Valley National's Slow Climb Back Up The Mountain

| About: Valley National (VLY)
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Summary

Valley National is looking at expansion into Florida as its primary driver of growth, having made two acquisitions already and looking for more.

VLY's capital position isn't exactly flush, and management's desire to do more deals could lead to dilution; a high weighting of CRE loans relative to capital is also concerning.

If the company can get back to a double-digit ROE in four or five years and a mid-teens ROE five years later, a fair value of $12-12.50 seems reasonable.

Banks that rely on spread income, and particularly those with expensive funding sources, have had their challenges in recent years and that includes Valley National (NYSE:VLY). On the plus side, this conservatively-run bank has a well-deserved reputation for strong underwriting and a willingness to turn over rocks and sift through the couch cushions to find ways to cut costs without compromising the long-term viability of the franchise. What's more, this company has shown that it can (and will) do deals, and it pays a healthy dividend relative to its peer group.

In this new operating environment for banks, "fairly valued" is the new cheap, and Valley National doesn't look all that overpriced to me. That said, the company is not exactly flush with capital at the moment, and I think it's fair to be concerned that future M&A could be more dilutive. Likewise, I have some concerns about the bank's positioning with respect to its loan book and its capital, but tailwinds like a lower tax rate and a less stringent regulatory environment could both help.

Well-Established On Its Home Turf

Valley National is a well-established bank in New Jersey and the NYC metro area, with a top-15 position in the New York/Newark/Jersey City MSA and over 6% share in its core territory in New Jersey. Management has been in place for quite some time (the current CEO has been with the company about as long as I've been alive), and VLY has been operated with fairly consistent and sound policies.

Like most banks in Valley National's "weight class," the company is skewed toward commercial lending. About half of the loan book is presently made up of commercial real estate loans (excluding construction), with more than a third tied to housing (apartments, co-ops, mixed use) and close to 20% tied to retail. Commercial and Industrial (or C&I) lending is around 15%, which is light compared to many larger super-regionals, but not so unusual for Valley National's peers. Residential mortgages make up about 17% of the book, and auto loans are 7% (a little higher than the norm for larger banks).

The funding mix supporting that loan book is … interesting. On one hand, more than 80% of the bank's deposits can be considered "core," and non interest-bearing deposits make up a strong 30% of the deposit base. On the other hand, Valley National has used a lot of high-cost borrowings over the years to fill the gaps - the bank has prepaid/refinanced over $1 billion in higher-cost borrowings since late 2015, but the bank still has a somewhat elevated cost of funds (0.7% on total non-equity funding) due to around $1.5 billion in long-term borrowings that cost 3.55%. What's more, while Valley National's capital levels aren't at a level that is worrisome from a regulatory standpoint, they are lower than many of its peers that find themselves with ample surplus capital to deploy.

One thing that does stand out to me about Valley National is the company's strong underwriting history. Low non-performing asset and charge-off ratios have become commonplace at this point in the cycle, but Valley National's NPA ratio peaked at less than 2% back in 2012 and the bank fared better than many during the credit crisis.

Taking A Proven Model South

While strong underwriting helped Valley National, the changes in the banking industry have nevertheless hit the company. This bank is in many respects a "plain vanilla" lender in as much that spread income makes up about 85% of the bank's revenue. With the low rates and weaker loan demand of recent years, Valley National has found it hard to grow and hard to leverage its cost base; a bank that once had quite good efficiency ratios has seen those number go above 60% due in large part to weak spreads for its earning assets.

Driven in part by a desire to find better long-term growth opportunities, Valley National has pivoted toward the South in recent years, and Florida in particular. Two deals (in May of 2014 and May of 2015) have established a beachhead in Florida and the state now makes up about 15% of the bank's overall deposit base. Valley National has decent share now in the Tampa and Fort Myers areas and a good starting position in Miami, but management has made it clear that it intended to use further M&A, ideally for banks with about $1 billion to $2 billion in assets, to build the Florida business further. Management has laid out a target for New Jersey, New York, and Florida all making up about one-third of the company's deposit base, so that would suggest meaningful future expansion in this market.

Expanding into Florida is a mixed blessing. The demographics support the move insofar as population and household income growth is likely to be stronger in Florida than in New Jersey/New York in the coming years, and loan growth should be correspondingly stronger. On the flip side, seemingly every bank wants to have a meaningful presence in Florida, which means not only more competition for deals (higher multiples and lower returns), but also more in-market competition as well. While I do believe a well-run bank can do okay almost anywhere, a market that is already crowded with the likes of Bank of America (NYSE:BAC), SunTrust (NYSE:STI), Wells Fargo (NYSE:WFC), Fifth Third (NASDAQ:FITB), PNC (NYSE:PNC), Regions (NYSE:RF), and many more is not exactly my idea of the easy path to success.

The Opportunity

Management gave an outlook for 6% to 8% loan growth in 2017, with Florida likely outgrowing the Northeast, and that seems like a reasonable expectation. I would note some concern about the company's commercial real estate book, though, CRE loans are already over 450% of capital, and I have to think that the bank is going to get some pushback from regulators on that. There are opportunities to grow the C&I and mortgage books, but I do have some concerns that the bank's heavy skew could require pulling back on CRE underwriting, selling some of the portfolio, or raising more capital.

Valley National also recently unveiled its LIFT initiative - an as of yet largely undefined effort to improve revenue and expenses in the coming years. Management has apparently reassigned some of its best people to work on this full-time, and it has engaged the services of a consulting firm that will be paid a percentage of the benefits obtained. In some respects, I suppose this is like Fifth Third's North Star plan, which likewise targets multiple revenue and expense items and has seen management gradually unveil more details as time has gone on. Insofar as every bank is looking for ways to improve revenue and reduce expenses, there is nothing special about LIFT, but management's past performance on expense initiatives does at least lend it a little more credibility.

As for the basic business, Valley National isn't particularly asset-sensitive, but it should see its spreads improve as rates head higher, particularly as its deposit betas are on the low side and deposit betas industry-wide have been lower than expected (which means low-cost deposits are largely staying put). With widening spreads and decent loan growth, Valley National should better leverage its expense base and drive improving operating income growth. Given how good the credit situation already is, it really can't help improve profits that much from here. What could help, though, are a lower tax rate and less stringent banking regulation - both of which have been discussed in general terms by the new administration but without any well-defined specifics at this point.

I think it will take a few years for Valley National to get back to a double-digit ROE, but a long-term return toward the mid-teens can drive double-digit earnings growth and support a fair value around $12 today. M&A could accelerate the company's growth, but management has already noted that it's difficult to find good deals (or rather, good prices for deals), so there is a balance to be struck here between growth and returns.

The Bottom Line

With discounted earnings supporting a $12 fair value and an ROTCE-based TBV approach supporting a fair value of $12.50, Valley National seems more reasonably valued than many of its peers. That said, a mid-teens ROE could prove too ambitious of a target, and I do have some concerns about that CRE-heavy loan book and the company's overall capital position. On the other hand, the dividend yield isn't bad at all (and investors may also want to check out the preferred shares issued back in 2015 as a higher-yielding option), and I think management has a credible plan. While Valley National is still looking at a tough climb back to double-digit ROEs, it does at least seem like the expectations here are more reasonable than is the norm in the sector today.

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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.