- 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.
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.
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