intensity has the potential to keep returns and keep a lid on returns going forward in the banking industry. And then the banks have narrow business models. 30 years ago the banks all looked like JP Morgan with corporate bank, consumer bank, bank trust department, asset management, and now really the typical regional bank just has CNI lending and commercial real estate lending. They’re very narrow businesses. When we goes through a recession, some of the banks will be too fragile to survive or will have problems because they’re just not diversified enough.


That leads us to growth banks. Growth bank, not all banks grow at the same rate. Different organizations grow at different rates. Some are more aggressive, some just have a history of growing faster. The growth banks, there’s a handful of, I identified in my letter about 12 or 14 growth banks that have put up higher than industry average growth over the past five years. This group has all had poor recent stock price performance in the last 18 months, so they used to trade at multiples of 15 to 20 times. Now they trade at multiples nine, 10, 11 times earnings. Think some of the multiple compression has been due to asset sensitivity with the fed switching from increases to cuts, the tailwind of a higher rates is turned into a headwind of lower rates and so that’s put a crimp on the out year forecast and has made multiple contraction come in.


Also, I think there’s a subset of investors out there that are worried about credit with these companies. Normally fast growing financial institutions don’t do well going into a recession because they’ve put on a lot of assets that are not seasoned and they’ve gotten, won that business by having low underwriting standards and so I wouldn’t say you need to go buy this basket of growth banks. I think it’s an interesting group of companies to do additional work on to see, can you get comfortable with the credit amongst these players? There’s some in this list of 14 that I’m not comfortable with their credit, but there’s a few that I think the credit’s pretty strong and I’m going to a profile West Alliance in a few minutes. I think their credit’s going to be fine through the next cycle, but it’s an area where there could be a reason why the multiples have come in is credit worries.


I like the growth banks. I think organic growth is much more valuable than M and A growth. I think organic growth, easier, finer organization to digest, and you’re also not transferring wealth to a seller’s shareholders when you grow organically. You’re able to reinvest the capital efficiently. I just think organic growth, you should pay a premium for organic growth versus M and A growth. And then the, I think the main reason why some banks grow faster than others is compensation plans. I think some of these growth banks are younger organizations, so they’re comfortable paying up for talent. They’re willing to pay for performance. I think a lot of banks that have mediocre growth, they pay their bankers 125 or a $150,000 a year in salary, and their bonus can be 10 to 25% of their salary and no higher.


Whereas I think some of the growth banks pay for performance and they pay you 50 basis points on all the loans and all the deposits you raise. And so if you have a, if you’re a banking officer and you have a $100 million loan book and a $100 million of deposits, get paid 50 basis points on each side and you make a million dollars a year in compensation. And I just think there’s some slower growth banks that would never think to pay a relationship officer a million dollars. And so I think that’s the main reason why some banks grow faster than others.


That moves us into a Western Alliance. This is my investment thesis. I’m going to go through these different parts. Organic growth, they’ve grown, Western Alliance has grown loans 16% a year on a per share basis over the past five years and they’ve grown deposits 14% whereas their peers grow deposits at 7%. I think this is because they’re an aggressive organization, they pay for performance. They’ve higher targets and higher expectations that drive the growth. This has led to great operating metrics. Western Alliance’s return on assets is 2% which is best in mid cap peers. They have an ROE of above 20% where peer ROA and ROE is 1.3 and 15% respectively. Well above peer median for their returns. Western Alliance only trades at 10.7 times next year’s earnings where from 2010 to 2018 they traded 16 times. This you get super growth at the low end of the valuation range over the past decade.


Some of the reasons why they have great operating metrics is the loan portfolio. The loan portfolio earns above average yields. It’s a mix of local CNI and commercial real estate with several national businesses. They have a homeowners association business and they have a hotel franchise business where they are lending to hotels nationally. Earns higher than normal returns. Also their loan portfolio’s diversified between the national business lines and the local business lines. They’re not dependent on one type of loan growth to make their numbers. They can go where the opportunities are. Expense base is a big reason why Western Alliance has higher returns. Their efficiency ratio is only 42% versus peers at 56%. this is driven mainly by branch light strategy. They serve markets with fewer branches in the markets and then the relationship officers are more productive due to the compensation plans.


Their franchise I would say is not as strong as their loan portfolio, but it’s still good. It’s able to keep up the funding, the loan growth. The HOA business, deposit business is very attractive and the loan to deposit ratio is acceptable at, it’s in the low nineties. I think it’s 94%. I think to keep up with the loan growth, they’ll have to continue to work on improving the deposit franchise. One aspect of Western Alliance that I really like is the potential for geographic expansion. They’re mainly in Phoenix, Vegas, San Diego, and San Francisco. They have a little bit of business in LA and in Reno. They can enter a new market through a small acquisition and use that as a platform for growth in that market. Think they’ll target, they’re following national migration trends and they’re targeting states with no state income taxes like Texas, Tennessee and Florida.


I think they also have some opportunities in western cities. They could be much bigger in LA or they could enter Seattle and Denver. I think that’s additional legs to the growth story at Western Alliance that’s not priced into the stock. With their high ROE, 20%, They’re generating a lot of capital, so they use a good portion of the capital to grow organically and fund the loan growth. And then they’ve also started to return capital to shareholders. They’ve initiated a dividend. Dividend payout ratio is low but I think it’s more than sustainable and expected to grow in future years. And then over the past year with the stock being down, they’ve used it to opportunistically buy back stock in the low forties. Now with the stock above 50, I would expect them to slow their stock repurchases and use the capital for a small acquisition going forward as a platform for growth.


More on the general bank industry valuations. I think banks are trading cheap to their normal levels due to the way interest rates have moved over the past year and some life cycle fears. I think banks in general will revert to the mean on their valuations and I think Western Alliance will benefit, be a beneficiary of the whole industry rising. There are a couple areas that are concerns for me that just to balance out the investment thesis. Credit risks, spent a lot of time going through the credit risk and the the loan portfolios and talking to management about the types of loans they’re putting on the books. This is still an area to watch. They’ve grown a lot. I think this is what they need to emphasize with investors is how low their credit risk is going forward.


I would say during the last recession, they were not a standout performer on the credit risk side, but the bank was a lot different then. They were 70% based in Las Vegas. And Las Vegas was a real problem area during the last recession. They’re much more diversified now and Nevada is only about, it’s below 15% of the loan portfolio now. I think have much different result going forward. And asset sensitivity is an issue. If we have further rate cuts from here, it’ll be a headwind to earnings. I don’t think it’s a deal breaker, but it’s just something to caution, a low rate environment the stock won’t perform. That’s my investment thesis on Western Alliance, it’s we purchased the position in the third quarter in the stock. It’s benefited from some of the bounce I think in the industry valuation since the end of August.


Think their earnings reports for the June and September quarters were very strong. They continue to show growth and beating an expectation. I think that will continue and they’ll regain some of their multiple that they’ve lost over the past 18 months.


That brings us to the end. This is my contact information, my email address and phone number. If you want to discuss any of the concepts that I talked about on this call in greater detail, happy to do that. Or be thrilled to talk to you about our different investment portfolios and ways we can work with you. Everybody, thanks for joining us today. Hope you have a good day.


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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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