BOK Financial: A Valuation Fantasy

| About: BOK Financial (BOKF)
This article is now exclusive for PRO subscribers.

Summary

BOKF has the highest energy exposure relative to total loans and total equity of all banks in the United States.

BOKF is one of the most under-reserved for loan losses in the United States.

Why is BOKF one of the most expensive banks across every valuation measure in the United States?

Management continues to give a narrative that does not seem to add up.

I use oil as proxy for price across the board below as it may be more familiar to most and the percentage declines in natural gas are very highly correlated.

Introduction:

BOK Financial (NASDAQ:BOKF) is a US-based financial services holding company that operates predominately in the West South Central States with a long history of lending to the energy sector. In this current boom-bust cycle, it is our opinion that they have become way too exposed to the sector and are vulnerable to the default cycle already underway. As a long/short investor in the energy sector, we went looking for the other side of the debt on energy producers books when it became apparent to us that even senior secured debt will not be spared. At BOKF's current valuation, we feel it represents an attractive short position with a risk reward heavily weighted to the downside because of some of the headwinds outlined below.

Earnings per share:

TTM earnings per share after reporting Q1 results is now $3.77 implying a 15.62 PE multiple at today's closing price of $58.88. This seems an absurd ratio for any bank, let alone a bank facing the challenges that BOKF does. Based on guidance from management on the Q1 earnings call, the $60-$80mm loss provision estimate for the year will be at the higher end and most likely "front-end loaded" in Q2. After a $35mm loss provision in Q1, this would imply that Q2 is getting a majority of the $45mm remaining reserve hit and then, we are to make the assumption that all is fixed from that point forward. Based on the information herein, I will not even comment on that and leave you to draw your own conclusions.

Looking at TTM earnings, we can see that overall pre-tax income without any hits from loss provisioning is: Q2 2015 - $125mm; Q3 2015 - $117mm; Q4 2015 - $110mm; and Q1 2016 - $97mm. This is a disturbing downward trend to say the least even without the headwinds from the energy book. Let's assume that the downward trend in pre-tax income is over, which is a generous assumption, and the company can produce an approximate $100mm of pre-tax income per quarter, or ~$1.00 per share net income based on current tax rate if we remove all the provisions for credit losses.

Now if we realize the $45mm loss provision that management has given guidance for, we have $255mm of pre-tax income for the rest of the year ($300mm - $45mm) which is a net income of $167.5mm or $2.56 per share. Adding in Q1 earnings of $0.64, we have full-year EPS of $3.20. That would give the company an even more absurd 2016 forward PE multiple of 18.4. Ask yourself, when most banks are valued at 10-11x EPS and ~1x book, why does BOKF trade at such a premium for a declining income stream to the tune of an estimated 24% year over year and having the most energy exposure on a percentage to loans and total equity than any other bank? I can't seem to come up with a reasonable answer to that.

A 10-11x EPS would make this a ~$32-$35 stock. That would be a best case scenario as it assumes they can, in fact, achieve $100mm pre-tax income net of loss provisions and you take management's guidance at face value that after Q2 all loss provisioning and thus energy stress should be over. It also does not take into account the other $13bb portion of the loan portfolio which only carries a $143mm or 1.10% allowance for losses and is exposed to spillover effects as their entire footprint is all throughout the oil patch states, the majority of which is Texas and Oklahoma.

Book Value:

BOKF reported a BV of $50.21 per share as of the end of Q1. This is based on a $16bb loan book with $240mm or 1.5% of combined allowance for credit losses. The energy book is $3bb in outstanding energy loans, (19% of total loans) which is almost the same size as its total equity position of $3.3bb. What is even more alarming is its total energy exposure including undrawn but committed lines is $5.3bb. This is a staggering 1.6x factor of total equity from this one sector alone.

Total allowance for loan losses in the energy book is a paltry $97mm or 3.19% which is over half of what some other heavily exposed lenders are reserving in percentage terms. Management continually emphasizes that 82% of their loans are senior secured reserve based and that they do their own thorough underwriting for each credit and are very conservative in lending ratios etc. (Don't worry about the other $540mm to midstream and energy services I suppose).

Consider this - Oilmen or "Wildcatters" are about as risk averse as Evel Knievel. How is it that in 2013-2014 at the peak of the boom when mezzanine lenders were effectively shut out of the market because the senior lenders were becoming ever more aggressive as competition was rife and oilmen had funders lining up at the door, does it seem likely that they thought it through and said "let's go with the more conservative tougher terms and higher rates just to be safe?" Of course not, they pledged every piece of collateral they had to obtain every last dollar at the best terms available which were about as loose as they have ever been in history. 54% of BOKF commitments and 45% of their outstandings are in Shared National Credits, so it is unclear if they were even driving the bus on any of that underwriting or just happy to get a slice of the pie.

The energy book from Dec. 31, 2012, to now shows that they have increased loans outstanding from ~$2.5bb to $3bb and have grown outstanding commitments from $5bb to $5.3bb. Therefore, it is safe to assume that the majority of these loans were written in boom times with oil pricing bouncing either side of $100 per barrel. Let's assume $100 per barrel on average when the reserve based lending underwriting was done and now we are at ~$45 for a 55% markdown in value.

Obviously, as wells are producing and depleting, they are replaced by new wells and they would be added as collateral. If the value of the underlying has dropped by 55% and production at large/mid-size/small oil weighted E&Ps only increased 13% and 7% in the last couple of years, where are all the proven developed producing reserves (PDPs)? There appears to be a mismatch here and in order to replace all you depleted at $100 oil, you would have to replace it at a greater than 2:1 pace just to maintain your collateral value. A cumulative 20% gain in production the last couple of years does not indicate that has happened, yet until this spring, very few borrowing bases have been reduced.

It appears the banks have a choice - mark the reserves correctly and reduce borrowing bases causing a deficiency in payment requests and accelerating the bankruptcies, non-performing loans and losses on their books or allow covenant relief, extend and pretend, etc., and focus on the ability to service the debt and hope that things work themselves out. The regulators have now issued guidance to lenders to focus on the ability of the producers to service the debt, implicitly meaning do not mark-to-market and force deficiency payments.

The regulators and the banks have absolutely no appetite for more non-performing loans and losses on lender's books. So how does one value what the loans on the books should be worth? What is the appropriate haircut to book value? 40%... 30%... (which would put the book value in the 10-11x EPS range above), 20%... with probability 1, it is not zero.

NPLs and Capital Ratios:

Taking a look at the acceleration in non-performing loans, the last few quarters portrays why they are opting for the hope strategy. Since Sept. 30, 2015, non-performing loans have increased 113% and the pace is accelerating with the most recent quarter reporting an increase of almost $100mm or 62% bringing total non-performing loans to $252mm with only $240mm of combined allowance for credit losses. This also coincides with the TTM 100 basis point deterioration in common equity tier 1 capital ratio and most notably accelerating to 78 basis points just over the last 6 months.

At this rate of deterioration, any further adverse effects still to come in the E&P space and the spillover effects throughout the rest of the book would have to call into question the sustainability of the current dividend, and a revisit to the Jan-Feb scenario, the need to cut it all together and raise equity. Hyperbolic? Read on.

Oil and Gas E&P Industry:

Even though the price of commodities has rallied hard in the last couple of months, consider that prices this time last year were ~$60-$65 per barrel and drove 42 companies into bankruptcy. The fourth quarter where oil started at ~$50 and went down to $40 by Dec. 1st was the ultimate nail in the coffin for several of the E&P producers. Now consider we are celebrating mid $40s oil per barrel, yet April 2016 has had the most chapter 11 filings involving more debt ($14.9bb) than any previous month since the beginning of 2015, bringing the 2016 bankruptcies total to 27 through May 1st. (Actually 29 - 2 more today since I started this article - I am not a fast writer).

Anyone involved in or following the energy sector will know there has been massive cuts in capex across the E&P space this year, in some cases as high as 90%, but guidance from management of a group of large and mid-size producers show that 50% reduction across the board is a good starting point. They will be able to keep producing with maybe 7%-10% production declines in the short term which along with the recent rally certainly helps cash flow.

Something that fails to be mentioned or at least barely talked about by mainstream media so far is that the capex reductions have about a 6-8 month lag on production. Now fast forward 6-8 months from the beginning of the year and right when you have depletion rates running through the roof and no new wells drilled, you are going to have a toxic combination of declining cash flow, declining reserves against your reserve-based lenders' borrowing base, and a need for new capital to drill new wells. Where does this capital come from? Well, if you are not going to mark-to-market your loans appropriately, then probably write-off any unfunded commitments left on your borrowing base, which in BOKF's case is up to $5.3bb. Remember how these revolvers work.

The producer only services the debt. There is no amortization unless there is a deficiency (which would require marking the borrowing base appropriately) and the producer can withdraw the full amount right up to the day before the next determination. This is almost always standard practice deployed by any producer headed to bankruptcy to conserve as much liquidity as possible entering the process (See Ultra Petroleum most recently). You can now start to build a picture of the box the lenders have put themselves in. All in all, there is a massive need for debt restructuring across the entire industry. Whether this can be done out of court or through chapter 11 bankruptcies, it means haircuts on all debt, including reserve based lending, and will leave the E&Ps with a much lower debt burden and ability to continue production. This combined with recent commentary from the Middle-East and Russia show that production is more likely to increase rather than decrease, thus the supply glut will continue.

Conclusion:

In our opinion, BOKF is grossly overvalued due to its outsized exposure to energy relative to its total loan size and total equity position and the spillover effects from the remainder of its loan portfolio, which is heavily concentrated in commercial and residential real estate in large oil patch geographies. We believe investors may be overlooking just how large the potential risks are going forward. We would expect continued deterioration in earnings and capital ratios due to the continuing ramp up in non-performing loans.

Increased oil production in the second half of the year will put pressure back on oil prices further exacerbating the problem. We would expect that defaults and losses will ultimately tick higher regardless of price and that there will be a massive restructuring of debts just as April has confirmed to us the stress remains even with a 60% rally in oil price. Consider that even at $110 oil most E&Ps were burning cash at an alarming rate.

Disclosure: I am/we are short BOKF.

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.