Hilltop Holdings: Flawless Execution Continues

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About: Hilltop Holdings Inc. (HTH), Includes: BBT, PNC
by: Michael Boyd
Summary

Hilltop Holdings in 2012 was structurally flawed. The business was overly complicated and unprofitable. Tangible book value had been flat for years.

The past four years has seen incredible change, and now the company is undergoing incredible growth.

The valuation is fair, despite the rapid rise over the past year. Excess capital leaves the door open for another game-changing acquisition.

Hilltop Holdings (NYSE:HTH) has evolved into a rather unique financial holding company over the past several years, yet it remains deeply intertwined with the fate of one of America's most divisive states: Texas. The boom and bust cycle of Texas, along with its ever-evolving economy, give financials exposed to the area the opportunity for significant growth - provided those same financial companies can navigate the natural undulations of the area's economy.

The management here (co-CEO team of Alan White and Jeremy Ford) has extensive knowledge of the area, with Alan White spending three decades at Plains Capital (bought by Hilltop in 2012), and Jeremy Ford spending most of his working career within banking M&A, including integration at Hilltop for nearly a decade.

Overall growth here has been compelling. Despite a weak interest rate environment, pre-tax income has grown from nothing in 2012 to an estimated $210M for full year fiscal 2016. While Hilltop once looked like yet another overvalued community banking operation in 2012, the company has grown into its current valuation, with Hilltop now trading in-line with large super-regionals like BB&T (NYSE:BBT) and PNC Financial (NYSE:PNC). However, with shares up more than 50% on the year, is there more room to run, or can investors find better value in the financials space elsewhere?

Plains Capital

Hilltop Holdings' banking operations consist of the company's legacy banking business, along with the acquired operations from FNB (September 2013) and the merger with Southwest Securities (December 2015). The banking business holds $8.7B in assets, nearly wholly from Texas residents and businesses. Retained loans are primarily commercial secured lines of credit and property loans, with the vast majority of residential loans being sold off to be securitized.

The mortgage loan origination business (PrimeLending) is actually fairly diversified, with a multitude of branches located nationally. This is one of the few businesses that Hilltop holds with substantial national diversification, given that only a little under one quarter of origination volume ($13.3B in total in 2015) generally occurs in Texas.

Like nearly all multi-national lenders, California and Florida represent a key source of volumes as well. PrimeLending cross-sells well with the homeowner's insurance premium business that Hilltop owns. However, the company's core competency there primarily falls within the Texas market, with nearly 75% of underwriting occurring locally.

The banking business has seen some weakness in 2016, after years of strength. Net interest income is down marginally (lower net interest margin), reserves for losses are up, expenses are up moderately, and non-interest income has weakened as well (management has pointed its finger at the Durbin Amendment as a driver). This weakness has been buffered by continued strength in mortgage origination, which have continued to grow unabated for years.

Origination growth has grown double digits (12% YTD in 2016) for quite some time. Strength has been broad-based, and has come from both new home purchases and from refinancings. Given most loans the company originates are service-released, there continues to be excellent appetite for the company's loans in the secondary markets. Hilltop retains very little in the way of retained residential loans or mortgage servicing rights on its balance sheet.

Hilltop Securities Holdings

The broker-dealer business is interesting, given the overall size of Hilltop and the marginal size of this business. The company has somehow managed to carve out a small niche for itself in the public and structured finance space as one of the top companies, helping municipalities originate municipal bonds and support investment pool administration, along with deal-making within agency mortgage-backed securities. To support that division, Hilltop Securities also operates a capital markets group, which specializes in trading and underwriting corporate bonds, municipal bonds, and asset-backed securities.

The division was only marginally profitable over the past several years, and existed mainly as a complementary business to other Hilltop businesses, such as driving deposits to the core banking operations. However, 2016 has been an incredibly strong year for the broker-dealer business, with the division actually posting $30.5M in pre-tax income year-to-date, more than what was generated for the entirety of the 2013-2015 period combined.

A lot of this is due to integration and building out of the company's platform as the company has consolidated a variety of subsidiaries, including the integration of First Southwest in early 2015. Pre-tax margins have climbed to 15%, well above initial projections for the business. Some of this is due to a strong market for the company's services given the appetite in the sector, but it appears that the effort Hilltop has directed towards this segment is starting to pay off fundamentally.

Management has guided towards expectations of 12% in pre-tax margins, but co-CEO Alan White seemed pleased with results within the segment on the last conference call, and put most of the strong strength here on finally being able to focus on growing the business rather than structural and integration challenges that occurred over the past several years:

"Matt, if I could say something in this [regarding broker-dealer business]. We've gone through all this integration, and that's taken away from our focus on generating revenue. We've been able now to start focusing on revenue. And now we're seeing the results of what we hoped would happen."

National Lloyds Corporation, Sale Thoughts

National Lloyds Corporation (NLC), a wholly-owned subsidiary, primarily provides fire and homeowners insurance for low value dwellings and manufactured homes throughout the Southeastern United States. NLC targets this underserved market, an area which many larger carriers have been unwilling to break into given the very low premiums, lack of volume, and potential for reputational risk. The reputational risk there comes from the structure of the business.

Unlike with homeowners insurance that many SA readers would be familiar with, which focus on replacement cost, most underwriting done here is done on a cash value basis, so that depreciation on manufactured homes is taken into account. This lowers out-of-pocket costs, but it could lead to a situation where a family could be displaced, but have a difficult time finding a replacement property given the cash value of the original dwelling.

For large, national corporations, the potential for reputational damage if a news story broke out surrounding that coverage type is generally not worth the small market size, despite the fact that serving customers like this is often more profitable from a margin standpoint.

As fellow contributor Stephen Simpson pointed out, Hilltop is exploring the potential sale of this business, but a buyer may be harder to find given the business structure mentioned. I do think a sale here would be excellent. It is easy to make a case for $120M given historical returns, potentially $150-160M for a buyer that sees significant synergy opportunities within their own core business.

Hilltop continues to hold excess capital ($500M), so a sale could boost that available capital to $650M. Management here loves situational M&A, and with integration costs rolling off from prior purchases, I wouldn't be surprised to see a deal with another Texas-based bank with some size ($1-2B). Unfortunately, most in the space are likely demanding significantly higher pricing on M&A deals then they were just a year ago. The rally in energy has assuaged a lot of fears related to energy loan books. Given management's preference for acquiring companies with a bit of "hair" it might be a little time before we see a deal.

Takeaway

Overall, this is an incredibly solid financial holding company. In doing due diligence, I was quite impressed with the way the bank has performed over the past several years. I'm not quite willing to pull the trigger at 1.8x tangible book value (although this is a discount to the 2.5x P/TBV the company reached in 2014). Like most other financials, the company has gotten caught up in the Trump-fueled interest rate rally. I suspect that there will be a moderate fallback at some point, and at anything closer to 1.5x ($23.50/share target), I would be a more than happy buyer of the company.

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