Will More Time Bombs Go Off At Bank OZK?

About: Bank OZK (OZK)
by: Canadian Dividend Growth Investor

OZK stock fell off a cliff last Friday.

The bank incurred charge-offs on 2 credits in Q3.

There's another risky credit that's on watch.

The market has lost confidence in the stock (at least for now). However, the long-term track record of OZK's RESG portfolio is still excellent despite Q3's anomaly.

To shareholders' dismay, they woke up to Bank OZK (OZK) stock falling nearly 27% last Friday after the bank reported its Q3 results.

The quarterly results were average compared to the industry. However, this was seen as an underperformance because OZK usually outperforms. In addition to that, and what really threw investors off was that the bank incurred charge-offs. Investors' worries of future potential charge-offs added fuel to the selloff.

The bank also incurred expenses due to its name change, but this was a one-off. So, I don't think this was a big reason for the selloff.

Despite falling off a cliff, the stock still delivered market-beating annualized returns of 13.8% from November 30, 2007, before the last recession.

OZK delivered market-beating returns from pre-financial crisis Source: FAST Graphs

Recent Results

In Q3, OZK reported net income of $74.2 million, an annualized return on assets of 1.33% (this equaled to the industry's), and an annualized return on equity of 8.07%.

Management reassured that

...being average has never been our goal. We expect to achieve our more typical performance in the coming quarters.

For the first three quarters of the year, OZK reported net income of $302.1 million, an annualized return on assets of 1.85%, and an annualized return on equity of 11.32%. Its net income increased 9.6% for the first nine months of 2018 compared to the same period in 2017.

The Time Bombs that Just Exploded

In Q3, OZK incurred charge-offs on 2 credits that dated back to 2007 and 2008 in its Real Estate Specialties Group (“RESG”) portfolio. It was revealed in the earnings call that both credits were classified as substandard in 2017 and so OZK had combined allowance allocations totaling $19.1 million as of the end of Q2 for the 2 credits. (That is, OZK set aside $19.1 million for these 2 credits.)

However, after obtaining the updated appraisals, it turned out the performance of the properties was worse than expected. So, the bank had a provision expense of $26.4 million in Q3 in addition to the $19.1 million for combined charge-offs of $45.5 million on the 2 credits. (That is, the $19.1 million wasn't enough. So, there was an additional expense of $26.4 million.)

After the charge-offs, the combined remaining balance on these 2 credits, is $20.6 million. (So, in the worst case scenario, there would be another charge-off of $20.6 million down the road for these 2 credits.)

Are There More Time Bombs?

The short answer to the question is "yes". Unfortunately, there will always be bad loans; it's just the normal course of doing business for banks. That's why banks set aside an allowance for potential losses.

Here's an infographic illustrating OZK's RESG portfolio by loan-to-value ratios and origination dates as of the end of Q3. The South Carolina and North Carolina credits are the 2 credits that had charge-offs in Q3.

an infographic of OZK's RESG Portfolio By LTV and Origination Date Source: Management comments (Oct 2018) - p4

As you can see, there's another credit that was originated in 2008 that's a watch-rated credit because its loan-to-value ratio is about 97% and approaching 100%. The market is probably worried that this California credit may blow up too, but management assures that "the sales velocity and pricing trends for that project are stable to positive, and we project that all principal and interest on that credit will be fully repaid in accordance with the credit terms."

The watch-rated credit is a revolver for lot development. It has a total committed balance of $57.5 million and currently has an outstanding balance of about $49 million.

In the earnings call, management shed more light on the stable and positive trend of the project:

In the last 12 months, they've sold 16 lots and have four under contract to close between now and the end of the year. They've sold four townhomes out of the vertical inventory and have 6 more under contract expected to close before the end of the year. (Source: Q3 2018 earnings call transcript p3)

Management believes the RESG portfolio is still of excellent quality and that it's conservatively managed:

...the fourth highest leverage loan in the RESG portfolio is 73%, and every other loan in the RESG portfolio is less than 67% of appraised value. Properties are regularly and frequently appraised. So we feel very confident in the quality of the portfolio and the fact that there's not another shoe to drop or another issue in the portfolio beyond the substandard and watch credit. (Source: Q3 2018 earnings call transcript p2)

...even though the portfolio is a lot bigger, we'll probably have a similar volume of losses over the next 15 years. We will occasionally, in a quarter here and there, in a year here and there, have a loss on the RESG portfolio. But we're not changing our business model at all because we believe it is very, very sound and very, very conservative. So it's business as usual for us, and we still are originating loans. (Source: Q3 2018 earnings call transcript p4)

Were the Charge-Offs Really That Bad?

As shown below, in RESG’s roughly 15-year history, OZK has only incurred losses on 5 credits, whereas, in recent years, at any point in time, there have been 300 to 400 credits in the portfolio. The incurred losses resulted in a weighted average annual net charge-off ratio of 0.20% for the RESG portfolio.

OZK's RESG portfolio 15-year net charge-off table Source: Management comments (Oct 2018) - p4

OZK's annualized net charge-off ratio for non-purchased loans was 1.32% for Q3 2018 compared to 0.08% for Q3 2017, and it was 0.49% for the first 9 months of 2018 compared to 0.06% for the first 9 months of 2017.

The bank’s annualized net charge-off ratio for all loans was 1.14% for Q3 2018 compared to 0.09% for Q3 2017, and it was 0.43% for the first 9 months of 2018 compared to 0.08% for the first 9 months of 2017.

It's true that there was a spike in charge-offs in Q3. However, over a period of 9 months, it doesn't look so bad. Moreover, as shown below, OZK has a track record of charge-off ratios that tend to be below that of the industry.

OZK net charge-off ratios vs. industry's in a graph Source: Management comments (Oct 2018) - p5

Other Risks

In Q4, OZK expects near-zero or even negative growth in non-purchased loans because of accelerated RESG loan repayments that followed strong RESG loan repayments in Q2 and Q3.

OZK RESG loan repayments 2016-2018 Source: Management comments (Oct 2018) - p15

Combined with accelerated loan repayments, RESG loan originations have been relatively slow this year thus far, though there was somewhat of a rebound in Q3.

OZK RESG loan originations 2016-2018 Source: Management comments (Oct 2018) - p15

Management anticipates 2019 non-purchased loan growth to improve.

The bank changed its name to reflect that it has evolved from an Arkansas community bank into a larger regional bank that has national lending businesses. OZK's recent net margin was about 41%, which was 1.8 times that of the industry's average.

OZK's recent net margin compared to peers Source: Thomson Reuters [TSX:TRI](TRI)

As OZK expands into new markets and competes with existing players that already operate in those markets, we may see margin compressions for OZK.

Investor Takeaway

In the short run, there will likely be increased volatility around OZK stock. There could be a relief rally or the emotion of fear could continue to dominate. In the long run, this could be the buying opportunity for investors to buy a top-performing bank, as it trades at recession-level cheap multiples.

Disclaimer: This article consists of my opinions and is for educational purposes only. Please do your own research and due diligence and consult a financial advisor and or tax professional if necessary before making any investment decisions.

Disclosure: I am/we are long OZK. 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.