Next, an update on Synovus Financial (SNV), a name we’ve talked about glowingly here before, that continues to be a large position in the portfolios we manage. The company made some moves a few weeks back that, in my view, materially changed its investment appeal. The good news is that the risk in the stock has been substantially reduced. The less-good news: so, alas, has some of the potential upside. My bottom line: I’m still a fan. Synovus remains a major position for us.
I’ll get to the details in a moment. First, though, a broad comment about the investment environment, which has been, shall we say, unsettled for the better part of the last month. Market watchers have come up with all kinds of culprits for the weakness, from the Greek crisis to investor jitters following the “flash crash” on May 6. I don’t buy it. Rather, I believe stocks are simply experiencing the sort of normal correction one would expect following a non-stop, 80%, 15-month rise. With one caveat: the financials in particular face new uncertainty in the form of the semi-irrational financial reform bill that’s working its way through Congress. But even the financial reform bill doesn’t pose a serious new negative to the group, in my opinion.
So if this correction hasn’t ended yet, I believe it will soon, and without much further erosion in valuations. I believe the bull market will resume shortly, as the U.S. economy moves from recovery to outright expansion.
(If you’re a market timer and disagree with my view of the market, you might as well stop reading now. But if you believe, as I do, that the U.S. economy will continue to expand, by all means stay with me, since Synovus will likely be a strong investment performer in the scenario we both have in mind.)
Recall that the investment case for Synovus is familiar and simple to understand. The company made too many residential construction loans during the housing boom and, once the bubble burst, its credit expenses soared. By now, Synovus has lost money for seven quarters in a row, and will likely lose money for one or two quarters before things get back to normal. But in the meantime, leading indicators of credit quality have markedly improved and credit costs have begun to decline. By my reckoning, Synovus can return to profitability by the fourth quarter.
Yet, at 0.9 times tangible book value and 7 times normalized earnings, the stock trades as if Synovus is still on life support. If you take the company’s credit indicators at face value (and I can’t imagine a reason why anyone shouldn’t), you should simply own the stock and watch it rise as fundamentals continue to improve. That’s essentially the strategy we’ve followed, on our way to becoming one of the company’s biggest shareholders.
Now, to those recent events at Synovus that altered the stock’s potential risk and reward. As I’ve said before, Synovus comes with two main investment risks. First, credit might not improve as we expected, or might even get worse. That’s not happening—more in a minute.
But the second risk was that the company might choose (or be forced) to bolster its balance sheet by raising fresh equity, and thus dilute existing holders.
There, things haven’t gone as well as we might have hoped. On April 28, Synovus raised $1 billion via the sale of common stock and equity units. Frankly, I can’t say I was pleased when I saw the size of the deal; it was quite a bit more than I thought the company needed to raise. The dilution was substantial, and has somewhat reduced (but far from eliminated) the returns long-term Synovus holders stand to earn. The remaining upside is nonetheless considerable, in my view.
And in the meantime, no one should have any questions anymore about the company’s capital ratios or the strength of its balance sheet. Post-deal, Synovus’s Tier 1 capital ratio is now 13.7%, its total capital ratio is 17.2%, and its Tier 1 common ratio is 10.0%. Those are of course very strong numbers.
Meanwhile, the other investment risk, credit quality, continues to diminish. Synovus is now clearly on the path to profitability, as credit expenses continue to decline from levels that, at their peak, were fully 14 times normal. (See Chart 1).
In all, then, the risk in the stock has been greatly diminished—as has the potential reward. Back in March, before the equity raise, I thought Synovus would eventually trade at 15 times an earnings power I estimated to be 75 cents per share, for a price target of $9. Now, with the added shares, Synovus’s earnings power is more like 40 cents to 44 cents per share. Using the same target multiple, I get to a target of $6. That’s still more than a double—and at vastly reduced risk.
And, as I say, the credit picture continues to improve. I spoke recently with Kevin Howard, Synovus’ chief credit officer, and came away from the chat with more confidence than ever in my credit forecast. Here’s an update on the key credit indicators I discussed here in March. Notably, all of them are improving!
1. Exposure to the biggest problem areas continue to fall. Recall that Synovus’ biggest credit problems, both in frequency and severity, have been in its residential construction loan portfolio in general, and in metro Atlanta in particular. Chart 2 shows that the performing loans left in this portfolio continue to decline at a rapid pace.
2. The rate of new nonperforming loans continues to slow. The level of new nonperformers is the single best leading indicator of future credit costs. Chart 3 shows that new nonaccrual loans have fallen at Synovus for the past four consecutive quarters. In March, we expected new nonaccrual loans for the first quarter would come to $620 million. In fact, they were just $531 million. Back in March we expected new nonaccruals for the second quarter would be $500 million. Now we’re expecting $475 million. We continue to expect new nonaccrual loans to fall to around $300 million by the fourth quarter. That would be low enough for Synovus to actually report a profit!
3. The loss content of new nonaccrual loans is declining. New nonaccrual loans have an inherently lower loss content than earlier nonaccruals, primarily because their underlying collateral is stronger. In particular, many (even most) of the earlier nonaccruals were secured by land. More recent nonaccruals, by contrast, are secured by properties that are generating some level of cash.
4. Nonaccrual loan upgrades are trending higher. At Synovus (and industry-wide), Commercial & Industrial credit quality is improving as the economy improves, so that an increasing number of loans are being upgraded from nonaccrual. (Table 1). We expect this to continue, and for loan upgrades to become an increasingly important part of the reduction in nonaccruals at many banks in the coming quarters, including Synovus.
5. Nonperforming assets have started to decline. Chart 4 shows Synovus’ nonperforming assets over the last nine quarters. We expect the company will report its first decline in nonperforming assets in the second quarter.
6. The level of net chargeoffs is declining. Synovus’ quarterly new chargeoffs (Chart 5) have declined for two consecutive quarters. We expect the decline to continue. Why? Three reasons: 1) the inflow of new nonperforming loans is falling, 2) the loss content of new nonperforming loans should fall, as well, and 3) the company has already taken extensive writedowns (like, 49%) on its existing nonperformers. While the quarterly level of chargeoffs will be lumpy, the overall decline will likely proceed much faster than consensus expectations for the next six quarters.
7. The loan loss provision is coming down. The items listed above will all help determine the one number most critical to the timing of Synovus’s return to profitability: the loan loss provision. Chart 6 shows that the company’s quarterly loan loss provision has declined for the previous four quarters. This is a pattern we expect to not only continue, but to accelerate.
8. Problem-asset disposition has accelerated. Synovus disposed of $271 million of problem assets in the first quarter, better than our estimate of $225 million. But the “realization ratio” was only 43% compared with our estimate of 53%. Sales activity and realization rates picked up late in the first quarter, and that has continued. We expect the company to exceed its goal of $600 million in problem-asset disposition in the first half of 2010 (Chart 7) and the realization rate in the second quarter is likely to be higher than it was in the first.
A lot has happened at Synovus since we last wrote about the company in March: it has reported another quarter of credit improvement and has completed a sizable capital raise. The capital raise has had the effect of reducing both potential risk and reward in the stock in my view. The speed of credit improvement, meanwhile, will likely hasten price recovery in the stock.
At its current price, the potential reward in Synovus seems compelling to me, particularly when weighed against the now vastly reduced risk. Credit is improving—and as that process continues, earnings will follow. The stock’s valuation should recover steadily, all of which suggests a potentially doubling in Synovus’ stock price over the next two-three years.
Disclosure: The author and his clients hold long positions in SNV