SVB Financial Looks Undervalued Relative To Its Unusually High Quality

Summary

• VC and private equity investment activity is likely to slow, and client companies are likely to slow expansion plans, but any slowdown in lending growth is likely to be brief.
• Asset sensitivity is a challenge and spreads are going to be under pressure as more deposits are directed into lower-yielding securities.
• Every cycle is different, but SVB's lending has historically looked and sounded more risky than the actual credit losses.
• A long-term core earnings growth rate in the mid-single-digits can support a substantially higher share price.

If you’re new to the banking sector, I’m not so sure SVB Financial (SIVB) is a good place to start. That’s not because SVB Financial is a bad bank (it’s far from that), but because it’s just so atypical of most bank companies. Instead of taking deposits from retail customers and smaller businesses and lending them out as mortgage, CRE, and “regular” business loans (typical “branch banking”), SVB Financial focuses on capital call loans to venture capital and private equity funds, as well as business loans to emerging/less-established companies in sectors like technology and health care.

While SVB Financial is a different sort of bank, I believe it has proven itself over the years and currently trades at a meaningful discount to fair value.

A Generally Healthy First Quarter

Like many banks, SVB came up a little short in fee income this quarter, but otherwise it was a very solid quarter on balance. Revenue was basically as expected, as slightly better net interest income offset weaker fee income, but lower expenses drove a nice double-digit beat at the pre-provision line. While higher provisioning erased that benefit, SVB Financial’s reserve position looks pretty good at this point.

Revenue rose 2% yoy and down 6% qoq by my methodology. Net interest income (FTE basis) rose 2% and fell 2% qoq, with a weaker net interest margin (3.12% vs. 3.81% a year ago and 3.26% last quarter) partly offset by stronger earning asset growth.

Fee income merits a discussion of methodology; some analysts (including myself) exclude investment securities gains and losses, others don’t. You can certainly argue this is an ongoing part of the income mix and I won’t really disagree, and likewise you can argue that volatile businesses like mortgage banking are typically included with most other banks. I should note, though, that management’s definition of “core” fee income excludes those.

By management’s definition, fee income rose 9% yoy and was flat qoq, while my version (which includes items like investment banking income that management excludes from core) saw 2% yoy growth and a 13% qoq decline. Everybody agrees, though, that client investment fees (down 2%/down 4.5%), forex fees (up 25% / up 12%), card fees (up 3% / down 12%), and service charges (up 18% / up 4%) are among the more prominent core fee income items.

Operating expenses rose 9% yoy and declined 13% on an adjusted basis, leading to a 4% yoy decline and flat sequential performance in pre-provision income (if you include security gains, that shifts to up 1% / up 15%). Tangible book value per share is a less controversial metric, and this grew 28% yoy and 10% qoq, beating expectations by around 3%.

Building Reserves, But Credit Experience Has Long Been Good

Like every other bank, SVB Financial management is building reserves in response to the downturn sparked by the Covid-19 outbreak. Management built reserves by $214 million ($191M if you look solely at Covid-19-driven changes), bringing its reserves to about 1.5% of loans.

That may sound low for a bank with exposures to what sounds like risky lending – lending to VCs, private equity funds, and early-stage companies, many of which haven’t seen a real recession. There are some important “buts” to consider.

A little more than half of the loan book is capital call loans. These are typically short-term loans made to venture capital or private equity funds to cover the gap between the fund making an investment and receiving capital from the fund’s investors. Investors typically have 30 to 90 days to pay, and the loans are repaid when the investors’ funds are received. While the collateral often isn’t very liquid (shares in the funds themselves, for instance), the yields are good and defaults are rare (investors don’t want to lose their stakes) – SVB has had zero loan losses in capital call loans since starting the business in the 90’s.

Another 10% or so of the loan book is in the private bank operations, and these are predominantly jumbo mortgages to wealthy individuals with low loan-to-value ratios (57% in Q1).

There certainly are riskier loans on the books, particularly the early-to-later-stage “investor dependent” loans, but SVB has now brought its reserves up to 4% to 7% of these loans (7% for the early-stage loans). I’d also note that most of the areas where SVB lends aren’t really especially Covid-19-sensitive (not much in the way of hotels, restaurants, and oil/gas here).

Looking at SVB’s history, NCO’s peaked at 3.3% in 2000 (the tech bubble collapse) and 2.6% in 2009 (the global financial crisis), and while I think SVB will likely need to add more to reserves given developments in the economy since the reserving decisions were made in late March, I believe the reserve position is okay. Likewise, the company’s capital position is strong, with a CET1 ratio over 10%, so adding more to reserves won’t really constrain the bank.

There Are Still Challenges, Though…

While I think SVB scores very high in quality metrics, there are still challenges ahead for this business.

This is an extremely asset-sensitive bank, and while management has been using derivatives (swaps and the like) to reduce that, the fact remains this is an asset-sensitive bank in a low-rate environment.

I’m also concerned about the prospect for weaker loan growth – though in this case, “weaker” likely means falling into the high-single-digits for a year or two and then resuming double-digit growth. New business formation always slows during a recession, and management has already noted slowing investment and exit activity on the VC/PE side, as well as liquidity-preserving steps among client companies.

With weaker loan growth, SVB will have to put more of its large deposit base into lower-yielding securities. The loan/deposit ratio is already at a very low sub-60% level, and with loans yielding 4.6% (Q1 average) versus securities yielding 2.5% (Q1 average) or 1.0%-1.1% (recent new purchases), that’s going to further pressure spreads despite the bank’s exceptionally low 0.24% deposit cost.

The Outlook

While SVB is going to see a sharp drop in core earnings this year, I expect the company to quickly return to double-digit earnings growth and continue to grow at a pace well above the average bank. Given the markets that SVB serves, I see no reason why mid-to-high single-digit long-term core earnings growth wouldn’t be possible, with a long-term ROE in the mid-to-high teens, though I would note that capital call lending is getting more crowded; it’s a significant market for First Republic (FRC), among others, and banks like Signature (OTCPK:SBNY) have poached from SVB in the past to build lending teams in this area.

The Bottom Line

Between discounted core earnings and an ROTCE-driven P/TBV approach, I believe SBV Financial is meaningfully undervalued – somewhere around 25% to 35%. Of course, as highly leveraged businesses, bank models are very sensitive to relatively small changes in assumptions, so drivers like a suddenly steeper yield curve (or a very low Fed Funds rate for a long time) make a big impact. That’s why I like using both a long-term earnings-based model and a shorter-term return-based model to triangulate fair values. Either way, I think this is a name for investors to consider with bank stock valuations generally down across the board.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Comments

[Bhughes7918]

cheap OPY and TMP

[Seaconservationist]

If you want to: go long all the companies without balance sheet or access to capital markets with little to no collateral; have a disproportionate and levered exposure to lumpy (>50% over 20 million) commercial loans (86% vs. JPM's 48%) and MBS (62% vs. JPM's 12%); and think non conforming Residential Jumbo Loans you keep on balance sheet in the bay area is a solid bet in this market, buy SIVB!!!

Perhaps the definition of Moral Hazard, p0nzi and violating volcker:
1) they take fdic insured deposits and speculate/lend to companies below junk-those that don't have access to the capital markets (MH), to help grow the deposit base;
2) they then offer capital introductions to the next round of investors who take them out of their original investments, oh and by the way, Funds, we will lend you the money to do so (P) and
3) they rarely make these loans without warrant coverage... ....a long dated option on a credit. they then MTM these warrants, but volcker doesn't allow banks to speculate (hold positions) for more than a set time period when taking FDIC insured deposits.

Capital Markets, let's wake up to the reality that this is a ticking time bomb: regulators, please don't make us bail them out, especially their vineyard consulting and capital business.

If you want a bargain bank at a low multiple with solid balancesheets and mgt; pls look at canadian, scandinavian and heck even argentine banks

[John Root]

Well, they have been highly successful doing what they have been doing for the last forty years. They easily survived the 2007-2009 financial crisis, so I have a feeling they will do the same here.
There have always been people who have avoided them because they felt like you do; those people have left a lot of money on the table by doing so.

[ding dong]

Fair points

[greendeath]

@Seaconservationist

So far it appears that the only time bomb bank investments have been other traditional banks for whom these rules were written. And they have low multiples for a reason. But hey maybe believe that you’ve been right and the market wrong for 2 or more investing lifetimes. Maybe if you never change your mind you think you’ve never been wrong.

[John Root]

If you like volatility, you will love SIVB.
A great company, though.

[Stephen Simpson]

Fair point

[ConservativeOutperformer]

Traded around its BV during the downturn. That would have been a great spot to pick up shares.... Good article about a good bank. As someone that works in the technology industry I'm a little too levered to the customers, but if we get down there again I'll nibble.

Good luck!

[Bhughes7918]

yes, but it ran already and is now fairly valued I think.
PCSB and OPY two smaller banks are much cheaper today.

[Stephen Simpson]

Fairly valued based on what?

[Godbless]

In my Calculation any price below 200 is still under valued for me

[Bhughes7918]

recent price movement alone since other banks in there space like avbh have not moved back up at all and do the same thing either avbh is forgotten or sivb is way ahead of itself. There are always comps for all kinds of banks even in their nich market, avbh is way way cheaper if you are right today about sivb, I would rather own something like PCSB or OPY that has not moved back up at all and are way below tangible book hence much less downside risk and the same upside I feel!