When the biggest bearish argument you can come up with is "I'm not sure how long the bank can continue to grow earnings at a double-digit clip", you know you're looking at a pretty good bank. Such is the case with First Republic (FRC), and I continue to believe this high net worth-focused lender as a long run of exceptional growth ahead of it, as the company continues to benefit from a strong networking effect and very strong underwriting.
Valuation is difficult. By conventional approaches, First Republic looks quite expensive, but then this is not a conventional bank. While metrics like ROTCE can help separate winners and losers when growth rates are similar, First Republic's growth is well beyond "exceptional" and conventional metrics just don't work as well here. Bank investors have historically been willing to pay robust premiums for banks with outsized revenue, earnings, and tangible book growth, and I believe First Republic is well-placed to continue doing just that.
Another Strong Quarter, And Growth Is Really Standing Out
First Republic saw the same lackluster spread performance as other banks this quarter and likewise saw some pressure on operating leverage, but this bank once again broke from the pack with its strong loan growth. Ironically, First Republic's core EPS beat wasn't as large as many larger banks ($0.12/share, or about 7%) as reserve releases aren't much of a driver here relative to those large banks.
Revenue beat expectations by about 4%, growing 34% year over year and 8% sequentially to $1.2B. Net interest income rose 27% YOY and 7% QOQ (to $B), but only beat by about 2%, as net interest margin (up 1bp to 2.68%) was about 2bp light of expectations.
As has been the case for several banks so far, non-interest income was a source of strength. Fee income rose 72% YOY and 16% QOQ, driven in large part by the 15% sequential growth in wealth management fees, and beat expectations by about 15%.
Operating expenses rose 34% YOY and 6% QOQ, exceeding expectations by 4%. The efficiency ratio was about 40bp better than expected, though, and the overage was driven by compensation expense largely tied to the revenue outperformance. While bank stock analysts and investors always want more operating leverage, I think this qualifies as a good problem to have for First Republic, and skimping on compensation wouldn't be wise given the intense competition for revenue-generating employees right now.
Pre-provision profits rose 34% YOY and 13% QOQ, beating expectations by about 5%. I haven't yet seen the earnings from SVB Financial (SIVB) or other high-growth peers, but I don't think I'm going out on a limb saying that First Republic's PPOP growth will come out of the quarter looking excellent on a relative basis.
The Growth Engine Is Still In High Gear
In a quarter where most banks are still seeing disappointing and lackluster loan growth, First Republic posted its strongest-ever quarter for originations. Management has pointed to some challenges to loan growth on the horizon, including slowing refi activity and housing supply limitations, but loan growth continues to be extremely good here.
Loans rose 23% YOY and 5% QOQ on an average balance basis, with 7% sequential growth in single-family loans, 3% growth in multifamily loans (well above supply growth), and 4% growth in business lending. While capital call lending line utilization dipped some (from 40% to 36%), it's still not at a bad level, and an improving economy should support ongoing demand for capital call lending.
On the deposit side, average deposits rose 40% YOY and 8% QOQ, and the loan/deposit ratio remains somewhat tight at 90% (or 91% using end of period balances). Given the loan growth outlook, I would expect First Republic management to continue to look to raise capital from time to time in the market - the company raised around $335M in March of this year, and has a recent track record of one or two small offerings a year. While I can appreciate that some investors may resent this dilution, I think it's actually a reasonable strategic decision, and I wouldn't prefer to see First Republic rely more on higher-cost wholesale funding.
Going beyond the numbers, the core of First Republic's growth engine is in strong shape, if not getting stronger. Private banking (banking to high net worth individuals) is very much a relationship and customer satisfaction business, and First Republic's satisfaction scores remain outstanding. This appears to be leading to strong networking effects, with existing clients not only doing more business with the bank, but referring more of their friends and colleagues to the bank.
On top of that, the wealth management business continues to offer growth potential. Only around 10% of the bank's current banking clients use First Republic's wealth management services. While there will always be some limitations on this - HNW individuals have a lot of options for wealth management services - I do see this has an area that can still grow, and First Republic continues to hire to support that growth.
The Outlook
With around 5% share of private banking business in its currently-served markets, I don't believe First Republic has to worry much yet at this point about its growth runway. In addition to gaining share in existing markets, there are still several meaningful geographic markets where First Republic doesn't have much presence today, including Chicago, Dallas, Houston, and Miami.
And while it's true that First Republic addresses attractive markets that are seeing more competitive entries, it's tough to break up service-driven relationships, particularly when newer entrants (like larger super-regionals/national banks) aren't really geared towards high-touch service.
Given stronger lending trends than I expected, as well as improving trends in the economy, since my last update, I've meaningfully raised my earnings growth expectations, boosting my expected five-year growth rate to over 20%. Long term, I think mid-to-high teens core earnings growth is possible.
Valuing that growth is challenging. Discounting core earnings works well enough, but given how leveraged banks are, even small changes to input assumptions in the out years leads to big changes in the output, and I'm not going to pretend that I have a crystal ball where 2030 interest rates are concerned. Shorter-term metrics like ROTCE-driven P/TBV aren't very useful, as they don't work well for high-growth bank stocks.
The Bottom Line
I'm not exactly trying to say "ignore the valuation and just buy", but I am saying that the markets consistently pay up for banks that can deliver well above-average revenue, earnings, and tangible book value growth, and I do believe that First Republic is absolutely poised to that for the next three to five years, and likely the next decade. For investors who can understand and accept the risks that even modest-looking shortfalls in growth will be punished harshly in the short term, this is a high-growth bank worth consideration for investors who want financials with strong growth credentials.
