South Plains: Coronavirus And Permian Oil Bust Could Cripple This Texas Bank

Summary

• South Plains Financial is a Lubbock, Texas-based bank that completed its IPO in 2019.
• South Plains has many potentially problematic assets on the balance sheet including energy loans, commercial real estate lending, and auto loans.
• As a new IPO with minimal trading volume, I believe investors haven't discovered SPFI stock yet.
• I expect shares to trade at a substantial discount to book value, which will result in a single digit share price.
• This idea was discussed in more depth with members of my private investing community, Ian's Insider Corner. Get started today »

I've been digging through community and regional banks recently. The sector has gotten walloped, with the median bank falling around 35% since February. In general, that makes sense. A sudden economic shock is going to cause significant lending losses for most banks, regardless of their geography or particular lines of business.

That said, this crisis is going to hit some banks much harder than others. Over the past quarter, however, many people have simply dumped their regional banking stocks indiscriminately, making little distinction between the stronger and weaker names. This offers up strong buying opportunities for the good banks, which I have focused on - see my case for Northrim Bank (NRIM).

It also creates great set-ups on the short side as well. There are some banks that will be hit far harder than others as a result of this economic mess. In South Plains Financial (NASDAQ:SPFI), we have a fantastic example.

Source

South Plains is based in western Texas, lends to energy companies, has worrying exposure to vehicle loans, and is significantly involved in construction lending as well. These would be risky things to be involved in even during a garden-variety economic slowdown. And this storm could be a massive blow. At best, South Plains is likely to take a major earnings hit. And many potential downside economic scenarios could see the bank face existential crisis; most of Texas' largest banks failed outright in the 1980s energy bust.

I've been looking at this bank for a couple months now. After selling off in March, the stock has settled into a trading range around $12.50 recently, with a slight uptick this week:

Data by YCharts

At this point, South Plains is trading for just a few bucks less than it did last fall, long before there was any sign of the coronavirus, or that oil prices were heading to $30/barrel. Even if you assume the virus' impact is relatively benign on the banking sector, crashing oil in and of itself is an economic tornado barreling down on the cities and towns in West Texas where this bank operates.

South Plains' Story

South Plains is a regional bank of modest size hailing from Lubbock, Texas. By my count, there are around nine publicly-traded Texas-based banks with at least $10 billion in assets. By comparison, South Plains' $3.2 billion of assets makes it a smaller player. However it has branches in several major Texas cities in addition to its primary markets of Lubbock and the nearby Permian Basin cities of Midland and Odessa. It also has several branches in New Mexico. So while it's not huge, it's far from the stereotypical sleepy small town bank either; South Plains has a considerable asset base and geographical footprint.

Notably, unlike many regional banks, South Plains has few residential loans - it's instead highly geared to commercial real estate lending. As a recent IPO, it's also embarked on an M&A-based growth strategy that differentiates it from many of its peers.

To that point, South Plains Financial went public on May 9th last year:

Source: The Nasdaq

However, the celebratory mood of the successful IPO has quickly faded. After rallying last fall, shares have now dropped back below their IPO price:

Data by YCharts

And shares should probably be a lot lower. In fact, I suspect the reason there is still an opportunity here is precisely because this is a recent IPO, and very few people are tracking the bank yet. Trading volume averages just 25,000 shares per day, and the stock has received virtually no attention on social media, Seeking Alpha, or other popular investing websites since the IPO concluded. Look at short-term charts and it's clear that the stock is highly illiquid, even small orders move the share price around significantly.

All that said, just one big holder liquidating, or energy bears discovering the stock could send shares tumbling into the single digits. South Plains comes with several of the same risk factors as fellow Texas energy-lending outfit Cadence Bancorporation (CADE) - a stock I profiled recently that was down 77% from its highs. In fact, South Plains even has some additional risks to take into account as well. As such, this performance gap could narrow considerably in coming weeks:

Data by YCharts

West Texas State Bank: A Scary Acquisition

If you were designing a bank that would be poorly-suited for the current operating environment, it'd probably look a lot like South Plains. The bank is centered around key oil-producing regions of the state. On top of that, they doubled-down on energy last year, using capital from their IPO to acquire West Texas State Bank, which was headquartered in the Permian Basin city of Odessa.

In their presentation about the purchase, South Plains specifically highlighted the "attractive" opportunity to grow within the Permian Basin, adding much more exposure to oil-driven cities such as Midland and Odessa.

Source

As South Plains' presentation puts it, the Permian is the "Heart of American Oil Country". As recently as 2018, that was a compelling feature, as the Permian enjoyed massive job growth and related commercial and construction projects. However, the advent of $30 oil is absolutely decimating the Permian Basin. Oil production growth will roll over soon, taking many jobs and commercial opportunities with it. And that's even before you get to coronavirus impact, which is hitting banks with its own unprecedented shocks.

In West Texas, South Plains added another bank with an unorthodox lending profile to its already somewhat atypical loan mix:

One thing jumps out from the start: West Texas State Bank had essentially no home mortgage loans - residential real estate made up less than 4% of their loan book. By contrast, the bank was heavily-involved in commercial real estate, with more than 45% of its loan book there. Needless to say, commercial real estate is a huge question mark lately; look at the absolute collapses of retail and office REIT share prices this past quarter if you need more evidence of that. Needless to say, owning the mortgages on those properties in Texas' oil center during an energy collapse isn't exactly ideal.

On top of that, they had 17% of the loan book in construction loans. As you can imagine, these are now potentially in grave danger. What are the odds of most construction projects producing their anticipated returns in an oil-fueled economy when the price of oil implodes? Read articles such as From Boom To Bust: Permian Shale Towns Face Exodus to get a taste of what is coming down the line. And keep in mind that the article was written in December when oil was still around $50 and coronavirus hadn't come to the U.S. yet:

Perhaps it’s not evident to anyone who is not an oil-worker living in America’s biggest shale towns, but signs of the shale slowdown predicted by many analysts, and the EIA itself, are already surfacing in the form of vacant hotels, a dip in home prices, a noticeable reduction in overtime hours for oil workers, and a change in standards for hiring.

The commercial and industrial loans are more of a mixed bag - some industries will be fine if the local economy goes into a depression; but others will take a massive blow. Notably, South Plains focuses on lending to small businesses. That is, of course, the most vulnerable type of business at the moment given the coronavirus outbreak. As South Plains warned in its 10-K:

Our business development and marketing strategies primarily result in us serving the banking and financial services needs of small- to medium-sized businesses. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities, frequently have smaller market shares than their competition, [and] may be more vulnerable to economic downturns.

South Plains' loan book was already fairly risky even prior to the West Texas merger, as it had heavy exposure to consumer lending and construction loans of its own along with only a modest position in residential real estate. Add West Texas to the mix, and the overall company has gotten more exposed to construction lending and oil region-lending at the worst possible time.

Risk Factors Abound

As I mentioned above, I expect the bank's commercial real estate loans to be a substantial stress point going forward. Retailers, restaurants and other commercial enterprises are in a terrible position given the coronavirus. I expect many places to prune back their locations as a result, and for franchisee-model chains, weaker franchise operators may fail outright.

Which areas will be first to get cut back? Areas where the local economy isn't going to bounce back anytime soon. The Permian was already heading into a bust before the coronavirus hit. A lot of the stores and restaurants that are closed now in West Texas may never reopen, or if they do, expect major rent concessions. That in turn, probably leaves South Plains exposed. As their 10-K notes:

[C]ommercial loans typically are made on the basis of the borrowers’ ability to make repayment from the cash flow of the commercial venture. If the cash flow from business operations is reduced, the borrowers’ ability to repay the loan may be impaired. As a result of the larger average size of each commercial loan as compared with other loans such as residential loans, as well as the collateral which is generally less readily marketable, losses incurred on a small number of commercial loans could have a material adverse impact on our financial condition and results of operations.

Obviously cash flows have been reduced thanks to the virus (stopped altogether in many cases). And the result is worth considering as well. As the 10-K states, commercial property is more problematic than residential property. If you foreclose on a house, it's not hard to sell it - put it up for auction and you'll usually attract a decent number of potential bidders; it's a liquid market.

If you foreclose on a mall, a shopping center, an energy company's office building, or so on, who is the obvious buyer? It's not so clear, is it? You're likely to have to sit on the property longer and accept a bigger discount to get it off your books. Also, as the bank noted, commercial loans tend to be larger - you're not going to lose a lot of money selling a foreclosed house at a loss. Try to resell a shopping center, for example, into a lousy market and you could lose millions in one transaction. That's an issue - since, as we'll discuss below - the bank's entire loan loss allowance as of year-end 2019 was just $24 million. The bank's non owner-occupied commercial real estate lending portfolio alone, by contrast, constitutes $732 million of its loan book.

South Plains has a relatively modest energy loan book, weighing in at just under 3% overall. However, there are several troubling signs here - for example, their energy lending doubled last year even as other banks pulled back. The bank plans to lend even more to this sector. Additionally, the bank acknowledges that it may be contractually forced to extend more credit to firms as energy prices slump:

Although our energy loan portfolio is relatively small, the energy industry is a significant sector in our markets in Texas, and we intend to increase our energy lending. A downturn or lack of growth in the energy industry and energy-related business, including sustained low oil prices or the failure of oil prices to rise in the future, could adversely affect our intention to increase our energy lending, and our business, financial condition and results of operations.

[...] As of December 31, 2019, our energy loans, which include loans to exploration and production companies, midstream companies and oilfield service companies, totaled $61.3 million, or 2.9% of gross loans held for investment, as compared to $30.9 million, or 1.6% of gross loans held for investment as of December 31, 2018. In addition to our direct exposure to energy loans, we also have indirect exposure to energy prices, as some of our non-energy customers’ businesses are directly affected by volatility with the oil and gas industry and energy prices. Prolonged or further pricing pressure on oil and gas could lead to increased credit stress in our energy portfolio, increased losses associated with our energy portfolio, increased utilization of our contractual obligations to extend credit and weaker demand for energy lending.

As if that weren't enough, then we've got the bank's consumer loans, which include a large piece of auto lending business. I probably don't need to say much here. In the middle of coronavirus, are people that rely on energy sector jobs going to keep paying their car payments on time? Auto loans were potentially heading for trouble even in 2019, in 2020, they look like a fiasco for banks. Here are South Plains' comments from their 10-K:

At December 31, 2019, $211.3 million, or 9.9% of our total loan portfolio, consisted of indirect dealer loans, originated through automobile dealers for the purchase of new or used automobiles, as well as recreational vehicles, boats, and personal watercraft [...] Auto loans are inherently risky as they are often secured by assets that may be difficult to locate and can depreciate rapidly.

To give some sense of scale, the bank's total market cap at this point is $230 million, and here we've got $211 million of outstanding vehicle loans heading into what looks like an economic collapse, at least within the Permian. I'd also note that failures within the rental car industry, such as the Hertz (HTZ) bankruptcy may put significant further strain on the car market. In any case, this exposure is not ideal if you own SPFI stock.

Finally, I should note that the bank has a major agricultural lending franchise as well; it had 6% of its loan book in farming-based credits as of the last 10-K. As far as I know, the coronavirus crisis isn't having a particularly-outsized hit on farming products. That said, there is some talk about a shortage of migrant workers to harvest crops, and also delays in exporting food as a result of global supply chain issues. While this isn't my biggest concern about the bank, it is something that differentiates it from other regional banks and is worth taking into consideration.

Expect Loan Loss Allowances To Increase

With all these concerns in the air, you might expect that South Plains would be substantially increasing its loan loss provisions ahead of a potential downturn in their loan book's performance. But, as of the latest 10-K, this has not happened to a meaningful degree:

Accordingly, we maintain an allowance for loan losses that represents management’s judgment of probable losses and risks inherent in our loan portfolio. At December 31, 2019, we had on a consolidated basis an allowance for loan losses of $24.2 million based on our overall evaluation of the risks of our loan portfolio [...] The allowance for loan losses reflected an increase of $1.1 million over our allowance as of December 31, 2018.

Considering that the whole loan book clocks in at $2.1 billion, they had just 1% of it covered with loan loss allowances and they barely bumped this figure last year despite loan growth and a downturn in the Permian region. In Q1 2020, they provisioned another $6 million, which increased their allowance for loan losses by 25 bps to 1.38%. I'd argue this is still quite low given the types of loans that make up South Plains' balance sheet - and the allowance figure is only up from 1.2% in the same quarter of 2019. It seems plausible that the combined impact of the coronavirus and slumping Permian oil activity will cause the bank to need to take more loan allowances in further quarters.

These loan loss reserves are also interesting in the context of the bank's largest lending commitments - even one or two of these relationships going sour could blow through much of the bank's loan loss provisions:

As of December 31, 2019, our 20 largest borrowing relationships ranged from approximately $14.1 million to $34.0 million (including unfunded commitments) and totaled approximately $430.1 million in total commitments (representing, in the aggregate, 16.8% of our total outstanding commitments as of December 31, 2019).

We've got a portfolio filled to the brim with seemingly higher-risk loans in a local economy that is rapidly heading toward bust. And now the national economy has shut down for a prolonged period as well. Will their current loan allowance be nearly enough? Keep in mind that loan loss allowances come out of earnings; if the bank provisions more, earnings will decline. The bank has run a higher-risk, higher net interest margin portfolio and up to this point done fairly well with it. Credit to management for that. But things could turn south in a hurry; this is precisely the sort of bank you don't want to value based on trailing earnings at this time.

As if the bank's lending portfolio wasn't interesting enough on its own, there's another question mark for South Plains Financial. That is the bank's former Chief Credit Officer, Kevin Bass, left the bank last September. According to the bank's press release, he left the firm to start his own business within the energy sector. Of course, there are many reasons people make career moves. Still it's worth thinking about why a bank's chief credit officer would leave at that particular moment when the bank had just successfully completed its IPO and seemed to be flying high.

Comparing This Texas Bust To The 1980s Collapse

The last time Texas had a massive bust, nearly all the state's major banks failed. This happened in the mid-to-late 1980s as the price of oil collapsed. Texas had enjoyed a huge speculative boom tied to the 1970s energy boom. This reversed itself, not only wiping out over-leveraged energy companies, but also crushing the housing and office markets in Texas as well. Of Texas' then 10-largest banks, only Cullen/Frost (CFR) survived the downturn as an independent entity. 100 of the Texas' then 1,400 banks failed in just the year 1988 alone. Even Cullen/Frost, though it survived, earned very little in profits for many years, finally returning to growth in 1993.

Texas shouldn't see as bad of a downturn now as the mid-to-late 1980s. For one, the state's economy is now much more diversified with things such as a large tech sector having developed in the Austin area, for example. And asset prices didn't really inflate in Texas this time around like they did heading into the 1980s bust. Less of a boom on the way up makes for a more manageable downside.

Additionally, oil already crashed back in 2014-16, causing banks to re-evaluate their energy exposures and in many cases take down risk. Oil recovered strongly enough to prevent a wholesale liquidation of energy-related assets following the 2015 plunge.

That said, South Plains still faces substantial risk. For one, it's been aggressively moving into energy as other Texas banks have been on the retreat. South Plains specifically bought a Permian bank for growth in 2019, long past the time when that was such a compelling idea. And even as of its latest annual report, it still wants to grow its energy lending book in the face of moribund oil and gas pricing.

More broadly on the Permian, keep in mind that even as oil prices crashed through the mid-2010s, the Permian remained a hotspot.

Source: EIA March 2020 report

As you can see, Permian oil and gas production continued to rise slightly through the 2015-16 energy slump, and went into an even faster boom starting in mid-2017. Rig counts across the region surged back to prior levels while improved efficiency led to major output gains. At $50 or $60 a barrel, shale oil was competitive, or at least had a fighting chance.

At $30, however, most wells will be significantly underwater, and producers are announcing major CAPEX cuts. This, in turn, will turn to job losses, people leaving the region, construction projects getting canceled, and all sorts of other second-order effects that can crush a local bank's assets. The drop from $100 to $50 oil didn't kill the Permian; in fact, it gained strength as other lesser oil regions scaled back growth first. This second plunge in oil, if sustained, may crush the Permian and lead to a massive reversal of recent prosperity in the region.

All that to say that while Texas, the state, isn't likely to see banking conditions sour nearly as much as the 1980s, the generally nonchalant attitude toward this energy bust may be misplaced. Particularly for banks that are actively involved in energy lending and have a major presence in the Permian, expect major trouble ahead.

Short Sellers Are Unaware of South Plains

Another notable factor for a short position in South Plains Financial is that short sellers are seemingly unaware of it at this point. As of the Nasdaq's April 30th data, just 60,753 shares of SPFI are being sold short at the moment, representing less than $1 million of South Plains stock.

That's a tiny amount, both in an absolute sense, and also in comparison to the company's $230 million market cap. This gives the trade two benefits: One, there are essentially no short sellers to squeeze out here. Two, as South Plains' risks become more apparent to the market, the stock could quickly move toward fair value.

Cadence Bancorporation, by contrast, has 6% of its float sold short. BOK Financial aka Bank of Oklahoma (BOKF), another energy-heavy regional bank, has 9% of its float shorted. SPFI stock, with less than 1% of the float shorted, is a clear outlier among the energy-exposed banks. Once more market participants start asking themselves what a bank with substantial energy, construction, commercial real estate, and vehicle lending is worth, there could be significant price discovery.

Short South Plains: What Could Wrong?

There are several things that could go wrong with this short position in isolation. One, as a small bank, it's always a potential acquisition target. Given the bank's positioning, it wouldn't shock me if some larger Texas bank might buy it, particularly if the share price becomes distressed. The bank is seemingly inefficient, having high salary costs as compared to its asset base. As a result, it earns generally mediocre returns on its assets and equities despite having a more aggressive loan book that should, in theory, result in fat profitability ratios during good times. A larger bank that could put up with major potential loan losses in the near-term could buy the bank and boost ongoing profitability once the current crisis passes.

Second, the Fed (or treasury) may take specific measures to try to help out regional and community banks. I don't have anything specific in mind that would greatly improve South Plains' outlook, but the Fed's recent actions give the perception that they're prepared to do just about anything. If the Fed starts buying low-quality credits backed by energy industry assets, for example, it could give South Plains and other such banks a way to offload some of their worst assets without taking major losses.

Third, oil might bounce back sharply. There's all sorts of rumors of OPEC deals and who knows what else to try to bolster oil prices. Given the coronavirus and the collapse of oil demand for the foreseeable future, it's hard to imagine oil moving beyond $50 or so within the next 12 months or so. But never say never with commodity prices.

South Plains Bank: Numerous Catalysts To Trigger Massive Downside

South Plains stock has outperformed most of its regional banking peers, and it has particularly outshined other Texas banks during this bear market. And that, frankly, makes little sense. With the sort of loan book South Plains has, you'd expect it to be closer to Cadence (down 70% over the past year) rather than in the top quadrant of performers.

With its exposure to commercial real estate, auto loans, energy loans, and the Permian Basin in general, South Plains is in a perilous position heading into the one-two punch of coronavirus and the collapse in oil prices. The loss of its Chief Credit Officer last year is also noteworthy. Just the recognition of these risk factors alone could easily send the stock into the single digits. Throw in any specific bad news, such as major loans losses, a dividend reduction, or the like, and South Plains could end up falling sharply, like Cadence and other Texas banks have done.

At the end of the day, South Plains is fundamentally not a great banking franchise. Its efficiency ratio in particular has been quite high, running above 75% in recent years (though it dropped to 70% following the West State merger). The efficiency ratio is a bank's operating costs divided by net revenues and is a key barometer of how profitable a bank will be across a cycle. Generally 60% or lower is considered good and you can find superior operators at 50% or lower - 75%, by contrast, is poor.

This means that South Plains won't tend to be a particularly profitable franchise, even during good times let alone downturns unless they manage to cut costs substantially or grow enough to offset their larger cost base. They may be able to grow their way to a more sustainable cost structure. The West Texas merger appears to have made a significant improvement in their overall efficiency. And South Plains' CEO Curtis Griffith said in January that:

"While we still have more work to do to fully integrate [West Texas], we are now at a point where we can begin exploring additional M&A opportunities. M&A will continue to be an important growth driver for the Bank and we see a solid group of potential acquisition candidates across our core markets which would enable South Plains to increase the franchise value of the Bank for the benefit of all of our stakeholders.”

While the M&A window is theoretically open, given the economic standstill and plunging stock prices across the sector since January, I expect that M&A opportunities are now off the table for awhile. That's a problem for South Plains, as it's not a particularly compelling banking franchise on its own, and it's particularly levered to energy and the Permian Basin economy. At the time of its IPO in 2019, perhaps investors could maintain a bullish view on South Plains as an aggressive M&A consolidator in West Texas and New Mexico. It'd get its costs in line and enjoy rapid EPS growth.

But with the sharp downturn in economic conditions, growth is no longer on the menu, and South Plains stock is too expensive to justify its current franchise value even in a decent economy let alone the current mess.

Keep in mind that as of last quarter, the bank's tangible book value was around $16 per share. Thus, buyers are only getting a modest discount to tangible book - I'd argue that you can find countless banks around the country with more attractive prospects trading around 80% of book. For a Texas comparison, look at a regional competitor like Cadence, which now trades for just 47% of book value now. SPFI, at a similar discount would trade around $8.

Yet, to date, South Plain's stock has held up better than numerous other Texas and Oklahoma banks. Over the past year, South Plains has been better than most rivals, and far ahead of the weak names like Cadence and Texas Capital (NASDAQ:TCBI):

Data by YCharts

While there are risks to any individual short banking stock position, a good deal of it can be hedged by owning other regional banks, particularly one with an energy component. I own Alaska's Northrim, for example, as it has a proven track record of thriving despite previous energy busts. And operating in Alaska gives it access to a sheltered banking market with persistently high profit margins. NRIM stock also offers a far higher dividend yield than SPFI, making it attractive for the carry in a pair situation.

If you want an even more specific hedge, Cullen/Frost itself is a major player in both Texas and energy, and is also historically well-run. Over time, Cullen/Frost should produce much stronger full-cycle returns than South Plains, even assuming the latter avoids any sort of catastrophic fallout from the current economic crisis.

Analyst’s Disclosure: I am/we are short SPFI. 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.

I own shares of NRIM and CFR.

Comments

[The Millennial Investor]

Great read like always. Shorting is not my thing, but I still appreciate the pitch.

[David Stallard]

Good work, but the 8 largest banks in Texas failed in the late 1980s primarily due to commercial real estate loans. Yes, some took a hit on energy loans; however, the mortal damage was due to heavy concentration in speculative commercial real estate development loans, typically including inflated land costs & all interest carry, i.e., no risk to developer/borrower (& even land profits) when projects failed. I worked in FDIC LBI (Large Bank Investigations) in Dallas during that time period and did the financial autopsies on several of them, i.e., examining the largest losses causing insolvency ... almost all were CRE, not energy, loans.

[Ian Bezek]

Hey David, thanks for reading. As I noted in the article, only 3% of the loan book is energy directly. The bank is primarily in commercial lending. As you can understand, commercial real estate in oil-rich towns and cities is now a particularly risky asset given the one-two punch of the plunge in Permian activity and the coronavirus.

[David Stallard]

Yep, I agree.

[tech attorney]

Fascinating writeup, thanks Ian.