First Republic Bank: Wait For A Better Entry Point

| About: First Republic (FRC)

Summary

First Republic Bank has strong fundamentals and strong earnings growth outlook but the price tag is too high in our view.

Higher rates curbing the demand for residential mortgages and a shift into a lower yielding asset mix are the possible headwinds that the bank could face in the near term.

In our view, the current valuation is unsustainable; our 12-month price target is $68 which implies 12% downside potential.

First Republic Bank (NYSE:FRC) reported its 3Q results last week when a quarterly EPS of $1 coming one cent ahead of the expectations was overshadowed by a revenue miss. Market reaction to the announcement has been quite negative so far and the stock is now trading almost 5% below the pre-announcement level. Even if we believe that First Republic is a fundamentally strong company, our investment discipline tells us the stock is too expensive, and we see no upside at this time. This quarter will probably mark the end of long-lasting outperformance.

Click to enlarge

First Republic is a San Francisco-based bank that has provided private banking, commercial banking, and real estate lending for more than three decades, and it added wealth management to its services several years ago. The bank has footprints in metropolitan areas of the United States but majority of its offices are based in California. The bank is known for its deep-rooted and seemingly permanent relationship with clients. It has achieved above-par growth rates thanks to the years of strong operational performance, and managed to become a premium stock in the industry since it went public in 2010.

Banks typically look for client base expansion to grow their business volumes. The distinguishing feature of First Republic's business model is that it implies growth with the same client base. The bank's client attrition per annum is extremely low at 2% versus the industry average of 10%. The management explains its long-term objective as registering a high retention rate and growing volumes through higher client satisfaction. Half of growth in lending and deposits comes from existing clients in First Republic. That said, the bank is easily able to manage the counterparty risks since it simply does not take new risks by acquiring new clients.

This conservative way to increase loans and deposits has not prevented the bank from growing its business above the industry average. Between 2010 and 2015, loans and deposits have risen by 18.4% and 20.8% per annum, respectively, leading net income to increase by more than 10% each year during the same time frame. Wealth management unit has flourished with increasing assets from $20.1 billion in 2010 to $72.3 billion in 2015. Also, this year the bank has showed solid performance with increasing its net income by 29.4% y/y in 9M16, supported by 16.6% and 24.5% average loan and deposit book growth, respectively. As expected, the bank reported superior asset quality metrics as NCO rate stood at $1.6 million in nine-month period, which was even lower than 0.01% of total average loans.

Meanwhile, First Republic also benefited from a lower effective tax rate this year due to its concentration on tax-exempt securities, tax-advantaged loans and particularly higher volume of employee stock options exercise this year. The effective tax rate for 9M15 was 17.5%, compared 24.4% for 2015 and 27.3% for 2014, and an average of 24.1% for regional banks.

We find no difficulty accepting that there is shining future for First Republic thanks to its strong earnings outlook. However, there are some risks that are needed to be mentioned at this point. First, the bank's loan growth has been increasingly dependent on residential lending. The demand for purchasing and refinancing has been strong, driven by a healing labor market and extremely low rates. While rate hikes will work as an earnings driver for banks in the upcoming period, it somehow would decelerate the mortgage production by curbing the demand which correspondingly would have a negative impact on top-line growth. Second, the bank is likely to deploy more cash into securities rather than loans to increase its high-quality liquid assets. It had operated with a loan to deposits ratio above 100% until early 2015. We expect the bank to keep that ratio slightly above 90% this year, and drive down further in the upcoming years to low-80s. This could potentially put some pressure on margins, which may cause a slower-than-expected NIM acceleration in First Republic.

Bank Holding Company

2016E EPS

2017E EPS

Stock Price

2016E P/E

2017E P/E

First Republic

$3.18

$3.91

$73.32

23.06

18.75

Bank of the Ozarks (OZRK)

$2.07

$2.44

$37.28

18.01

15.28

Bank of Hawaii (BOH)

$3.70

$4.17

$73.26

19.80

17.57

BNC Bancorp (BNCN)

$1.24

$1.62

$24.15

19.48

14.91

BOK Financial Corp (BOKF)

$4.21

$3.87

$68.95

16.38

17.82

Eagle Bancorp (EGBN)

$2.50

$2.79

$48.96

19.58

17.55

Hancock Holding (HBHC)

$1.77

$1.81

$32.46

18.34

17.93

Pinnacle Financial (PNFP)

$2.61

$3.03

$53.73

20.59

17.73

PrivateBancorp (PVTB)

$2.29

$2.56

$45.64

19.93

17.83

ServisFirst Bancshares (SFBS)

$2.39

$2.79

$52.96

22.16

18.98

Texas Capital Bancshares (TCBI)

$2.91

$2.99

$55.45

19.05

18.55

UMB Financial Corp (UMBF)

$2.44

$3.08

$60.64

24.85

19.69

Average

20.10

17.72

Source: Yahoo Finance

Click to enlarge

Our pessimistic view of future stock performance is based on the current valuation. Above we list some regional lenders with premium valuations where First Republic is close to the top-end of the spectrum that makes the stock looks like premium of the premiums. Our price target is $68 per share on a 2017E P/BV of 1.65x based on some assumptions including a sustainable ROE of 11.5%, a COE of 9%, and long-term growth rate of 5%. As our price target implies 12% downside potential, we recommend investors to wait for a better entry point to build positions.

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.