For a lot of reasons, Bank of N.T. Butterfield & Son (or "Butterfield") (NYSE:NTB) is an odd bank. It's the only publicly-traded pure-play on banking in Bermuda and the Cayman Islands, it has uncommonly high market share, and it operates with uncommonly low risk-weighted assets. It also has a very healthy trust business and quite a bit of capital, not to mention above-average asset sensitivity.
Perhaps odder still is that this bank actually looks undervalued. Although I think it will be a challenge for Butterfield to deliver meaningful loan growth, the interest sensitivity and fee-generating businesses should generate revenue growth and good expense leverage. While compliance, regulatory, and oversight risks are real, even with an elevated discount rate, these shares look potentially undervalued today, with a solid dividend kicker as well.
A Bank For The Offshore Havens
Territories and jurisdictions like Bermuda, the Cayman Islands, and Guernsey are perhaps best known as tax havens and offshore financial centers; places where businesses will locate their legal headquarters so as to reduce their corporate tax bills and/or benefit from less regulatory scrutiny and burden. In the case of these three areas (which make up about 95% of Butterfield's revenue), that has meant large contributions to GDP from insurance, banking, and fund management companies, with tourism a meaningful runner-up as a contributing industry.
In terms of deposit and loan market share, Butterfield is the largest bank operating in Bermuda and the Caymans, and it generates around 55% of its revenue from Bermuda and about 30% from the Caymans (with its loan book reflecting a broadly similar weighting).
Although Butterfield used to engage in a meaningful amount of commercial lending, serious losses on commercial real estate loans made to the hospitality industry a decade ago threatened the survival of the bank. Butterfield retrenched and restructured, bringing in new management and a new business plan. Since then, the company has de-risked its balance sheet and refocused itself around what I would call pretty much plain vanilla banking.
Over 60% of Butterfield's lending is now in residential mortgages, almost all of which are floating rate (which is much more typical outside the U.S.). CRE and commercial lending combined make up about a quarter of the loan book, with government and consumer lending making up the rest. Due in large part to very little competition (there are four licensed banks in Bermuda), Butterfield can originate loans at very high yields - north of 5% in recent quarters despite low risk weightings and very low non-performing asset and charge-off ratios. Given that the company doesn't have access to secondary markets where it can sell its loan production, it keeps the loans it writes.
Butterfield's market share also translates into an attractive deposit base. While the percentage of core deposits at 83% isn't necessarily strikingly good (nor is the 20% contribution from non-interest-bearing deposits), the cost of those deposits is still very low (around 15bp), as even its time deposits only cost around 50bp. Butterfield has a roughly 50/50 mix of retail and corporate deposits, but not all that much exposure to P&C and reinsurance companies, as it tends to work with larger multinational banks.
Growth Could Be A Challenge
Although Butterfield has an excellent average loan yield (over 4.9% in the fourth quarter), its net interest margin of 2.45% is quite unimpressive when compared to similarly-sized mainland U.S. banks. The issue is demand. Bermuda (and the Caymans) is small, and there are only limited opportunities to grow the loan book (at least at the underwriting standards management demands), but deposits continue to come in. With that, only about a third of the company's earning assets are in loans, with close to 40% in a security portfolio that yields around 2% and about 25% in cash/cash-like assets that yield around 0.5%.
I view this as an ongoing challenge for the bank. The growth outlook for the economies of Bermuda and the Caymans is pretty good, but the supply of housing is relatively limited, the populations are aging, and there's not much net immigration. While Butterfield could look to grab some share from its rivals (HSBC (HSBC), Clarien, and BCB in Bermuda; Scotiabank (BNS), RBC (RY), and CIBC (CM) among others in the Caymans) or try to move back toward more commercial lending, I think low-single-digit loan growth is a more realistic expectation.
With that, rate action could be one of the more meaningful drivers for Butterfield's growth. With a book of almost all float-rate loans and a sticky low-cost deposit base, Butterfield is very asset sensitive; management estimates that a 100bp increase in rates should boost net interest income by more than 5%.
Fee income growth is another important driver. More than a third of Butterfield's revenue comes from fee-generating businesses, with its trust business generating more than 10% of overall revenue. Trust management is an attractive business, for large banks like PNC (PNC) and U.S. Bancorp (USB) as well as smaller players like First Republic (FRC), and Butterfield is looking to take advantage of larger multinational banks retreating from the offshore trust business due to heightened regulatory scrutiny. Butterfield also has meaningful fee-generating operations in wealth management and foreign exchange services, and growing these businesses (as well as its private banking operations) is a key focus for management.
An Unusual Set Of Risks
I don't view the risk environment/profile for Butterfield in the same way that I would for banks in Hawaii or Puerto Rico (arguably the closest analogs/comps for Butterfield). For starters, the economies of its major markets depend upon their ongoing status as offshore financial centers, and if the U.S., EU, and other jurisdictions decide to crack down on this, it would be a real threat. I don't think this is particularly likely, but it's possible.
Butterfield also has risk (and risk perception) around issues of tax evasion, money laundering, and overall regulatory supervision. The bank is phasing in Basel III standards, and the Bermuda Monetary Authority seems to have credible capital requirement standards, but it's not the same as operating under the Fed. The bank has also tried to be relatively forthcoming about its internal policies and controls, and I think it is worth noting that it clears through BNY Mellon (BK) and Wells Fargo (WFC), both of which have ongoing oversight obligations with respect to Butterfield's operations. Nevertheless, I think investors are still nervous about the regulatory situation, particularly when you think about what banks like HSBC and Standard Chartered (OTCPK:SCBFF) have done (in terms of money laundering) despite regulatory oversight.
The U.S. Department of Justice has issued "John Doe Summonses" as part of an investigation into tax evasion, and a small number of non-compliant U.S.-based Butterfield customers have been discovered. The bank has cooperated with these investigations and set aside a small reserve for future fines and settlements. I'd also note that the bank generally won't take American customers unless they have clear business ties to Bermuda.
There could also be a small risk of Butterfield being considered a passive foreign investment, which would mean more adverse tax treatment. The bank does generate most of its income from interest, but the IRS has typically exempted banks from these standards. Still, with all of the uncertainty about potential changes to the U.S. tax code right now, this could be a risk factor in the future.
With ample capital and likely not a lot of future loan growth to fund, I expect Butterfield to continue raising its dividend in the future. I would also expect future M&A, though management has been pretty consistent about sticking to its guns regarding valuation and business focus. Adding more trust operations seems likely, but management's price discipline makes the timing (and magnitude) less certain.
In terms of its core operations, I'm looking for interest rate leverage, fee income growth, and expense leverage to drive most of the adjusted earnings growth. While growth could approach 10% over the next three to five years, I expect the longer-term rate to be more in the "mid-high" single-digit area. Given the regulatory/supervisory risks, I apply a 150bp penalty to my discount rate relative to what I'd normally use for a bank with these traits (high ROTCE, high market share, low deposit beta, low non-performing assets, etc.), but I still arrive at a mid-$30s fair value. Using a back-up methodology that calculates a "fair" tangible book value multiple based upon return on tangible equity, growth, and earnings volatility, I get a similar fair value ($36.50).
The Bottom Line
The relatively weak prospects for loan growth at Butterfield do concern me, but I like the rate leverage and the opportunities to grow the trust and other fee-based businesses. What's more, I think the bank will be able to better leverage its expenses as it sees higher spreads and more fee income. The regulatory situation is more of an "is what it is situation"; you're either comfortable with it or you're not, but it is a risk factor that will likely never go away. Considering the profitability of the bank, the growth opportunities, the valuation, and the dividend yield, though, I think there's an argument that Butterfield deserves more benefit of the doubt and a higher valuation today.
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