We met privately with the management of Synovus Financial (NYSE:SNV) earlier this week at the company’s headquarters in Columbus, Georgia—and came away more convinced than ever a credit recovery is on track at Synovus that will set the stage for a massive earnings recovery and a much, much higher stock price. I’ve said before that I believe the stock will be worth $9 per share within two to three years (versus a recent price of $3.30). I’m now more convinced of that than ever.
I am enormously bullish on this company. Anyway, here are my key takeaways from the meeting:
1. Synovus is on the path to profitability.
The company has reported a net loss for the past six straight quarters, and we expect it to lose money for the first two quarters this year.
But based on what we saw in Synovus’s fourth-quarter earnings report and have learned since then in chats with management, we’re confident that even though the balance sheet is set to shrink, the company will be able to maintain its pre-tax, pre-credit earnings. Then, as credit costs fall dramatically in the second half of this year, earnings will likely rise rapidly.
The big swing factor is, of course, credit costs. Last year they reached $2.2 billion, well above what we would consider “normal,” and overwhelmed the company’s pre-credit, pre-tax operating earnings of $553 million (see Chart 1). But the spike has at last begun to reverse. Credit costs peaked in last year’s second quarter and, as new problem loans and chargeoffs have fallen since then, the company’s loan loss provision is set to fall as well--and Synovus can return to profitability.
2. All the company’s credit quality indicators are improving, and will likely continue to improve.
Note to readers who might be in a hurry: This is all you need to know! If credit continues to get better, then (and this is simply how the arithmetic works) earnings will recover and eventually surge. In turn, Synovus’s valuation will expand from its current depressed level (0.8 times tangible book value) to something more in line with historical levels of 2.5 to 3 times tangible book.
On this latest visit with the company, we became more convinced than ever that Synovus has been among the most conservative banks in dealing with credit problems. It has honestly identified problem credits and has been aggressive in writing them down and resolving them. By now, all credit quality indicators are improving. For instance:
Exposure to the biggest problem areas continues to fall.
The company’s greatest problems, related to both default frequency and severity, have been centered in its residential construction loan portfolio in general and the Atlanta metro area, in particular. Step 1 toward a solution there: stop making the loans that are giving you problems. Synovus did that two years ago; since then, its residential construction loan portfolio has fallen steadily, as seen in Chart 2.
Last year, residential construction loans made up 56% of the company’s new nonaccruals, even though resi construction makes up only 14% of the company’s total loans. This problem is done.
The rate of new nonperforming loans is slowing.
If there is a single number that best indicates the direction of a bank’s credit quality, it’s the amount of loans newly entering non-performing status. Chart 3 shows new nonaccruals at Synovus over the last four quarters and our projections for next two. As you see, the numbers are headed in the right direction. In the first quarter, we expect an increase in new nonaccruals in investment property and commercial nonaccrual loans, but the increase will be more than offset by a decline in new nonaccruals in residential construction.
By the fourth quarter, I expect new nonaccrual loans to have fallen to around $300 million. That’s still well above normal, but low enough for Synovus to be able to report a profit. Chart 4 compares Synovus’ quarterly inflows as a percentage of beginning loans to a group of peer banks.
New nonaccruals are set to fall yet again this quarter, which would be their fourth straight quarter of decline. I expect further declines in coming quarters, at an accelerating pace through year end. Fewer new nonaccruals now means lower chargeoffs. It’s a simple, straightforward path to profitability, and it’s happening.
The loss content of new nonaccrual loans is declining.
It should come as no surprise that loans that can hang on for awhile before going on NPA produce lower losses than shakier loans that went delinquent early on. On average, the loans Synovus has already classified as nonaccrual have been written down by 42%. However, for a number of reasons (most important of which is the nature of the collateral) loans more recently classified as nonaccrual figure to have loss content that’s an estimated 10% to15% less than that.
Nonaccrual loan upgrades have started trending up.
Believe it or not, some troubled loans actually walk out of the hospital. Table 1 shows the change in nonperforming assets over the last four quarters. As you can see, $30 million in nonaccrual loans were upgraded in the most recent quarter. This will be a volatile number on a quarterly basis but, with the economy clearly improving, the total should move higher over time, which in turn should help chip away at total NPAs.
Nonperforming assets have flattened and will likely soon start to decline.
Chart 5 shows Synovus’ nonperforming asset totals over the last eight quarters. A sub-segment of nonperforming assets is nonperforming loans. They declined last quarter for the first time 15 quarters! This doesn’t count as a clear trend yet, but, given what’s going on with new nonaccrual loans, we believe it’s not unreasonable to expect that non-performing loans have peaked and are set to start an extended decline.
The level of net chargeoff is falling.
As the inflow of new problem loans declines and as the expected loss content of those new problem loans declines, as well (and because existing problem loans have already been written down by fully 42%) quarterly chargeoffs have to fall. Indeed, Synovus’ quarterly net chargeoffs (Chart 6) declined in the fourth quarter. We think that’s the beginning of a trend.
The loan loss provision is coming down.
The reason all these leading indicators are important is that they influence the biggest swing item on the income statement: the loan loss provision. Declining levels of problem loans and lower net chargeoffs will lead ineluctably to a declining loss provision, as well. Chart 7 shows Synovus’s level of provision, by quarter, split between the amount to cover net chargeoffs and additions to build the reserve.
For the first quarter, we expect only a modest reserve addition (and hopefully none at all). Then, for the remaining quarters of 2010 and all of 2011, we expect the quarterly provision levels to come in below chargeoffs, by greater and greater amounts. This is what will technically drive the company back to profitability and, ultimately in 2012, back to a normalized level of earnings.
A Sea Island resolution is in sight.
Synovus’s whopping $220 million exposure to the Sea Island resort in Georgia has drawn an enormous amount of media and investor attention. The credit was classified as nonperforming last year and impairments (writedowns) have been taken since then based on what the company describes as “very current” appraisals.
The company won’t discuss individual lending relationships, but the media has reported that Goldman Sachs has been retained to market the property, either to obtain an equity investment or and outright sale. Investor interest is said to be quite strong. We believe the most likely resolution for Synovus would be a sale of the property. It could be achieved as early as the second quarter, and almost certainly before year-end. Should a sale happen, the Sea Island credit would be resolved and would come out of Synovus’s non-performing assets. NPAs would thus fall dramatically (no other nonperformer is close to Sea Island’s size) with little, if any, addition writeoffs.
Other problem asset resolution is proceeding at a healthy pace.
Last year, the company decided to step up the pace of its problem asset resolution, and has clearly followed through on that decision. In 2009, Synovus sold $1.2 billion of OREO and problem loans (Chart 8). Chart 9 shows the quarterly pace of resolutions, along with our estimates for the next two quarters. Management indicated in January that its goal was $600 million in sales in the first half of this year, with the first quarter being seasonally weaker than the second. During our meeting this week, management expressed confidence in achieving this goal.
Of course, the positive impact of reduced inflows of new problem assets, along with stepped-up resolution of existing problem loans, should cause the company’s nonperforming assets to decline.
Synovus’ credit quality was badly damaged over the last two years, due to both internal mistakes (in particular, excessive concentration) and external factors (the real estate bust and economic recessions). But once it recognized the problems, management has done an impressive job of dealing with them. Credit costs are incredibly high but they are coming down. This is what will drive a huge positive swing in earnings over the next three years.
3. The company should complete the consolidation of its bank charters in the first half of this year.
For a number of reason (not least being cost saving) Synovus last year decided to collapse its 30 bank charters into one single charter. It’s begun the process, and is set to file an application this week. Approval is expected before mid-year.
The consolidation will likely enable the company to see significant savings. On the other hand, Synovus has $1.8 billion in deposits shared among its existing banks that, post-consolidation, will be at risk as FDIC insurance limits effectively fall. The company anticipates it could lose up to half of those deposits over the first 18 months following conversion. It says it plans to mitigate the loss and does have sufficient excess liquidity to offset it in any event.
4. A succession plan is in place. After both an internal and external review, the company named Kessel Stelling president and chief operating officer last month, making him the likely successor to current CEO Richard Anthony, who is 63.
Stelling is a good choice He founded Riverside Bank in 1996, and then sold it to Synovus ten years later. Synovus merged Riverside into its Bank of North Georgia unit, and appointed Stelling CEO of the bank in 2007. He became the regional CEO for Atlanta the following year.
Once Synovus’ credit quality recovery is complete, the company will become less dependent on commercial real estate, and will become more focused on small and mid-sized business. This is exactly the business model that Stelling operated at Riverside, which is one of the reasons it avoided the credit problems that hit other banks in Atlanta, including Synovus’s.
As I say, we like the choice, but expect Stelling’s rise to fan rumors that Synovus is a takeover target down the road, since both Richard Anthony and Stelling have been sellers of banks in the past. At the present, Synovus’ credit recovery is the overriding investment factor.
5. The company is incrementally improving its capital ratios for now. While Synovus’s capital ratios are well above the minimums to be considered “well capitalized” under current regulations, management is aware of the jihad among regulators to force banks to maintain even higher capital ratios.
While the company’s capital ratios will continue to be hurt by expected losses in the first half of this year, management is considering incremental actions that would partially offset that erosion. In particular, the company could continue to shrink its balance sheet or sell its merchant processing business or other assets. It might also convert it subordinated debt or its TARP capital to trust preferred. The company is mulling other moves, as well.
We would be very surprised to see a large dilutive common equity offering at anything close to the current stock price. Assuming the company’s credit and earnings improve along the lines as we have suggested, we’d expect a common equity issuance in the future at a higher stock valuation, and have included one in our normalized earnings forecast.
It is possible (though we don’t expect it) that bank regulators will call off their capital-ratio jihad and let Synovus’ capital ratios rise organically. Call me crazy, but forcing banks to raise so much capital today, when they are on the verge of years of tremendous internal capital formation, makes no sense. In a worst case, and could lead to harmful practices later on as banks stretch to find adequate returns on their redundant capital.
6. Informal SEC investigation announced. Synovus disclosed in its 10-K that it is subject to an informal SEC investigation. During our visit we asked for more information, but the company couldn’t provide any because it’s had no further contact with the SEC.
One potential thesis was that, since Synovus raised equity in September and then announced “disappointing” earnings in October, whether management might have made misleading statements on their road show.
If that’s what the S.E.C. is going on, it’s grasping at straws. We met with management on the road show, and were disappointed with the third quarter results. But by no means did we feel we’d been misled. After the massive overreaction in the stock following the earnings release, we bought more. If this is what the S.E.C.'s investgation is about, I doubt it's going very far.
7. The stock remains unloved. To my surprise, while the company’s fundamentals have steadily improved, and as its stock has risen off a tremendously depressed level, Wall Street analysts and investors have remained incredibly negative about the investment outlook for Synovus.
Of the 24 analysts that Bloomberg lists as following the company, only 7 rate the stock a “buy” while 12 say “hold” and 5 are at “sell.” In addition, as seen in Chart 10, the short position in the stock has continued to climb, reaching 52 million shares as of the end of February.
We are obviously on the other side, and find both the company’s improving fundamentals and its stock valuation (80% of tangible book value and 4.5 normalized EPS) to be exceptionally attractive, even compared to other highly attractive opportunities among banks.
Bloomberg lists the investment partnership that I manage as the third-largest shareholder as of year-end--and we have increased our holdings since.
Having reviewed the company’s fourth quarter earnings, digested its 10-K and spent a day visiting with management, we are more convinced than ever that Synovus is in the midst of a powerful earnings recover that should be very financially rewarding to shareholders.