SVB Financial Group

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April 15, 2019

We started a position in SVB Financial (ticker: SIVB) during the 1^st quarter.  SIVB is the bank holding company for Silicon Valley Bank, which has a strong franchise providing commercial banking to venture capital firms and their venture-backed investment companies.  Over the past 20 years, SIVB’s stock has returned 17.3% annually compared to the S&P 500 returning 5.9% and the bank index returning 2.6%.  These returns are a testament to the bank’s strong franchise.

Despite SIVB’s strong franchise and great long-term track record, SIVB’s stock has underperformed since the market’s highs last September.  Here are some of the concerns that we’ve heard from other investors.

1. SIVB is the most asset-sensitive bank, so with the Fed further pausing interest rate increases and potentially cutting rates, SIVB is the most exposed bank to lower rates;

2. The venture investing community has been on fire for the past few years and valuations for late stage venture companies are high so SIVB will experience a much tougher environment when the current venture capital environment reverses;

3. SIVB will have less warrant income in Q1 due to the delayed IPO calendar created by the federal government shutdown in January;

4. During its Investor Day in early December 2018, SIVB’s management guided forecasts for deposit balances to decline for Q4 due to expected distributions by Venture Capital funds to their limited partners; and,

5. SIVB has periodically guided to higher expense growth than Wall Street has expected so they can continue to invest in and expand their franchise.

We think these five concerns have pushed SIVB’s stock down to a level that is compelling.  While these concerns are valid, we believe each is temporary and will not diminish the long-term franchise value of SIVB.

In addition to the recent underperformance of SIVB stock, here is what we find attractive about SIVB.

1. Extremely attractive deposit base – SIVB has one of the best deposit franchises in the country. SIVB has had a long-term focus on the venture capital community.  The bank has built strong relationships with venture capitalists.  They bank the venture firms and their funds, they bank the venture portfolio companies, and they bank the executives at the venture portfolio companies.  When a portfolio company gets funding from a venture firm, they receive cash and deposit it at a bank.  SIVB estimates it has a 60% market share among venture-backed portfolio companies.  SIVB is also different from other banks in that it has moved excess deposits off of its balance sheet into money market funds and other similar short-term deposit replacement products.  These off-balance sheet client assets generate fee income for SIVB and do not require equity capital support like an on-balance sheet deposit would.  A few other metrics that demonstrate the quality of SIVB’s deposit franchise are the 56% loan-to-deposit ratio and the total cost of funds of 0.20%.  For comparison, Bank of America, which is arguably regarded as the best national deposit franchise, has a loan-to-deposit ratio of 69% and a cost of funds of 1.12%.

2. Consistent double-digit loan and deposit growth – Since 1999, SIVB has grown loans per share and deposits per share at 15% and 13%, respectively. By looking at these metrics on a per share basis, we are adjusting for acquisitions, stock buybacks, and equity issuances, and get something close to the organic growth rates.  The growth rates of loans and deposits have been strong for 20 years.

3. Earnings estimates are too low – We believe the earnings estimates are too low for SIVB. We have noticed that the sell-side is mostly conservative on SIVB’s estimates because of the volatility of their warrant income.  We believe the sell-side’s estimates for 2019 are even more conservative because they don’t factor the December 2018 Fed rate hike that already occurred.  And we believe the messaging from SIVB management about conservative deposit growth at its Investors Day in December 2018 has caused the sell-side to lower its forecast of deposit growth too far.  We’ve already seen evidence that SIVB management was too conservative on their deposit guidance in December 2018 and beat that guidance when they reported earnings in January 2019.

4. SIVB’s positioning within Venture community is a true franchise – Over the past 30 years, SIVB has built strong relationships with the venture and private equity communities. These relationships have extended to the portfolio companies of these investment firms and the principals of both the investment firms and portfolio companies.  We believe the network of relationships gives SIVB a banking franchise where firms and executives are less price sensitive on their loans and deposits in exchange for access to the SIVB network.

5. High return on equity – With Fed Funds between 2.00% and 2.25%, SIVB reported a 20% return on tangible equity (“ROTE”). This ROTE is in the top 5% of banks and should lead to higher growth rates and a premium valuation.

6. Reinvestment opportunities – SIVB’s high organic growth rate and high return on equity allows the bank to reinvest more of the capital it generates. This is different from most banks who may generate high returns on equity but do not have the same reinvestment opportunities.  For example, U.S. Bancorp generates a +20% return on equity, but it has only grown loans and deposits per share at 5% and 9%.

7. SIVB is a beneficiary of an easing regulatory environment – One of the major regulatory rollbacks Congress passed was the raising of bank asset levels from $50 billion to $250 billion before major regulatory programs are implemented. SIVB is about to cross the $50 billion asset level, so it will not have to deal with major regulatory issues such as the CCAR stress testing process, resolution planning, Liquidity Coverage Ratio (LCR), and Risk Management.

8. SIVB will regain its premium valuation – SIVB is trading for 11x 2019 earnings per share estimates (“EPS”). For the previous 10 years, SIVB has usually traded between 15x and 22x EPS.  We think it will regain a premium valuation as current fears fade.

9. SIVB is generating excess capital, and management has started buying back stock – With rising interest rates, SIVB’s return on equity is above 20% and greater than its organic growth rate, so the bank is generating more capital than it can reinvest. Since SIVB doesn’t pay a dividend, management has started to use the excess capital to repurchase stock.

Bear Case:

Although we think the bullish investment thesis for SIVB is compelling, we always consider the bear case.  Here are the main bearish points as we understand them and our reasons that we can still own the stock despite these points:

1. SIVB faces interest rate headwinds if rates decline – SIVB is one of the most asset-sensitive banks, so with the Fed becoming dovish, SIVB’s earnings are at risk due to lower rates. A bank is asset-sensitive when its earnings increase due to higher short-term rates.  SIVB is the most asset-sensitive bank because its assets are mostly floating rate loans and it has the lowest cost deposit base in the country.

We note that the bank’s management has said that they are layering in interest rate hedges to reduce the asset sensitivity.  We don’t love interest rate hedging of this kind because we think it is costly, and if it works, the stock’s valuation will not reflect the value of the hedges.

In our view, we think the Fed is in more of a pausing rates phase than an actual cutting rates phase, so we don’t think SIVB’s earnings will go down.  If the Fed does cut rates, we believe SIVB’s long-term growth rate will be unaffected.  In fact, the bank’s loan growth may mitigate the earnings impact of lower rates.  We believe the low valuation is already pricing in several rate cuts by the Fed.

2. Technology start-up valuations and velocity may be unsustainable – We are reaching cyclically high levels of venture capital investing. SIVB’s earnings could decline in multiple ways in a venture investing downturn.  The last VC downturn took close to 20 years to recover prior peak levels.

We may be near a peak in venture investing, but what if the peak is 4-5 years away?  We haven’t seen a runaway IPO market for tech IPOs, yet.  Yes, some tech unicorns have had down rounds and lost value, but there continues to be significant innovation in the venture community.

3. SIVB’s technology lending is vulnerable to recession – SIVB’s technology lending is actually high-risk but is currently disguised by low current losses. SIVB’s technology lending has also expanded significantly since the Internet Boom/Bust.

4. SIVB may have been growing Capital Call loans too fast – SIVB fastest growing loan category is Capital Call loans to private equity funds. These loans are facing increasing competition from many banks because they have experienced almost no credit charge-offs in their history.  This category of loans has grown substantially since the Great Financial Crisis and is relatively untested in a recession.

We note this is a valid criticism.  The growth rate that SIVB has experienced may slow and spreads may tighten due to competition.  SIVB management would say they have the best customer franchise with the private equity funds, so they expect to be able to maintain or grow their market share.  In our experience, private equity fund managers are economic players and would be willing to move business to another bank for a better rate.  We are less concerned about the credit performance of these loans because we think there is low likelihood of default by private equity funds, and SIVB will have multiple avenues to recover on any defaults.

5. SIVB’s gains from warrants may be unsustainable – As part of its lending business, SIVB typically receives warrants in the borrower. Since SIVB has a large portfolio of lending clients, it also has a large portfolio of warrants.  Each quarter, a small portion of these companies have liquidity events, which allows SIVB to book warrant gains.  Some critics claim that the warrant income will dry up when the venture investing cycling dries up.  We think investors already discount warrant income, so SIVB’s stock does not have a lot of embedded premium in its stock price due to potential warrant income.

6. SIVB is taking another shot at investment banking – SIVB recently announced the acquisition of Leerink Partners, an investment bank focused on the healthcare and life sciences sector. The theory is SVB will be able to capture the investment banking business of their biotech clients who are now just commercial banking clients.  The secondary plan is to expand the investment bank to other sectors such as technology.  The two criticisms of this deal are the high price ($280 million cash) and the fact that SIVB had an investment bank 15 years ago (SVB Alliant) that they had to close.

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.