I’ve been concerned about the heavy weighting of some banks toward commercial real estate and construction lending given where we are in the CRE cycle. Apparently, I’m not the only one, as more than a few banks with high ratios of commercial real estate loans to capital have underperformed their regional banking peers so far this year.
This brings me to Bank of the Ozarks (OZRK) (soon to be “Bank OZK” (OZK)); this isn’t the first time I’ve been concerned about the combination of OZRK’s aggressive construction/CRE lending growth, its aggressive expansion into new markets, and its funding situation, not to mention its valuation, but it does seem like the market is now paying closer attention. The shares do now look undervalued if double-digit long-term growth remains a reasonable expectation, but investors should note the elevated risks that accompany that undervaluation.
Is Meeting The New Missing?
Only a handful of bank earnings reports are in hand so far, but those companies that have reported have generally offered up good results – making Bank of the Ozark’s on-target second quarter earnings a little less impressive by comparison.
Revenue rose 7% yoy and 3% qoq in the second quarter, with 10% yoy growth in net interest income driven by 18% growth in earning assets. Net interest margin continues to shrink as higher deposit costs bite into profitability, with NIM falling 33bp yoy and 3bp sequentially. Fee income is not an especially significant revenue line for OZRK, but fell 13% yoy and rose 5% sequentially, contributing a little more than 10% of total revenue.
Expenses rose 7% yoy on a core basis, allowing for 7% core pre-provision profit growth. Tangible book value grew 14% from the year-ago quarter.
Relative to expectations, I can’t call this a particularly strong quarter. Bank of the Ozarks benefited from lower than expected expenses and a lower tax rate but reported lower net interest income and lower balance sheet growth. I’d also note that provision expense was higher than expected and up 57% from last year, as non-performing loans increased 16%.
More Competition Means Less Growth
The biggest takeaway from the quarter, and likely the biggest cause of the post-earnings stock price decline, was management’s acknowledgement of rising competition for both loans and deposits. This has been a part of the bear thesis for a while, as the CRE cycle is rather mature and it has seemed unlikely that commercial construction and mortgage demand could continue to support banks’ aggressive growth targets.
End-of-period loans increased 10% yoy, but grew just 1% sequentially, with 4% sequential growth in originated loans offset by a 12% decline in purchased loans. Even those figures are somewhat misleading, though, as C&D sequential loan growth was 2% and CRE loan growth was flat, with the bulk of the loan growth coming from a seasonal increase in RV/marine lending. I would also note that closed unfunded loan balances declined 4% sequentially.
Loan yields do remain healthy, however, with a 66bp increase (yoy) in originated loan yields, somewhat offset by a 10bp decrease in purchased loan yields. A very large portion of OZRK’s originated loans are variable rate and with short-term (1-month LIBOR) benchmarks, giving the company good leverage to rate increases and a 64% cycle-to-date loan beta.
Unfortunately, OZRK remains pressured by a weak core deposit position that leaves the bank increasingly reliant on increasingly expensive funding. Deposits rose 10% yoy, but just slightly on a sequential basis, and the cost of deposits rose 51bp yoy and 21bp sequentially. The cycle-to-date deposit beta has now climbed to 50%, with a 70% beta year-to-date that exceeds the loan beta.
Loan growth is being pressured by elevated paydowns, with more commercial projects locking in permanent funding at an earlier point in the process than in years past, but also by intense competition in markets like New York (where about one-third of the company’s commercial real estate and construction loans are). While management maintains that it is not loosening its underwriting standards or lowering its profitability targets (and thus loan growth expectations are declining), contacts in the CRE world tell me that Bank of the Ozarks has been taking deals that bigger shops have passed on.
How OZRK management will handle this phase of the cycle is a key question. Bears will argue that the bank has charged into metro markets that they don’t really understand, while bulls can basically point to the company’s historical credit results and claim “scoreboard”. There is also an argument to be made that OZRK’s above-average due diligence quality will help it steer clear of sizable credit losses and that this is, in fact, part of the marketing pitch – supposedly at least some borrowers are willing to pay OZRK’s above-market rates because the company’s due diligence process often uncovers project or financing risks that other lenders miss or gloss over.
If credit remains benign, even slower than expected loan growth will still see OZRK accumulating a lot of surplus capital. That may, in turn, prompt the bank to consider M&A opportunities and particularly banks with good, lower-cost core deposit franchises. I’ve trimmed back my model a bit, but I’m still looking for long-term earnings growth in the double digits. That’s not a conservative outlook given where the CRE cycle is at, though, investors should not dismiss the risks of slowing loan demand and rising credit costs.
The Bottom Line
The share price weakness of Bank of the Ozarks has brought it below my mid-$40s to mid-$50s fair value range. I’ll say again that the underlying assumptions for that value range aren’t conservative, but it looks a lot of the excess enthusiasm for these shares is getting wrung out as the market backs away from those banks with heavy exposure to New York City commercial real estate and construction. Aggressive investors may want to start refreshing their due diligence on this name.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.