Earnings of First Republic Bank (FRC) are likely to jump this year on the back of strong loan growth. The company’s loan portfolio has benefited from the Millennial strategy targeting first-time homebuyers in suburban markets. The strong growth momentum from this targeted strategy will likely continue to bear fruit this year. Further, the provision expense will likely decline because First Republic has already built up a large level of loan loss reserves. Meanwhile, the net interest margin will likely remain under pressure because of a lagged impact of last year's interest rate cuts. Overall, I'm expecting First Republic to report earnings of around $6.53 per share in 2021, up 12% year-over-year. Valuation analysis shows that First Republic is quite overvalued in the market. Due to the combination of overvaluation and a strong earnings outlook, I'm adopting a neutral rating on the stock.
Loan Growth Momentum to Continue this Year
First Republic’s loan portfolio has grown strongly in the last few years. This momentum will likely continue into 2021 due to the economic reopening and relatively low interest rates. Further, the management mentioned in the fourth quarter's conference call that it is focusing on next-generation clients by offering them targeted products. First Republic’s Millennial strategy is focused on first-time homebuyers in the suburbs. For this purpose, the management has recently invested heavily in digital and mobile platforms. The management expects loan growth for 2021 to be in the mid-teens range, as mentioned in the conference call.
In my opinion, the management may fall short of its ambitious target. First Republic is focused on single-family residential and home equity lines of credit. These loan segments made up 57% of total loans at the end of December last year, as mentioned in the investor presentation for March. Demand for residential loans may dampen in the year ahead because home prices have recently surged due to supply constraints. The following chart shows the recent hike in the home price index.
Further, the 15-year mortgage rate has started increasing, which will dampen the demand for residential mortgages.
Moreover, the rise in inflation creates the risk of a hike in interest rates. The following chart shows the recent inflation rate trend.
Considering the factors mentioned above, I'm expecting the loan portfolio to increase by 12.6% by the end of 2021 from the end of 2020. I'm expecting the other balance sheet items to increase in tandem with loan growth. The following table shows my balance sheet estimates.
Lagged Impact of Rate Cuts to Limit Net Interest Income Growth
As mentioned in the presentation, the management’s interest-rate sensitivity analysis shows that the impact of interest rate changes on net interest income is greater in the second year of the rate cuts. The following table shows the results of the management’s sensitivity analysis.
The lagged impact of interest rate changes on net interest income is attributable to the loan portfolio mix, which is tilted towards fixed-rate loans with relatively long maturity. Moreover, First Republic’s deposit mix is concentrated in low costing and variable-rate transaction accounts. Certificates of Deposits made up only 8% of total deposits at the end of last year, while the rest of the deposits were made up of checking, savings, and money market deposits. As a result, the deposit cost was only 11 basis points for the fourth quarter of 2020, as mentioned in the presentation. Consequently, there is limited room for the deposit cost to decline.
The management mentioned in the conference call that it expects the net interest margin (“NIM”) to remain in the range of 2.65% to 2.75%, as opposed to the NIM of 2.72% for 2020. Considering the factors mentioned above and management's guidance, I'm expecting the NIM in 2021 to be 3 basis points below the average NIM for 2020.
Relatively High Allowances to Reduce Provisioning Charge for 2021
The provision expense will likely decline in 2021 relative to 2020 mostly because of First Republic’s high level of loan loss reserves. Allowances made up 0.56% of total loans at the end of December. In comparison, the company averaged net charge-offs of only 0.05% of loans in the last 21 years, as mentioned in the presentation. The highest level of net charge-offs, of 0.4%, were reported in 2009. Due to the allowance level and the average charge-offs, I believe it is likely that the existing allowances will easily cover pandemic-driven impairments in the year ahead.
Further, the credit risk appears to be at a manageable level. As mentioned in the fourth quarter’s earnings release, modifications made up only 1.1% of total loans at the end of December. Further, high-risk industries like retail, hotel, and restaurants made up only 2.2% of total loans.
Considering the factors mentioned above, I'm expecting the provision expense to decline to $140 million in 2021, down from $157 million in 2020.
Expecting Earnings of $6.53 per Share
The loan growth will likely be the biggest driver of an increase in earnings this year. Further, a decline in provision expense will likely boost the bottom line. On the other hand, pressure on the net interest margin will likely limit the earnings growth. Overall, I'm expecting the company to report earnings of $6.53 per share in 2021, up from $5.81 per share in 2020. The following table shows my income statement estimates.
Actual earnings may differ materially from estimates because of the risks and uncertainties related to the COVID-19 pandemic and new variants. Further, the future corporate tax rate is uncertain. To be conservative, I have assumed a tax rate of 28% in my earnings estimates for the second half of 2021.
First Republic Appears Overvalued
I’m using the historical price-to-tangible book multiple (“P/TB”) to value First Republic. The stock has traded at an average P/TB ratio of 2.10 in the past, as shown below.
Multiplying the average P/TB multiple with the forecast tangible book value per share of $61.2 gives a target price of $128.3 for the end of 2021. This price target implies a 23% downside from the April 5 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.
To support my investment thesis, I’m also using the price-to-earnings multiple (“P/E”) to value First Republic. The stock has traded at an average P/E ratio of around 19.8x in the past, as shown below.
Multiplying the average P/E multiple with the forecast earnings per share of $6.53 gives a target price of $129.4 for the end of 2021. This price target implies a 22.7% downside from the April 5 closing price. The following table shows the sensitivity of the target price to the P/E ratio.
Moreover, First Republic offers a low dividend yield of 0.5%.
The significant price downside warrants a bearish rating. However, due to the strong earnings growth potential, I believe a bearish rating is inappropriate for the company. As a result, I’m adopting a neutral rating on First Republic Bank.